Why Is the Investment Appraisal Process so Important?

2257 Words Aug 23rd, 2010 10 Pages
A) Why is the investment appraisal process so important?

Capital Investment Appraisal is of fundamental importance because:

1. Large Amount of Company Resources: Involvement of large amount of company resources and efforts which will necessitate careful evaluation to be undertaken before a decision is reached.

2. Maximization of Shareholder wealth: Investment decision is linked with strategic and tactical business decisions and therefore need to achieve desired long-term objectives. The most usual objective being the maximization of shareholder wealth.

3. Difficult to Reserve: It can be very expensive and perplex to reserve an investment decision so caution need to be exercised in reaching the initial investment decision.
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It is expressed in time or years. It is normally defined as the period, usually expressed in years, which it takes the cash inflows from an investment project to equal the cast outflows.
There are three important criticisms of the payback period method. The first is clearly fundamental and relates to the fact that cash flows after the payback period are ignored. So it could be the case that whilst a project produces a large net cash flow (i.e., where cash inflows significantly exceed outflows), they are generated in the later part of the project and may be ignored as this is after the payback period. For example, in the case of project A and B in this question , project B was preferred because of its shorter payback period, but overall project A generates more cash inflows, totaling £2,10,000 as compared to only £2,00,000 in the case of project B. However, project A`s cash inflows were mainly earned in the later years.

The second criticism of the payback method is that it relates to the method not taking account of the time value of money, similarly to the ARR. However, it does not have value in situations where the useful life of the project is short and difficult to predict. Japanese firms, particularly in consumer electronics, use the payback method when evaluating new products since the product life cycle can be quite short and a new product can be made unexpectedly obsolete by changes in technology. For example, imagine we have…