Investment Appraisal: Techniques, Pros and Cons

This article discusses the techniques of investment appraisal, including Accounting Rate of Return, Payback Period, Net Present Value, and Internal Rate of Return. It explores the pros and cons of each method and highlights the importance of investment appraisal for businesses. The article also provides an analysis of investment appraisal results and their implications for decision-making.

Running Head: FINANCIAL AND MANAGEMENT ACCOUNTING
FINANCIAL AND MANAGEMENT ACCOUNTING
Name of the Student
Name of the University
Author Note

1FINANCIAL AND MANAGEMENT ACCOUNTING
Section 5
Investment Appraisal
It is the collection of the techniques that are used for identifying the investment’s
attractiveness. It is concerned with the evaluation of the investment proposal’s attractiveness
by using the methods such as net present value, internal rate of return, average rate of return
or the payback period. Therefore, investment appraisal forms the integral part of the capital
budgeting and it applies to the areas where returns is not easily quantifiable such as
marketing, personnel and training. Therefore, it is the process of planning that is used for
determining the long term investments of the organization such as new plants, new
machinery, research and development projects and so on that are worth funding of the cash
by the capitalization structure of the company. It is the process of allocations of the resources
for their majority of their capital or investments1.
Purpose
The investment appraisal’s purpose is for assessing the viability of the projects,
portfolio or programs decisions as well as the value that is generated by it. In the business
context, the most important objective of the investment objective is for placing the value on
the benefits for justifying the costs. There are most of the factors that forms the part of
appraisal, which includes financial, legal, environmental, social, operational and risks. The
most easily quantifiable approach is financial appraisal, however, it should only be applied to
the benefits, which produces financial results. It has the main objective for increasing the
value of the organization for their shareholders2.
Importance for the business
1 Baum, Andrew E., and Neil Crosby. Property investment appraisal. John Wiley & Sons, 2014.
2 Wnuk-Pel, Tomasz. "The practice and factors determining the selection of capital budgeting methods–evidence
from the field." Procedia-Social and Behavioral Sciences 156 (2014): 612-616.

2FINANCIAL AND MANAGEMENT ACCOUNTING
Considerations of starting the business, contemplating of the investments in the new
or the ongoing enterprise requires for informing the decision with the investments appraisal.
These types of appraisals is very important for various reasons. These types of investments
generally involves committing of the substantial resources. Moreover, these decisions
requires the understanding of feasibility of the both tactical and strategic objectives. Hence,
the understanding of the relative risks depends upon the analysis of the cash flows by using
the ranges of the probabilities such as various inflation rates3.
 General Feasibility: The general appraisal of the project is revealed by the capital
investment appraisal. Projected cash flows as well as projected quarterly or the annual
profits are included under this. It generally includes the analysis of net present value.
Hence, all of these gives the good idea for the probable project’s profitability both in
short and long-terms.
 Alternatives Possibilities: Every investments that is proposed does not exists without
the alternatives. Hence, investments appraisal should provide the review of the
alternatives investments as well as comparison between alternatives projects and the
proposed projects4.
 Financing: This aspects assesses the capital resources that helps in determine whether
the capital resources available makes the feasible investments or not.
 Authorization: Investment appraisal helps in describing the progress that are required
for moving the project from initial investments to the further steps for its further
formalities for required authorizations.
 Uncertainty: Projection of the discounted cash flows that occurs over the time period
requires assignment of the specific values to the inflation rates, regulatory costs of
3 Dyson, R. G., and R. H. Berry. "Capital investment appraisal." Developments in Operational Research:
Frontiers of Operational Research and Applied Systems Analysis(2014): 59.
4 Guerra, Maria Letizia, Carlo Alberto Magni, and Luciano Stefanini. "Interval and fuzzy average internal rate
of return for investment appraisal." Fuzzy Sets and Systems 257 (2014): 217-241.

3FINANCIAL AND MANAGEMENT ACCOUNTING
future as well as other factors that is in reality is uncertain. These variables are
included in investment appraisal by the assignment of probabilities to the outcome
ranges. This techniques helps in providing the realistic model, which includes
assessment of risk.
 Strategic Fit: The relative financial feasibility is not only demonstrated by the
investment appraisal but it provides the scope for the assessment of how well the
specific project fits into the strategic plans of the company5.
Techniques of Investment Appraisal
 Accounting Rate of Return: It is the technique that is used for measuring the
expected profit from the investment. It helps in expressing the net accounting profit
that arises from the investment as the percentage of capital investment that is also
referred as return on investment.
 Payback Period: It is one of the simplest techniques among all the techniques of the
investment appraisal as it helps in stating the total time taken by the project for
generating sufficient level of cash flow for covering the project’s initial costs6.
 Net Present Value: It is considered to be the most common method. It is the sum of
the discounted future outflow and inflow that is related to the project. Under this
method, weighted average cost of capital is discounting factors for the future cash-
flows. This method takes into account all cash flows that arises as the result of the
project undertaking as well as discounting for finding the present value. The
significance of the positive NPV is the generation of the project that is higher than
5 Schlegel, Dennis, Franziska Frank, and Bernd Britzelmaier. "Investment decisions and capital budgeting
practices in German manufacturing companies." International Journal of Business and Globalisation 16.1
(2016): 66-78.
6 Alkaraan, Fadi. "Strategic investment decision-making perspectives." Advances in mergers and acquisitions.
Emerald Group Publishing Limited, 2015. 53-66.

4FINANCIAL AND MANAGEMENT ACCOUNTING
that of the costs of paying the financing of company leaving the increase in the wealth
of shareholders.
 Internal Rate of Return: It is the metric that is used in the capital budgeting for
estimating the profitability of the potential investments. It is the discount rate that
helps in making net present value of all the cash flows from that of the particular
project equal to zero. Hence, it is the measures of the rate of return of investment7.
Pros and Cons of the Techniques
Investment Appraisals
Methods
Pros Cons
Accounting Rate of Return  It is simple method
for understanding as
well as calculate.
 It allows for
availability of shares
option for employees
as an incentive.
 It fails for considering
the timings of the
cash flows.
 Time value of the
money is ignored by
the payback.
Payback Period  It is the simplest
method for
understanding.
 It provides the
estimation that is
based on the cash
 It does not takes into
consideration the time
value of the money.
 It discriminates in the
favor of the projects
of short-term and it
7 Nurullah, Mohamed, and Lingesiya Kengatharan. "Capital budgeting practices: evidence from Sri
Lanka." Journal of Advances in Management Research 12.1 (2015): 55-82.

5FINANCIAL AND MANAGEMENT ACCOUNTING
flows for the
businesses, which
values short-term
cash flow more than
that of the long-term
cash flows.
ignores everything
that happens after the
point of reaching
payback.
Net Present Value  It is more accurate as
it takes into account
time value of money.
 It helps for determine
the project’s
profitability by using
the cash flows rather
than that of the
profits.
 Timing of the cash
flows are ignored by
the method.
 Difficulties may be
raised in the
determination of the
cost of capital.
Internal Rate of Return  It is very simple for
understanding
because it is
expressed in terms of
percentage.
 Time value of money
are taken into account
under this8.
 It fails for considering
the risks as well as
uncertainty in the
projects.
 It does not considers
the important factors
such as duration, size
and future cost of the
project.
8 Szűcsné Markovics, Klára. "Capital budgeting methods used in some European countries and in the United
States." Universal Journal of Management 4.6 (2016): 348-360.

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Analysis of Investment Appraisal
After the conducting of the investment appraisal techniques on the business plan, it
has been analyzed that Net present value calculated is £3,116,402.69, which is profitable for
the business organization. Moreover, the Accounting rate of return calculated is 6.04%,
which is also at the good for the business plan. Lastly, after calculation of payback method, it
has been analyzed that the amount of the investment will be recovered within the 2 year of
the business. Hence, it is analyzed from the analysis that the investment will be able to give
the positively result to the business plan.
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Opening Balance 350,000.00£ 548,346.74£ 752,192.93£ 998,993.22£ 1,291,412.36£
Cash Inflow (+) 694,698.76£ 729,440.25£ 765,912.26£ 804,207.88£ 844,418.26£
Cash outflow 496,352.02£ 525,594.06£ 519,111.97£ 511,788.74£ 503,267.29£
(-)
Closing Balance 548,346.00£ 752,192.00£ 998,993.00£ 1,291,412.00£ 1,623,563.33£
Taxation @ 20% 109,669.20£ 150,438.40£ 199,798.60£ 258,282.40£ 324,712.67£
Cash flow After Tax 438,676.80£ 601,753.60£ 799,194.40£ 1,033,129.60£ 1,298,850.66£
Net Present Value @ 8.9%
Net Present Value Analysis
3,111,700.15£
Figure 1: Net Present Value
Avergae Net Profit 834,321.01£
Average Investment 788,189.05£
ARR 5.85%
Accounting Rate of Return
Figure 2: Accounting Rate of Return
Cash Flow After Tax 438,676.80£ 601,753.60£ 799,194.40£ 1,033,129.60£ 1,298,850.66£
Cumulative Cash Flow 438,676.80£ 1,040,430.40£ 1,839,624.80£ 2,872,754.40£ 4,171,605.06£
Payback Period
Payback Period
2 Year
Figure 3: Payback Period

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Reference
Baum, Andrew E., and Neil Crosby. Property investment appraisal. John Wiley & Sons,
2014.
Wnuk-Pel, Tomasz. "The practice and factors determining the selection of capital budgeting
methods–evidence from the field." Procedia-Social and Behavioral Sciences 156 (2014):
612-616.
Dyson, R. G., and R. H. Berry. "Capital investment appraisal." Developments in Operational
Research: Frontiers of Operational Research and Applied Systems Analysis(2014): 59.
Alkaraan, Fadi. "Strategic investment decision-making perspectives." Advances in mergers
and acquisitions. Emerald Group Publishing Limited, 2015. 53-66.
Schlegel, Dennis, Franziska Frank, and Bernd Britzelmaier. "Investment decisions and capital
budgeting practices in German manufacturing companies." International Journal of Business
and Globalisation 16.1 (2016): 66-78.
Guerra, Maria Letizia, Carlo Alberto Magni, and Luciano Stefanini. "Interval and fuzzy
average internal rate of return for investment appraisal." Fuzzy Sets and Systems 257 (2014):
217-241.
Nurullah, Mohamed, and Lingesiya Kengatharan. "Capital budgeting practices: evidence
from Sri Lanka." Journal of Advances in Management Research 12.1 (2015): 55-82.
Szűcsné Markovics, Klára. "Capital budgeting methods used in some European countries and
in the United States." Universal Journal of Management 4.6 (2016): 348-360.