Analysis of Investment Appraisal Techniques and Risk Management

This report provides a detailed analysis of investment appraisal techniques, focusing on their application in financial decision-making. It explores three primary methods: Net Present Value (NPV), Payback Period, and Internal Rate of Return (IRR), evaluating their assumptions, limitations, and applicability. The report also delves into risk and uncertainty, discussing various risk management techniques, including decision tree analysis, sensitivity analysis, and simulation, to help a global manufacturing company make sound investment decisions. It concludes by emphasizing the importance of these tools in effective financial planning and risk mitigation, highlighting the strengths and weaknesses of each method and their combined impact on investment outcomes. The report references academic literature and online resources to support its findings.

Financial Decision Making
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Table of Contents
Introduction..........................................................................................................................................3
Alternative methods of investment appraisal.......................................................................................3
Risk and uncertainty.............................................................................................................................4
Discussing and evaluating the risk management techniques in the context of investment
appraisal...........................................................................................................................................4
CONCLUSION....................................................................................................................................6
References............................................................................................................................................7
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INTRODUCTION
Investments are very important part of business. However firms are required to take investment
decisions by making sound decisions. These decisions can be evaluated on the basis of application
of investment appraisal techniques. The purpose of this report is to analyse three techniques so that
a global manufacturing company can take sound decisions. Under this study, their assumptions,
limitations and applicability will be discussed. The limitations and advantages associated with the
techniques will also be analysed. At last the report will end in evaluating the risk management
techniques in investment appraisal.
ALTERNATIVE METHODS OF INVESTMENT APPRAISAL
Different types of investment appraisal techniques are as follows:
Net Present Value
This method will help the organization in computing the present value of the proposed
investment proposals. It will deduct the value of the project’s cost from the value of the future
income. Positive NPV indicates that project is profitable one and negative NPV indicates that it will
incur loss. The formula for NPS is as follows:
Critical evaluation
NPV technique takes into consideration the time value of money which changes very
frequently at the time of high inflation or deflation. It can do the easy comparison of the proposal
and can make the decision making process very straight forward (Olawale and et.al., 2010). The
discount rate can be customized hence this makes the approach very flexible and customizable. It is
very effective in case of long projects. The approach is easy to apply and understand.
However on the critical note it can be said that this technique is very time consuming. It
needs complex calculations to be performed. It makes use of assumptions related to timing of the
future cash transactions (Bennouna and et.al., 2010). The assumptions may or may not be reliable
for making the investment decision. Issues can be faced in small scale investment proposals.
Interest rates associated with the option is also required to be estimated. Hence this decrease the
validity and reliability of the option which is being considered for the investment.
Payback period
It discloses the time period need to recover the cost of an investment. It is an important
determinant in deciding whether the project should be undertaken or not. It is calculated by
determining the number of years required to recover the funds invested in a particular project
(Mahlia and et.al., 2011). It is calculated by following formula:
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A + B / C
In this, A denotes the period at which cash flow is recovered to the large extent
B = Higher cumulative cash inflow – lower cumulative cash inflow
C = Cash inflow of the period of higher cumulative inflow
Critical evaluation
The technique is very east to implement and understand. It has the potential to provide fine
ranking of the projects. It is to be noted that payback method is an effective approach to measure
the investment risk. The investment option with a shortest period has low risk as compared to
option with highest period (Rahman and et.al., 2012). The technique gives more importance on
liquidity for making the decisions related to the investment proposals. It can show great results in
case of projects having smaller amount of investments.
However on the critical note, the payback technique do not take into consideration the time
value of money. Hence this increases the chances of producing false results. The cash flow which
arises after the time of payback, are also not been taken into account. Further the net incremental
cash flows are not adjusted for the time value of money (Wiesemann and et.al., 2010). Such type of
cash flows are generally ignored. Further the method gives more emphasis on liquidity and
profitability is ignored. Only the cash flow before the payback period are considered, hence it is a
limitation in this case.
Internal rate of return
The IRR can be regarded as the discount rate which makes the net present value of all the
cash flows from a particular project equivalent to zero. The higher the rate of return, more desirable
is to undertake the investment option. The formula for calculating the internal rate of return is as
follows:
Critical evaluation
The technique makes a good use of money theory. It has the potential to reflect high interest
rate expected from the investment. It gives identical importance to all the cash flows. The
visualization of the investment proposal becomes easy for the managers. It gives effective results in
case of mutually beneficial projects (Galvin and et.al., 2012).
On the critical note, the IRR technique do not take into consideration the size of the projects
when they are compared. The economies of scale are being ignored in the application of this
technique. The potential future costs are not followed as it is mostly concerned with the estimated
cash flows. It makes an implied assumption that cash flows can be reinvested at the same rate as the
IRR (Johnson and et.al., 2010). However the assumptions are not practically applicable because in
some cases, internal rate of return is very high and opportunities which yields such returns are
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limited.
RISK AND UNCERTAINTY
Discussing and evaluating the risk management techniques in the context of investment appraisal
In the present era, most of the business organization failed to assess the risk which are
highly associated with the investment appraisal tools and techniques. In this, business organization
requires to undertake most effectual tools and techniques which help them in managing the
investment appraisal risks more efficiently. Thus, global manufacturing company needs to
undertaker several investment appraisal risk management tools which helps business unit making
suitable and profitable investment decisions. There are several risk management tools and
techniques which are enumerated below:
Decision tree: It is tool which presents tree like graphs that clearly reflects the possible
consequences, resource cost and utility of the specific project. On the basis of this tree manager of
global manufacturing company is become able to draw the valid conclusion or results (Irani, 2010).
Moreover, in decision tree manager selects the outcome in the basis of their risk taking ability are as
follows:
 Maximax: This techniques is used by manager who is take more risk with the aim to
generate high level of return. Under this technique business organization needs to select an
alternative or option which maximizes the highest possible outcome. Under this method,
pay off table is prepared by the manager which clearly indicates the possible outcome in a
highly clear or precise manner. Thus, by evaluating the each possible outcome of the
different scenarios global manufacturing company is able to make highly profitable
investment decisions.
 Maximin: This technique of risk management is highly opposite to the maximax technique.
Under this, manager requires to select the option which maximizes the pay off among the
minimum alternatives. In maximin technique manager assess the worst outcome of the
alternative. Thereafter, manager selects the best from the worst outcome. It is the pessimist
approach of the investment appraisal which is used by the manager when they do not prefer
to take more risk. Thus, risk aversing manager makes use of this approach to work in highly
safe environment by preventing the huge amount of loss. Hence, by taking into
consideration this technique manager is able to manage the risk more effectively and
efficiently.
 Sensitivity analysis: It may also be served as a ''what if analysis'' which investment manager
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of global manufacturing company can use to make effective decision making. In this,
investment manager -plays with the number to the significant level. For instance: manager
can conduct this analysis to find out the extent to which net present value of the project
would be affected if operational cost increases (Investment appraisal risk management
strategy, 2016). Thus, by assigning the probability to the each task or activity on the basis
of its happening global manufacturing is able to make suitable decisions.
Thus, by assigning the probability to the each task or activity business organization can
make most effective decision which aid in the growth and success of it.
Simulation: It is also the most effective tool which assists in managing risk regarding the
investment appraisal in an effectual manner. In this, manager take decision in an artificial business
environment (Bennouna and et.al., 2010). This aspect offers opportunity to the investor to make
evaluation of the outcome of decision and thereby make necessary changes in the existing plan.
Thus, with the help of this strategy global manufacturing company is able to manage the risk in the
best possible manner.
Along with it, game theory is also the most suitable technique which provides assistance to
the global manufacturing company in minimizing the risk to the large extent.
CONCLUSION
From this report, it can be concluded investment appraisal tools such as net present value,
payback period, ARR and IRR etc. plays a vital role in making the effective decision making.
Besides this, it can be inferred that net present value method offers highly realistic framework by
taking into consideration the time value of money concept. Further, payback period method also
provides deeper insight about the time period within which business global manufacturing can
return back the initial amount. It can be stated that decision tree and simulation is the most effectual
technique which assists manager in managing the risk to the significant level.
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REFERENCES
Books and Journals
Bennouna, K. and et.al., 2010. Improved capital budgeting decision making: evidence from
Canada. Management decision. 48(2). pp.225-247.
Galvin, R. and et.al., 2012. Including fuel price elasticity of demand in net present value and
payback time calculations of thermal retrofits: Case study of German dwellings. Energy and
Buildings. 50. pp.219-228.
Irani, Z., 2010. Investment evaluation within project management: an information systems
perspective. Journal of the Operational Research Society. 61(6). pp.917-928.
Johnson, C. and et.al., 2010. What really determines policy? An evaluation of outcome measures
for prioritising flood and coastal risk management investment in England. Journal of flood
risk management. 3(1). pp.25-32.
Mahlia, T.M.I. and et.al., 2011. Life cycle cost analysis and payback period of lighting retrofit at
the University of Malaya. Renewable and Sustainable Energy Reviews. 15(2). pp.1125-1132.
Olawale, F. and et.al., 2010. An investigation into the impact of investment appraisal techniques on
the profitability of small manufacturing firms in the Nelson Mandela Metropolitan Bay
Area, South Africa. African Journal of Business Management. 4(7). p.1274.
Rahman, A. and et.al., 2012. Rainwater harvesting in Greater Sydney: Water savings, reliability
and economic benefits. Resources, Conservation and Recycling. 61. pp.16-21.
Wiesemann, W. and et.al., 2010. Maximizing the net present value of a project under uncertainty.
European Journal of Operational Research. 202(2). pp.356-367.
Online
Investment appraisal risk management strategy, 2016. Online. Available through:
<http://www.accountantnextdoor.com/investment-appraisal-risk-management-strategy/>.
[Accessed on 4th May, 2016].
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