INVESTMENT PROJECT APPRAISAL

The nature of investment will require appraisal of the different projects that can be embarked upon.
But the investment procedure will likely include the following;
1. Identification of possible projects
2. Evaluation of project
3. Authorization of projects
4. Monitoring and control of projects

Identification of Possible Projects

Ideas concerning capital investment maybe general at all levels of an organization. An initial
screening of project is normal to reject those that are unsuitable in terms of technical feasibility,
likely risk or cost associated with such project, Other important factors considered during this stage
are lack of compatibility of the project to the aim and strategy of the company or other.

Evaluation of Project
This stage will involve identification of expected incremental cash flows and the application of the
appropriate evaluation criteria such as payback period, internal rate of return, net present value
and the accounting rate of return to mention but a few. At this stage, there is likely to be wide
spread consultations amongst interested parties which includes; accountants, quantity surveyors,
marketing strategists/staffs, trade unions, etc.

Authorization of Projects
After evaluation of the projects, a report is usually submitted to the appropriate management level
personnel in the organization hierarchy for approval or rejection or a feedback or referred back for
modification. At this stage, the investment is likely to be re-appraised which might include a
reassessment of the assumptions and cash flow and/or an appraisal of how the investment fits
within the corporate strategy and capital budget constraint (if any) of the company.

4. Monitoring and Control of the Project

Any capital investment is a financial commitment that usually lasts for several years. After the
project has been approved and the development commences, it is important to review the project
to ascertain whether any major variation will affect the completion cost or the expected future cash
flow.

Where significant variations exist, it might be necessary to revise the assumption regarding the
remainder of the investment expected levels and sometimes possible abandonment of the
investment.

Characteristics of Capital Investment

The following are characteristics of capital investment:
i. Uncertainty: calculation in the nature of investment process are based on predictions about
the future. While the project cost might be known. It might not be possible to ascertain
correctly the future yields or over what period of time, this yield will continue. An
apparently correct decision may therefore sometimes come out disastrously because of the
intervention of unexpected factors.
ii. Non Quantifiable Factor: Doing capital investment, it is important to note that
calculations as regards money value are important but they are not the only thing to be
considered. Other factors such as the purchase of certain plants and machinery can be
said to be worthwhile. This would sometimes affect the running of your organization
on the long run especially if such plants and machinery can be used for subsequent
capital project.
iii. Unawareness of all Available Opportunity: A truly optimum investment will require
amongst all other things a complete knowledge of all investment opportunities
available. However, an organization can invest in a particular project with little or no
information / opportunities when compared with others. It is worthy of note that
organizations cannot finance an investment they are not aware of.

PROJECT APPRAISAL METHODS

Are broadly divided into two categories;
1. Traditional Method
2. Discounted Cash Flow Method

TRADITIONAL METHOD
The main distinguishing characteristics of this method is that they do not consider the Time Value
of Money. The appraisal methods under this category includes:
a. Payback period: the payback period highlights the time period required to recover the cash
investment outlay. If the projects generate constant annual cash inflow, the payback period can
be computed by dividing investment outlay / cash outlay by the annual cash inflow.

Acceptance or Rejection Rule

If the payback period calculated for the project is less than the maximum period of payback set by
the management it would be accepted, and vice versa

Merits/ Advantages of Payback Period

i. Easy to understand
ii. It is easy to calculate
iii. It costs less than most of the sophisticated techniques which require lots of analyst time and
use of computer
Limitations / Demerit
i. It fails to take account of cash inflow earned after the payback period
ii. It makes no effort to identify profitability which is the object of any investment
iii. It fails to consider the magnitude and timing of cash flow

2. Accounting Rate of Return: a capital investment project may be accessed by calculating the
ROI (return on investment) or accounting rate of return and comparing with a predetermined target
level. Unfortunately, there are several definitions of ARR and one of the most popular is given by:

ARR = Estimated Total Profit x 100

Estimated Initial Investment 1

The argument in favour of this type of appraisal method is the consistency of the use and
availability of the estimated profit when carrying out the project.

Acceptance and Rejection Rule

Organizations will accept projects with ARR higher than the minimum set by the management and
would encourage rejection with ARR lower than minimum set by management. This method will
rank a project if it has the highest ARR.

Merits / Advantages
i. Very simple to understand
ii. It can be readily calculated using accounting data
iii. It uses the entire stream of income
Demerits / Limitations
i. Uses accounting profits not cash flow of the project in appraising
ii. It ignores the time value of money
iii. It does not consider the length of project life. E.g. it assumes that 25% ARR for 2 years is
better than 20% ARR for 20 years.
iv. It does not allow for the fact the profit can be re-invested

DISCOUNTED CASH FLOW METHOD (DCF)

The main characteristics of this method is that they explicitly recognize the time value of money.
They correctly postulate the cash flow arriving at different time period differs in value and are
comparable when their present values are calculated.

The appraisal methods under this category (DCF) are:

1. Net Present Value
2. Internal Rate of Return
Advantages of DCF Methods
i. Allows for timing of cash flow within an investment
ii. They allow for the cash flow which results from an investment decision and not affected
by accounting conventions or policies
iii. They consider all cash flow
iv. Clear decisions are given in accept / reject situations

Net Present Value (NPV)

This is one of the commonest appraisal methods used for meeting investment decisions. It takes
into consideration the cash flow i.e. cash received, cash receipts and initial investment outlay. It is
given by:

NPV = [ C1 + C2 + … … … + Cn ] – Io
[ (1+r) (1+r)2 (1+r)n ]

n = Number of Years
Io = Initial Capital Outlay
C = Cash received or cashflow from the investment

Acceptance / Rejection
When NPV is positive, the project should be accepted but when NPV is negative, reject the project.

Advantages of NPV over IRR

i. NPV gives an absolute method of profitability and hence immediately shows the change in
the investor’s wealth.
ii. NPV gives clear accept and reject decision
iii. NPV always gives the correct ranking for mutually exclusive project

Internal Rate of Return

This is the second type of discounted cashflow method. The advantage and disadvantage of the
method are provided below;

Advantage:
Finds the Time Value of Money
Internal rate of return is measured by calculating the interest rate at which the present value of
future cash flows equals the required capital investment. The advantage is that the timing of cash
flows in all future years are considered and, therefore, each cash flow is given equal weight by
using the time value of money.
Simple to Use and Understand
The IRR is an easy measure to calculate and provides a simple means by which to compare the
worth of various projects under consideration. The IRR provides any small business owner with a
quick snapshot of what capital projects would provide the greatest potential cash flow. It can also
be used for budgeting purposes such as to provide a quick snapshot of the potential value or savings
of purchasing new equipment as opposed to repairing old equipment.
Hurdle Rate Not Required
In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at
which investors agree to fund a project. It can be a subjective figure and typically ends up as a
rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of determining
a wrong rate. Once the IRR is calculated, projects can be selected where the IRR exceeds the
estimated cost of capital.

Disadvantage:
Ignores Size of Project
A disadvantage of using the IRR method is that it does not account for the project size when
comparing projects. Cash flows are simply compared to the amount of capital outlay generating
those cash flows. This can be troublesome when two projects require a significantly different
amount of capital outlay, but the smaller project returns a higher IRR.

Ignores Future Costs

The IRR method only concerns itself with the projected cash flows generated by a capital injection
and ignores the potential future costs that may affect profit. If you are considering an investment
in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate
and maintenance requirements change.
.
Ignores Reinvestment Rates
Although the IRR allows you to calculate the value of future cash flows, it makes an implicit
assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption
is not practical as the IRR is sometimes a very high number and opportunities that yield such a
return are generally not available or significantly limited.

The different analysis are as follows:

1. Future value: the future value (fv) is the value in naira or any currency at some points in the
future of one or more investment
FV
Original sum of money invested

FVn = Vo (1+r)n
Vo = initial sum
r = interest rate
n = number of years the investor receives interest

example: what is the future value of 10m investment at 10% at the end of the second year.

FV(2) = 10,000,000 (1 + 0.10)2

= 10,000,000 (1.1)2

2 . present value (PV)

where can we use this to arrive at the formula

FVn = Vo (1+r)n
Divide both sides by (1+r)n
FVn = Vo
(1+r)n

FVn = PV
(1+r)n

e.g. what is the present value of N17.5m (future value) after 5 years @ 11% interest rate
17500,000 = 17,500,000 =
5
(1 + 0.11) 1.115

c. Net Present Value (NPV)

NPV methods is used for evaluating a desirability of investments or projects. It will reveal whether
it is profitable to invest in a project or not taking into consideration the initial capital outlay and
the cash return on investment annually.
NPV = C1 + C2 + C3 + Cn - Io
1+r (1+r)2 (1+r)3 (1+r)n

NPV = Ct - Io
(1+r)

Where:. Ct = Cash receipt @ the end of the year, n = number of years, Io = Initial Investment
Outlay, r = discount rate / required minimum interest rate.

Example
A firm intends to invest N100m in a project that will generate a net receipt of N80m to N90m, and
N60m in the 1st, 2nd and 3rd year respectively. Should the firm go ahead with such project
considering it has a discount rate of 7%
C1 = 80m
C2 = 90m
C3 = 60m
Io = 100m
r = 7%

C = cash receipt at end of year

I = Initial investment outlay
r = interest rate

Solution

NPV = ( C1 + C2 + C3 ) - Io
1+r (1 + r)2 (1 + r)3

= (80,000,000 + 90,000,000 + 60,000,000) - 100,000,000

1 + 0.07 (1 + 0.07)2 (1 + 0.07)3