INVESTMENT APPRAISAL Leecture Slides.pptx

INVESTMENT APPRAISAL PROJECTS • What are Projects? • Projects are the cutting edge of development. Projects are an investment activity in which financial resources are expended to create capital assets that produce benefits over an extended period of time. • UNIDO defines a project as a proposal f...

INVESTMENT APPRAISAL PROJECTS • What are Projects? • Projects are the cutting edge of development. Projects are an investment activity in which financial resources are expended to create capital assets that produce benefits over an extended period of time. • UNIDO defines a project as a proposal for an investment to create and develop certain facilities in order to increase the production of goods/services in a community during a certain period of time. • The Chartered Management Institute define a project as "an activity that has a beginning and an end which is carried out to achieve a particular purpose to a set quality within given time constraints and cost limits". • A project may be defined as an activity for which money will be spent in an expectation of returns and which logically seems to lend itself to planning financing and implementation as a unit. It is the smallest operational element prepared and implemented as a separate entity in a national plan of programmes of development WHAT IS A PROJECT? • A project is also defined as a proposal for an investment to create, expand and develop certain facilities in order to increase the production of goods and services in a community during a certain period of time. Furthermore, for evaluation purposes, a project is a unit of investment, which can be distinguished technically, commercially and economically from other investments. APPRAISAL • After a project has been prepared, it is generally appropriate for a critical review or an independent appraisal to be conducted. This provides an opportunity to reexamine every aspect of the project plan to assess whether the proposal is appropriate and sound before large sums are committed. • The appraisal process builds on the project plan, but it may involve new information if the specialists on the appraisal team feel that some of the data are questionable or some of the assumptions faulty. If the appraisal team concludes that the project plan is sound, the investment may proceed. • But if the appraisal team finds serious flaws, it may be necessary for the analyst to alter the project plan or to develop a new plan altogether What is appraisal • If a project is to be financed by an international lending institution such as the Project Appraisal World Bank or by a bilateral assistance agency, such an external lender will probably want a rather careful appraisal even if it has been closely associated with earlier steps in the project cycle. The World Bank, for example, routinely sends a separate rnission to appraise proposed projects for which one of its member governments intends to borrow PROJECT APPRAISAL • Project appraisal is the effort of calculating a project's viability. Appraisal involves a careful checking of the basic data, assumptions and methodology used in project preparation, an in-depth review of the work plan, cost estimates and proposed financing, an assessment of the project's organizational and management aspects, and finally the viability of project. Project Apraisal • Project appraisal is the process of assessing, in a structured way, the case for proceeding with a project or proposal, or the project's viability. [1] It often involves comparing various options, using economic appraisal or some other decision analysis technique.[2][3] The entire project should be objectively appraised for the same feasibility study should be taken in its principal dimensions, technical, economic, financial, social and so far to establish the justification of the project or project appraisal is the process of judging whether the project is profitable or not to client or it is a process of detailed examination of several aspects of a given project before recommending of some projects. • Process The project appraisal criteria can be divided under two heads: • Non-Discounting Techniques • Discounting Criteria Techniques Non-Discounting Techniques • Urgency • Payback Period • Accounting Rate of Return • Debt Service Coverage Ratio Discounting Criteria Techniques • Net Present Value • Benefit Cost Ratio • Internal Rate of Return • Annual Capital Charge INVESTMENT • Investment, in the economic sense of the word, is an increase in the stock of physical capital assets such as plant and machinery, buildings and other assets that will generate a flow of goods or services in the future. This is different to the concept of financial investment, such as buying financial assets like stocks and shares, which merely transfers ownership between seller (or issuer) and buyer, although such activities will generate a flow of income for the purchaser in the future from interest or dividend payments. WHY DO COMPANIES INVEST? • Importance of remembering investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank! • Buy equipment/machinery or build new plant to: - Increase capacity (amount that can be produced) which means: -Demand can be met and this generates sales revenue - Increased efficiency and productivity • Investment therefore assumes that the investment will yield future income streams • Investment appraisal is all about assessing these income streams against the cost of the investment Why do companies invest • If a business wishes to grow, it needs to invest. • The cash spent on investment in a business is normally referred to as "capital expenditure". This can be contrasted with spending on day-to-day operations (e.g. paying for materials, staff costs) which is known as "revenue expenditure". • The main difference is that capital expenditure is on noncurrent assets which have an "economic life" in the business – they are intended to be kept, rather than sold or turned into products. • There are several reasons why a business needs to invest in capital expenditure: • To add extra production capacity • To replace worn-out, broken or obsolete machinery and equipment • To support the introduction of new products and production processes • To implement improved IT systems • To comply with changing legislation & regulations • The problem for most businesses is that the finance available for capital investment is limited. There are usually more possible capital investment opportunities than there is available finance. So choices have to be made and some capital investments rejected. • A key consideration with capital investment is the rate or return that an investment will make. This is vital because the owners of the business look to management to maximise their return. If the business cannot earn an acceptable return, then the owners would be better off taking their cash out of the business and investing it elsewhere. INVESTMENT APPRAISAL • Investment appraisal is mainly concerned with the financial and economic viability of projects. This allows project analysts to consider whether the return that might be expected from an investment compares favourably with alternative investment in other projects (the opportunity cost of the investment). Thus, if there are a number of alternative investment options, which option produces the best financial return, taking into account other factors such as risk? • Investment Appraisal • A means of assessing whether an investment project is worthwhile or not • Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc • Used in both public and private sector Investment Appraisal • Investment appraisal in the private sector, often called financial analysis or capital budget, because companies in this sector will be primarily concerned with the profitability of their investments (although the private sector also includes not-for-profit organisations such as charities and NGOs). • Such investment decisions can involve: - the replacement and/or acquisition of new capital assets - new products - cost savings - acquisitions and mergers PAYBACK PERIOD • What is the payback period? • Payback is perhaps the simplest method of investment appraisal. • The payback period is the time it takes for a project to repay its initial investment. • Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months). • Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows. Advantages of Payback • Simple and easy to calculate + easy to understand the results • Focuses on cash flows – good for use by businesses where cash is a scarce resource • Emphasises speed of return; may be appropriate for businesses subject to significant market change • Straightforward to compare competing projects Disadvantages of Payback • Ignores cash flows which arise after the payback has been reached – i.e. does not look at the overall project return • Takes no account of the "time value of money" • May encourage short-term thinking • Ignores qualitative aspects of a decision • Does not actually create a decision for the investment Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital. The average rate of return ("ARR") method of investment appraisal looks at the total accounting return for a project to see if it meets the target return. An example of an ARR calculation is shown below for a project with an investment of £2 million and a total profit of £1,350,000 over the five years of the project. • he ARR for the project is 13.5% which seems a reasonable return. The project looks like it is worth pursuing, assuming that the projected revenues and costs are realistic. • A key question is - how does this return compare with the target return for investments by this business? Advantages of ARR • ARR provides a percentage return which can be compared with a target return • ARR looks at the whole profitability of the project • Focuses on profitability – a key issue for shareholders Disadvantages of ARR • Does not take into account cash flows – only profits (they may not be the same thing) • Takes no account of the time value of money • Treats profits arising late in the project in the same way as those which might arise early