If you want to invest your savings and enjoy the maximum return on your investment, it is important to evaluate the performance of various investment options first and choose the best. Investment appraisal is the process of evaluating and analysing the performance of an investment using investment appraisal methods, which are the payback method, average rate of return, internal rate of return and net present value. This article is a guideline on how to evaluate an investment proposal.
Methods of investment appraisal
Payback method This measures the number of years that are required to payback your initial capital injection to a project. The lesser the number of years, the more attractive is the project. Therefore, this is the best method to use if you want to know how quick you can cover up your initial capital injection from operational profits. Average rate of return This determines the attractiveness of an investment by adding up the incremental cash flows over the number of years that the money will be invested and divide it by the number of investment years to get how much income you earn per year. Net present value Net present value (NPV) calculation is used to compare the future value of an investment with its present value. A positive net present value means the project is attractive while a negative NPV shows that the project is not attractive. Internal rate of return (IRR) This measures the average annual return to be earned throughout the life of the project and if the IRR is higher than the desired rate of return, then the project investment is attractive.
Importance of investment appraisal
To determine the best investment
Capital investment appraisal is necessary when determining the best project to undertake, which gives the maximum returns. Each method gives a guideline on capital budgeting analysis, which investment to choose in order to maximise profits and quickly payback your initial capital outlay. Disadvantage
Depending on the method used, like when using the rate of return formula, it is be difficult to make a good decision when comparing the attractiveness of two mutually-exclusive projects. Difficult to understand the methods It is difficult to understand how to apply the investment appraisal techniques and how to interpret the results for better decision making if you are not an investment scholar.