Investment appraisal, more popularly known as capital budgeting is a planning process used
to determine a firm’s long term and short term investments. (Wikipedia 2007[online]). These planning methods are closely
related to the idea of capital expenditure that assess the outlay of cash for a project set in to bring a cash inflow over
a period of time (NetMBA 2007 [online]). Examples of capital goods that are usually given investment appraisals are property,
plant, equipment, research and development projects, and large advertising campaign. In essence, an investment appraisal is
the measure of capital value and its feasibility to the company. For small businesses or single proprietorship, an investment
appraisal governs business decisions in venturing to new markets or expanding to new activities.
Capital budgeting or investment appraisals can follow a wide criteria selection depending
on the priorities of the decisions maker or stakeholders. These differences in priorities are usually represented by long
term growth versus short term profits. Thus, in order to fully understand the effects of investment appraisal, there are academic
practices to measure capital investment appraisals.
One of the tools used for investment appraisals is net present value. Net present value
is defined as the measure of the excess or shortfall of cash flows in present value terms once financing charges are met (Wikipedia
2007 [Online]). This measure implies that all investment appraisal objectives should drive toward a positive net value or
there should be a surplus between the values that the capital good will bring over its cost. Practically, it is a measure
of what an investment can get you in the long run as opposed to the seemingly large short run cost. The NPV is a mathematical
simply understood as the net cash flow at time t over the discount rate at the
same time t minus the capital outlay at the beginning of investment time. As we
can see, a higher discount rate will decrease the net present value of a capital good. That is why most capital investment
appraisals are wary of higher interest rate which increases the discount rate of a good over time.
Another method to help decision makers in investment appraisal is internal rate of return
(IRR). The internal rate of return is defined as the discount rate that makes the project have a zero net present value (Odellion
Research 2006 [online]). This definition is equates the NPV to zero and deriving the discount rate. Although the NPV and the
IRR are related, they are not equivalent concepts. The IRR’s assumption of a zero NPV means that there is no need to
evaluate the discount rate. Instead the IRR takes into account the time value of money over the lifetime of the project (Odellion
Research 2006 [online]). Another objective of the equation is to measure the real world discount rate and compare it with
the IRR solution to assess the investment decision.
These two main methods of capital budgeting are correlated with each other. However, they
are read differently and are examined in various contexts. In the end the critical factor is valuing the decision of the shareholders
while communicating what is the most effective capital good. Capital budgeting is an exercise of making the right call for
future growth.
References
NetMBA. (2007). Capital budgeting. Available:
http://www.netmba.com/finance/capital/budgeting/.htm. Last accessed 18 October 2007.
Odellion Research. (2007). Capital budgeting.
Available: http://www.odellion.com/pages/online%20community/IRR/financialmodels_irr_definition.htm. Last accessed 18 October
2007.
Wikipedia. (2007). Capital budgeting. Available:
http://en.wikipedia.org/wiki/Capital_budgeting. Last accessed 18 October 2007.
Wikipedia. (2007). Internal Rate of Return.
Available: http://en.wikipedia.org/wiki/Internal_rate_of_return. Last accessed 18 October 2007.
Wikipedia. (2007). Net Present Value. Available:
http://en.wikipedia.org/wiki/Net_Present_Value. Last accessed 18 October 2007.
