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Investment appraisal

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Investment means postponing present consumption to increase future returns. In a business sense this will involve the purchase of capital equipment such as plant and machinery with the objective of increasing future output, sales revenue and profit.

In the next section we will be looking at investment appraisal. In essence, we will be looking at the question 'is it worth investing in that project?'

scales.pngJust like individuals, the finance available to firms is limited and so they must choose how to spend this finance in a way that offers the best return on their investment. This is not always an easy assessment because it is dependent upon the time period involved and the level of risk the firm is prepared to take.

A business may have a variety of investment decisions. They may have to choose between:

  • Launching one product or another
  • Between different locations for parts or whole of their business
  • Buying one piece of equipment or another

Investment appraisal is a quantitative technique used to avoid relying on 'hunch' decision making. However, like all such business tools it must be remembered that the reliability of the outcome is only as good as the data used in the appraisal. As is often said, 'Garbage In, Garbage Out' (GIGO).

Investment appraisal requires two main pieces of information

  • The capital cost of the project
  • The value of the project (what cash will it bring in for the cost?)

Investment appraisal is a forward-looking process. It considers what might happen, and makes forecasts of financial returns. However, these forecasts will always contain elements of inaccuracy, uncertainty and risk and we will examine how different investment appraisal methods account for these elements.

Investment appraisal will not only be used to choose between one project and another, but also to rank the investments in terms of financial returns. Just like other tools in the business and management toolbox, it is likely that investment appraisal will be used in combination with other tools to provide a broader analysis. Non-financial information may be just as important in the decision making as financial outcomes. It may be the best financial decision to locate in a remote area of the world, but how will employees and customers react?