topic 36 capital investment appraisal

• Capital investment means spending money on nca, with the intention of obtaining a return in the form of extra profits
• Capital investment appraisal refers to the techniques firms use to help them decide the best project to invest in. NCA have:

  • different prices
  • different lifetimes
  • different levels of production or quality
• NPV is a better method of investment appraisal because it takes into account profitability, the time value of money and the timing of inflows
• The payback period is the time it takes for the firm to recover its initial investment
• Advantages of payback:

  • easy to calculate
  • early payback is important for cash flow management and reducing the risk and uncertainty associated with long term investment
• Disadvantages of payback:

  • ignores the time value of money
  • ignores the timing of inflows
  • ignores the relative profitability of projects
  • cash inflows after the payback date are ignored
• Advantages of NPV:

  • takes into account the timing of flows
  • takes into account the time value of money
  • takes into account relative profitability
  • provides a more precise ranking of projects
• Disadvantages of NPV:

  • can be time consuming to work out especially when dealing with multiple projects in a year
  • discounting rate may be inappropriate as i/r vary according to the state of the economy
  • figures are still estimates and are only as good as the info on which they are based
  • all investment involves risk and the uncertainty of dealing with the future, cash flow projects are by definition based on estimates which differ from actual results
• Non financial considerations - financial techniques ignore non financial aspects such as pollution or redundancy but the growing emphasis on stakeholders and CSR (corporate social responsibility) means that firms have to consider the bigger picture
• Examples of non financial considerations:

  • a project that creates environmental pollution
  • a project that is dangerous for the employees to work with
  • a project which involves making many of the employees redundant
  • a project which involves relocating overseas and dealing with an unethical foreign regime
  • a project which involves animal testing
• Sunk costs - unrecoverable expenditures already incurred before a project is undertaken, and are not included in cash flow forecast