ACCA/CAT

Capital investment appraisal - part 1

by Samuel O Idowu

01 Aug 2000

Organisations operate in a dynamic environment. They must therefore continually make changes in different areas of their operations in order to meet the challenges that the dynamic nature of the environment brings and also in order to survive and prosper. It is believed that continuous change could improve the way things are done, thereby putting the organisation at an advantage over their competitors. Most changes involve capital expenditure, which can invariably involve large sums of money. The expenditure might involve replacing existing fixed assets with something more efficient and up to date or to acquire an entire business.

The decision to go ahead with any capital expenditure of a significant amount could necessitate spending a large sum of money. Managers must give careful thought to every step that they need to take before a final decision is made on whether or not to invest money on such a project. Most investments will have one form of return or another. The question to address is whether or not the future returns will be sufficient to justify the sacrifices the investing entity would have to make.

The intention of this article is to demonstrate how organisations justify capital investments using different appraisal techniques. It is hoped that the reader will supplement the knowledge gained from it with that gained elsewhere.

The article will be of interest to students taking paper 8, Managerial Finance, at the certificate level and also to those taking Paper 9, Information for Control and Decision-Making at the professional level

Basic information

To appraise an investment project, the appraiser must have information about the following relevant areas:

1 Cost of investment project.

2 Estimated life ofproject.

3 Estimated net cash inflows from project.

4 Estimated residual value of project at the end of its life if applicable.

5 Costofcapital.

6 Taxation implications of project.

7 Inflation rates and effect on project.

Anyone who has had to plan for a future activity/event should understand that the future is never certain. Bearing this in mind, one must try to predict the future by drawing from past experience and using available information either from published statistics or from other sources. Some of the data required about the project would have to be estimated taking into consideration all available information. The accuracy of these estimated data would have a consequential effect on the final result of the decision, as such care must be taken in making these estimates.

Methods of investment appraisal

When the decision-maker has at his/her disposal basic information about the project as stated above, he/she is then ready to use one or more of the four main methods used in appraising investment projects.

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