Investment appraisal and NPV analysis Essay Example | Topics and Well Written Essays - 2000 words

Investment appraisal and NPV analysis - Essay Example Capital Budgeting is the other name for Investment Appraisal. Every firm, company or enterprise is faced with the decision about which investment opportunities they are to choose from all the options available. The primary task of any enterprise is to maximize the wealth of its shareholders. So taking the right decision at right time is one of the key roles of any company. It is required for the profitability and sustainability of the company. More often than not every enterprise has to invest in assets, mainly capital assets, so that they get returns out of it which they can utilize either to reinvest again or to pay back its owners (Peterson & Fabozzi, 2002, p.3). Investments in assets can be of both short-term and long-term types but every firm is primarily concerned with long-term investment requiring huge amounts of money. Thus, decision on capital budgeting have a long-term effect on the performance of the firm and are critical to the firm’s success or failure. Financial appraisal or investment appraisal of a proposed investment in a firm is one of the key steps in capital budgeting and quite complex too (Dayananda, 2002, p.2). Thus proper valuation of the proposed investment projects of a company is required before coming to the conclusion about which investment proposal to accept. Some of the tools or techniques used by firms for investment appraisal are: a) Net Present Value (NPV), b) Internal Rate of Return (IRR), c) Profitability Index (PI), d) Accounting Rate of Return, e) Payback Period, etc (Shapiro, 2008, p.33). Of these NPV and IRR techniques are mostly used by companies for investments which are capital intensive and Pay Back Period technique, which is more of a traditional technique and mostly used by companies which are less capital intensive (Bedi, 2005, p.14). Now, NPV being one of the most widely used conventional tools for investment appraisal uses the Discounted Cash Flow (DCF) technique for the evaluation of proposed investments. But it can always be argued about DCF technique used in NPV analysis as being the effective and adequate technique and its relevance with business environment in reality. NPV option is always questionable when uncertainty is involved in the real business environment. Once an investment has already begun, it is very difficult to revise the investment decisions of a company using NPV analysis for its investment project appraisal. Thus, NPV analysis has its own merits and demerits in the evaluation of investment projects which have been discussed further in this study. A comparative study of two other alternative appraisal techniques to NPV is also discussed in this study. Further, what can be a more realistic approach to investment appraisal has also been discussed in details. Investment Appraisal Approaches Different approaches are adopted by different companies for evaluating their investment proposals in order to come to a decision about which investment proposal will be best for the company. Out of the many, Pay Back Period technique is one of the traditional approaches in this regard. NPV analysis and IRR techniques are commonly used investment evaluation techniques which uses the DCF technique. Risk-adjusted Present Value (RPV) analysis is one of the recently used investment appraisal technique which takes into account the risk factors involved in the investment valuation due to uncertainties present in real business environment. The concept of break-even analysis in investment is applied through the Pay Back Period method of investment appraisal technique (Banerjee, 1990, p.317). This method takes into consideration the fact that it is important to identify the recovery period of investment made originally by a company. Pay Back Period can be calculated from the following relation: Pay