Carrying out investment appraisals
For most organisations, capital investment is a significant activity. Expenditure is usually relatively large, including assets such as buildings, machinery, motor vehicles and IT equipment.
As expenditure is made in anticipation of long-term benefits, it also involves an element of risk. To ensure the best decision is made when new capital investment projects are considered, investment appraisal should be carried out.
A culture which facilitates the identification of potential capital investments within the organisation is important. A search should take place regularly to identify opportunities so that better investment proposals are developed. Any ideas that are generated should fit into the overall strategy of the business.
All of the relevant information should be brought together when an investment is proposed. This is usually the responsibility of the accountant or finance department. The amount of information required will vary according to the investment. Less detail is likely to be required for more routine investment decisions, for example when replacing sales team cars.
Other investments will require more detailed appraisals with a greater level of information provided by managers. Clear objectives for the proposed investment should be outlined so there is a good understanding within the business of what it is expected to be achieved. It is also important that alternatives have been considered and documented.
Information on assumptions made, risks involved, how the investment fits into the overall strategy and the likely impact on the business should all be included. Input from management is also required so that a financial analysis can be carried out (see below). For a checklist of items to be considered when appraising an investment proposal for a major new project, see the Finance and Management Faculty Special Report on Investment Appraisal.
Once all of the information has been gathered and evaluated, it should then be presented to the decision makers within the company to be approved, modified or rejected. In a small business approval is usually by the owner manager. In larger organisations other approval processes should be in place, with managers aware of their own level of authority. A formal sign-off by each relevant party can help reduce the number of poor proposals by increasing accountability.
There are a number of analytical techniques suitable for assessing an investment proposal in financial terms. They are based on estimates of the future cash flows associated with a project and include:
- payback method – the number of years it is expected to take to recover the original investment from the net cash flows.
- accounting rate of return - the accounting rate of return of a project is compared to the organisation’s existing (or target) return on capital employed.
- net present value – a discount rate is used to convert future cash sums into their present day cash equivalents.
- discounted payback – cash flows are discounted before accumulating them to obtain the payback period.
- internal rate of return – the appropriate discount rate is determined by calculating the internal rate of return (IRR) of the project. The IRR is that discount rate which produces a net present value of zero.
Most companies use several methods to assess a significant investment project as part of the investment appraisal process. Different methods can give conflicting results and so care should be taken. The International Federation of Accountants (IFAC) has developed a set of good practice principles for investment appraisal. For more details of these, together with the methods outlined above, see the Finance and Management Faculty Special Report on Investment Appraisal.
Implementation and review
Investments should be timed to minimise disruption to the organisation and to create synergies with other potential proposals. Ensure each project is implemented according to the investment plans, with progress regularly reviewed.
A review after the investment has been completed should be carried out to assess how well the process went, and the information used to improve future appraisals and investment decisions.
The information contained in this article is for general guidance only and does not constitute advice. You should always seek professional advice for your personal circumstances. Please read the full disclaimer.