Project Investment Appraisal Techniques

1. Identify the relative merits of the Project Investment Appraisal techniques and identify which is the preferred method by the Project Managers and Project Management.

Project Investment Appraisal is carried out by Project Managers to evaluate whether a particular project decision will in the long run make profits or not.

In order words, the project investment appraisal is intended to give advice on a project that will lead towards the maximizing of shareholders wealth.

Project management investment techniques are used to assist project managers to make decisions.

Notable amongst these techniques are payback period method (PBP); return on cost employed (ROCE), (also called accounting rate of return (ARR) or more simply as Return on Investment (ROI));Internal Rate of Return (IRR) and Net Present Value.

The payback period technique relies on the payback period is making a decision on any project period.

The payback period is the number of years it is expected to take to recover the original investment from the net cash flow resulting from a capital investment project. (WATSON and HEAD, 2007)

In this case, the project is accepted if the payback period is equal to or less than the predetermined target value, else it is rejected.

Despite the fact that the payback period method is quick, easy, simple to apply and calculate, it does not give any real indication of whether an investment project increases the value of the company.

Another drawback of the payback period method is that it ignores the time value of money.

The payback period ignores all cash flows outside the payback period and so does not consider the whole project as a whole.

What we can deduce from the foregoing is that the payback method does not really guarantee the maximization of stakeholder’s wealth. At best, it could be seen as a tool of assessing the effect of accepting a project.

Another project investment technique that we can use is the return on capital employed or the accounting rate of return technique.

The advantage of using this technique is that it considers all cash flows during the life of an investment project.

Another point of interest is that it gives the value in percentage terms. This is significant because the existing financial analysis used in assessing a company’s performance is in percentages.

One major drawback of using this method is that it uses accounting profits. The use of accounting profits makes the project open to manipulation.

The bottom line here is that there is no link to the fundamental objective of maximizing shareholders wealth.

Like the payback period method, it also does not consider the time value of money.

One thing that is common to the above two traditional methods of investment appraisal technique is their non-consideration of the time value of money.

The net present value works on the principle that an investment decision is viable if the money derived from business is greater than the money put in. It is clear that the time value of money is taken into consideration.

Also, it is clear that cash flow is used rather than profit. It also takes into account all relevant cash flow over the life of an investment project.

The internal rate of return is regarded as the arithmetic result of the NPV method.

It is instructive to deduce that the net present value method is “…academically preferred method of investment appraisal...” (WATSON and HEAD, 2007) based on the reasons below

1. The time value of money is taken into consideration

2. The shareholders’ wealth is maximized

3. It makes use of cash flows.

References:

WATSON, W. and HEAD, A. 2007. Corporate Finance: Principles and Practice . 4th ed. England: Pearson.

LUMBY, S. 1991. Investment Appraisal and Financing Decisions: a first course in financial management.4th ed.London: Chapman and hall.