No business can grow without investment, but choosing where to put your resources can be a challenge. Will new assets increase productivity, or is money better spent in product development and research? Appraisal investment techniques offer a useful framework when making important investment decisions. Basic appraisal investment techniques can help you make informed decisions, even when applied to projects that are not profit generating.
Financial and Strategic Considerations
The different methods of appraisal investment allow you to consider the potential risk and return of investments on your profitability and cash flow from different angles. However, direct cash flow impact is not the only factor to consider. Soft effects also have a financial impact. For example, an investment in new machinery that results in less downtime for repairs can result in a decrease in overall costs, while investment in new product development and trials can help you either avoid costly mistakes or aid in an increased profit in the future.
Accounting Rate of Return
One of the simplest methods, the accounting rate of return (ARR) technique, compares the cost of an investment with the investment's expected profit over the lifetime of the project. The ARR calculates the average percentage of profit as related to cost. For instance, if you invest $100,000 per year in a project and receive a profit of $10,000, the ARR is 10 percent. The higher the percentage, the better the investment. Drawbacks to this method include lack of consideration for timeline; profits are given the same weight, whether they take place in one year or five years.
The payback period appraisal technique focuses on cash flow and evaluates an investment's attractiveness based on the length of time it takes to pay back the investment. This method focuses on cash flow rather than profit. If a $100,000 investment creates an annual cash flow of $20,000, it will take five years to pay back. The faster the payback, better the investment. However, the payback period method does not consider an investment's cash flow potential after the payback period is over.
Discounted Future Cash Flow
The discounted future cash flow (DCF) method accounts for the changing value of money over time and the potential for increased risks presented by future investments. This technique applies a regular, discounted rate to determine a more realistic value for future cash flow, as risk can change over time. For example, you may invest $10,000 today and expect a $1,000 return in one year with little chance of risk; however, in 10 years, the chance of receiving the same return is much less certain. The DCF applies a required return rate, or the amount you think you should earn on your investment, over a period of time. For instance, if you require a return of 10 percent on an annual cash flow of $1,000, DCF determines what you should invest today for that future return. To calculate DCF, multiply the cash flow by the required return rate, or 1,000 by 1.1. The DCF or present value of that $1,000 is $909.09.
Net Present Value
The net present value approach (NPV) incorporates the discounting cash flow method and assesses the current value of both investment costs and the resultant future cash flow. NPV compares the difference between the cost of an investment and its market value. Higher NPV numbers equal more attractive investments. To calculate NPV, determine discount the future cash flow of an investment to find present-day value, then subtract the cost of investment.
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