�Consider the main ideas relating to the need for careful investment appraisal of projects.
�Consider how sensitivity and scenario analysis can be used in capital budgeting decisions.
�Discussing an example related to different capital investment appraisal techniques
�Offering examples of sensitivity analysis within the context of capital budgeting decisions
�Extending the discussion into new but relevant areas regarding financial management.
Introduction
A principled decision-making process includes the collection of all information that is
accurate for any organization seeking for avenues for investment. Investment appraisal,
therefore, remains an integral part that requires appropriate decisions. An assessment determines
the allocation of the organizations financial resource among the varying market opportunities.
Organizations, therefore, need to employ the functions of project appraisal to disclose an
analysis of a project and to determine whether particular projects should be implemented or not
(Adler, P. 15, 2000). An appraisal therefore derives avenues through which an organization can
determine the alternative approaches geared towards selecting an optimum solution with respect
to the size of a project, its location, technology, engineering, organizational set-up, the size of a
market, economic and social aspects, and financial cost-benefit. This paper therefore seeks to
focus on the elements of a projects appraisal.
The Need for Careful Investment Appraisal of Projects
It is significant to acknowledge that business enterprises make their investments over
their long-term assets. In the event that such an entity has limited capital, there is a need for great
care while considering the development of a program, a factor that necessitates the incorporation
of an investment appraisal.
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Investment appraisal therefore requires an organization to make significant decisions on
their capital investments through an analysis that is carried out to decide whether such an entity
should channel its funds to a particular investment process whose returns are more likely to be
realized within a short period of time (Adler, P. 15, 2000). An appraisal drives an organization’s
stakeholder into generating, evaluating, and following up on an investment alternative that would
suit an organization’s state.
There is consequently a need for a careful investment appraisal on organizations projects
to determine decisions that would prove beneficial for the organization before undertaking any
project. Such decisions would include evaluations on organizations expenditures and the benefits
of returns from such expenditures over a period (Damgaard, & Elkjaer, Pp. 245-260, 2014).
These decisions have an impact on the long-term profitability and flexibility of an organization.
It is also crucial to mention that the success and failure of an organization would be determined
by the quality of an investment appraisal developed for an organization.
Capital Budgeting
Capital budgeting mainly concerns an organization’s analysis it’s potential projects and
remains one of the most significant decisions that managers need to critically make. The capital
budgeting therefore involves a systematic evaluation of the amount of capital an organizations
should invest in a project including the specific assets that this organizations can employ to meet
an investments goal (Damgaard, & Elkjaer, Pp. 245-260, 2014). According to sources from the
financial literature, this process is described as an organization’s long-term investment. The
success of a capital budgeting process lies in the evaluation through a forecast and monitoring
procedure. The success of a company, therefore, depends on the appropriate choice of a capital
budgeting system for investment decisions of an organization.
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In the event that an organization faces challenges with limited sources of capital,
managers go through a sensitive and scenario analysis to carefully decide whether a particular
project can viably meet the organizations economic situation. In a case where the organization
has more than one project, the management is required to identify the primary project that will
bring returns to the value of the organization (Dragotă, & Dragotă, Pp. 1-7, 2009). Through this,
the process of capital budgeting is brought on board. The commonly used technique in
evaluating the capital budgeting process of a project includes the payback method that
determines the time limits of an organization in recovering its cash outlay.
The different capital investment appraisal techniques
There are four types of investment appraisals that companies can undertake in
determining the rewarding projects within its objectives. The four typologies can be classified
into two main categories; the ARR and payback period which includes a non-discounting
approach while on the other hand the NVP and IRR include the discounting methods. The ARR
approach of appraisal mainly measures the accounting profit rate by dividing an organization’s
average income with the average investment.
The payback method calculates the time length that an organization can employ in
recovering its initial investment from its operating cash flow in a project (Dragotă, & Dragotă,
Pp. 1-7, 2009). A shorter payback period may be a preferred method for an organization since it
capacitates an organization to generate equal levels of cash for an initial investment over a short
duration of time, also viewed as a proxy of risks. It is significant to mention that the payback
approach primarily ignored the element of time value of organizations returns.
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The NVP approach also calculates the bet value of an organization’s project by
discounting its cash flow in a manner that reflects the risks that would be associated with the
cash flows. This, therefore, offers an organization the advantage of the NVP method over a
discounting approach. The NVP method, on the other hand, assumes the maintenance of the
capital a factor that less happens since cash flows change with time (Sangster, Pp. 307-332,
2003).
Sensitivity Analysis within the Context of Capital Budgeting Decisions
Sensitivity analysis within an organization determines how critical an output is to change
inputs while also keeping the other inputs constant. The sensitivity analysis is important since it
enables a user to determine how dependant an output value is on each and every input. A sample
example of this can be determined below;
A construction company decides to build a road that is 20 kilometers long within a city.
The company bids for a $1 from vehicles that pass through the road for a period of 100 years.
The chief engineer resorted to and NPV of $ 1,218 million over the project with an assumption
of cash flows at the end of the year (Sangster, Pp. 307-332, 2003). He made an estimate of an
average cost of capital at 12.1% of the daily vehicles passing through the road approximated at
1,000,000. His daily operating expanse stood at 3% of the total revenues and a cost of $ 2 billion.
In determining the sensitivity in the net value of this project input, the approach below will be
essential.
Solution
Net present value of the WACC is assumed to be 12.1%
Daily traffic of vehicles= 1,000,000
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Daily operating expenses 3% of an initial cost of $2,000 million
Present value of the project=$925 million
Determining the percentage output would require;
-24.01% ($ 926million× $1,218 million) ÷ $1,218 million) over corresponding input of
10% (12.1%-11%) with an output of 1%.
This calculation therefore shows the relationship between the negative sensitivity and the output
and inputs in the project.
Financial Management
The investment appraisal method has some ties with the financial management
approaches within an organization. Financial management involves the processes of planning,
organizing, directing and controlling organizations financial activities (Tegarden, Pp. 5-14,
2013). It involves the aspects of applying the general managerial principles into the financial
resources of an organization.
Conclusion
Out of this, it is therefore relative to summarize that an appraisal derives avenues through
which an organization can determine the alternative approaches geared towards selecting an
optimum solution with respect to the size of a project, its location, technology, engineering,
organizational set-up, the size of a market, economic and social aspects, and financial cost-
benefit.
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References
Adler, Rw 2000, ‘Strategic Investment Decision Appraisal Techniques: The Old And The
New’, Business Horizons, 43, 6, P. 15.
Damgaard, J, & Elkjaer, T 2014, ‘Foreign Direct Investment And The External Wealth Of
Nations: How Important Is Valuation?’, Review Of Income & Wealth, 60, 2, Pp. 245-260,
Dragotă, V, & Dragotă, M 2009, ‘Models and Indicators For Risk Valuation Of Direct
Investments’, Economic Computation & Economic Cybernetics Studies & Research, 43,
3, Pp. 1-7,
Sangster, A 2003, ‘Capital Investment Appraisal Techniques: A Survey Of Current
Usage’, Journal Of Business Finance & Accounting, 20, 3, Pp. 307-332
Tegarden, Tk 2013, ‘Income Approach Techniques In Central Assessment Appraisals’, Journal
Of Property Tax Assessment & Administration, 10, 3, Pp. 5-14
