Decisions related to investments are one of the most important and vital decisions for any organization. Making investments is the only way to increase, and maximize return on the shareholder’s wealth. However, taking the right investment decisions is the biggest challenge that management faces.
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Investment decisions are always characterized by risk and uncertainty. According to Lumby (2004) investment decision defined in simple terms, is one in which organizations make an initial cash outlay, with the aim of receiving, in return, the future cash inflows. Investments can be analyzed from several perspectives, like its suitability according to the company’s objective, social cause, environmental concern etc. Yet, for the purpose of investment appraisal, it is analyzed from the point of view of cash flow only. Thus, the basic aim of investment appraisal is to check whether the initial outlay would result in enough future cash inflows, to be considered worthwhile. In order to achieve this objective, companies require certain inputs. These inputs are put through the process of investment appraisal, to reach the final outcome.
Investment appraisal in broad terms requires only two inputs – the estimated cash flows, and discount rate. The estimated cash flows includes all the cash outflows starting from the initial stage till much later, and inflows taking place during the lifetime of the project. This gives the final figure, which is positive or negative cash flows i.e. either inflows are more than outflows which is the acceptable case, or outflows are more than inflows which obviously leads to rejection of that project. Calculation of these cash flow figures, involves the treatment of a number of items.
For the investment appraisal process as discussed earlier, cash flow estimates are the primary input. Initial outlay is easy to estimate as compared to future cash inflows, and even outflows. This is because current requirements for any project, would be ascertained according to which the required finance, can be obtained. Whereas, in the case of future estimates, all the figures are estimated on the basis of some premise, which is always prone to uncertainty. Once these estimated figures are available, companies calculate these future cash flows, in terms of today’s value. This is known as the time value of money, according to which, a pound today is not equivalent to a pound tomorrow. According to the time value of money, the investor needs to be compensated for certain factors. Firstly, the investment made has delayed the current consumption of the investor. Current consumption is preferred over future consumption for which, the investor needs to be compensated. This compensation is the interest that is expected on the money invested,
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