CAPITAL INVESTMENT APPRAISAL

Capital investments appraisal is an offshoot of capital budgeting. This constitutes techniques

traditionally applied to the principle of economics to assets replacement and expansion decisions.
In facts, the two terms are sometimes used interchangeably to denote the same meaning.

Capital investment appraisal, also known as capital budgeting is primarily a planning process
which facilitates the determination of the concerned firm's investments, both long term and short
term. The components of the firm that come under this kind of capital investment appraisal
include property, equipment, R & D projects, advertising campaigns, new plants, new machinery
etc. Thus in simple words, capital investment appraisal are the budgeting of major capital and
investment to company expenditure. For example, capital investment appraisal in small
companies decides on future ventures into newer markets as well as expansion and inclusion of
new activities.

Capital investment appraisal factors are selected based on the priorities of stakeholders and
decision makers. This available wide criteria selection of capital investment appraisal or
budgeting is based upon long term growth when compared to short term profits. In order to get a
fuller picture and better understanding of capital investment appraisal, various capital investment
appraisal techniques are employed to measure capital investment appraisal of a company.

Ten Capital Investment Appraisal Techniques

The capital investment appraisal techniques used to measure capital investment appraisal of a
business project include:

 Net present value

 Accounting rate of return
 Internal rate of return
 Modified internal rate of return
 Adjusted present value
 Profitability index
 Equivalent annuity
 Payback period
 Discounted payback period
 Real option analysis
 Net Present Value (NPV) – this capital investment appraisal technique measures the
cash in-flow, whether excess or shortfall, after the routine finance commitments are met
with. All capital investment appraisals have a single objective – drive towards a positive
NPV. The NPV is a mathematical calculation involving net cash flow at a particular
present time 't' at discount rate at the same time, i.e. (t – initial capital outlay). Thus there
is an inverse proportional relation between discount rate and NPV. A high discount rate
would reduce the net present value of capital. A high interest rate increases discount rates
over a period of time and most capital investment appraisals are wary of such an increase.
 Accounting Rate of Return (ARR) – this capital investment appraisal technique
compares the profit that can be earned by the concerned project to the amount of initial
investment capital that would be required for the project. Projects that can earn a higher
rate of return is naturally preferred over ones with low rate of return. ARR is a non
discounted capital investment appraisal technique in that it does not take into
consideration the time value of money involved.
 Internal Rate of Return (IRR) – capital investment appraisal techniques define IRR as
discount rate that gives a value of zero to NPV or net present value. Among all capital
investment appraisal techniques, IRR is generally considered to measure the efficiency of
the capital investment. Thus, if cost of capital investment in company works out to be
greater than the IRR value, the project is highly likely to be rejected. On the other hand, a
low cost of capital has more chances of being accepted. IRR is calculated by equating
NPV to zero and then deriving the discount rate. Even though IRR and NPV are related
capital investment appraisal techniques they are different from each other. IRR considers
the time value of money over the project life time and derives the world discount rate.
 Modified Internal Rate of Return (MIRR) – the IRR does not give the actual annual
profitability of capital since it does not take into consideration the intermediate cash
flows which is never reinvested equaling project IRR. Hence the IRR capital investment
appraisal technique is not effective enough since the rate of return in actual is certainly
going to be lower. This flaw is over come by a more efficient capital investment appraisal
 technique – MIRR. MIRR evaluates capital investment projects assuming that
reinvestment rate equals the company's cost of capital.
 Adjusted Present Value (APV) – APV capital investment appraisal technique
overcomes the shortcomings of NPV technique and evaluates a project on the basis of
risks associated to prospective company undertaking the investment.
 Profitability Index (PI) – evaluates a project based on calculation of value per unit of
investment. Also known as value investment ratio and profit investment ration, this
capital investment appraisal technique is a ratio of amount of money invested to profit or
pay off of the project.
 Equivalent Annuity – capital investment appraisals done using equivalent annuity
usually compares projects with different life spans. In cases where two projects have
different time spans, NPV would not justify a fair comparison. This capital investment
appraisal technique divides the NPV value with annuity factor resulting in expressing
NPV in relation to annualized cash flow.
 Payback Period – appraising capital investment on the basis of time that would be taken
to get back your initial investment is called as payback period. Payback period is one of
the easiest methods of capital investment appraisal techniques. Projects with a shorter
payback period are usually preferred for investment when compared to ones with longer
pay back periods.
 Discounted Payback Period – capital investment appraisals using discounted payback
period is similar to payback period but here, the time value of money or discounted value
of cash flow is considered for calculation of payback period.
 Real Option Analysis – capital investment appraisals using real option analysis
considers and values the various options that managers would have while managing their
projects in terms of increasing cash inflow and decreasing cash out flow. These values
are added to NPV in the course of capital investment appraisals.