An investment appraisal is usually the final stage of a putting together a business case. Some may view it as more complex than a cost-benefit analysis, but it can be useful to help determine the best option based on the financial benefits.
Before conducting an investment appraisal, the following steps should have been conducted:
This is where the user looks at the financial aspects of the change, by considering the tangible costs and benefits. There are two main measuring methods used in producing an investment appraisal; the Payback Calculation and Net Present Value (NPV)/Discounted Cash Flow (DCF).
Using one or more of these methods will provide the analyst and senior management with a better understanding of the finances involved for each option within the business case and whether it’s worth pursuing.
There are two main measuring methods used to produce an investment appraisal:
The first is a payback calculation, which is the simplest out of the two to produce. A payback calculation is often used to provide a cash-flow forecast for a change or development project. In order to produce a payback calculation the analyst must list all tangible costs and benefits. From this the analyst can then start to project the cumulative cash-flow throughout a period of time (example shown below)
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|Item||Year 0||Year 1||Year 2||Year 3||Year 4|
|Tangible Costs||Hardware Costs||£200,000||-||-||-||-|
|Tangible Benefits||Staff Savings||£150,000||£150,000||£150,000||£150,000||£150,000|
|Cash Flow for Year||-£260,000||£90,000||£90,000||£90,000||£90,000|
|Cumulative Cash Flow||-£260,000||-£170,000||-£80,000||+£10,000||+£100,000|
By working out the cumulative cash-flow over the period years, we can see that the accumulated benefits exceed the accumulated costs by Year 3 and accrue afterwards.
The next method is known as NPV/DCF. This method takes account of the time value of money. This means that all cash-flows are adjusted for inflation and other factors. The DCF rate is often determined by accountants, but can be worked out by the user by studying a number of financial factors. Let’s assume that the accountant has calculated the discount rate of 10%, and we then apply it to the same example as shown above.
|Year||Net Cash Flow||Discount Factor||Present Value|
|Net Present Value of Project: £25,210|
We can now see that the project is not as attractive as it first appeared in the payback calculation. The project is still profitable but only after Year 4 and only by £25,210 instead of +£100,000.
It can be worthwhile to conduct the above calculations to ensure that the financial justification for the project is kept in perspective.
By this point you should be working towards the completion of the business case. It’s important to remember that not every business case would include every business analysis technique. The size and nature of the project would determine what tools or techniques you would use to build your business case.
Once you have your business case, you can take it to the senior management team for approval. Once an option is approved, you can start establishing requirements for the approved change or development project.