An Investment Appraisal is usually the final stage of a business case; therefore the analyst should have documented, or at least considered the following stages – Identifying Options, Assessing Project Feasibility, Cost-Benefit Analysis, Impact Analysis, Risk Assessment and Recommendations.
This is where the analyst conducts the financial aspects, by referring back to the tangible costs and benefits. There are two main measuring methods used in producing an Investment Appraisal, which are Payback Calculation and Net Present Value/Discounted Cash Flow.
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.
As mentioned above, 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 build up there 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 to today’s value of money. The DCF rate is often determined by accountants, but can be worked out by the analyst 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 still profits but only after the 4th year and only by £25,210 instead of +£100,000.
It is always worth the analyst’s time to develop a payback calculation followed with a NPV/DCF. This will just keep everything in perspective.
By this point you should be looking at the completion of the business case. From here, the analyst would take it forward to the senior management team. If the senior management team agree to go ahead with one of the options, it will then be up to the analyst to start establishing requirements for the approved change or development project.