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INVESTMENT APPRAISAL METHODS The managers of all businesses will find themselves faced, from time to time, by Capital Investment decisions. Capital investment decisions have direct effect on future profitability --- increase in efficiency and reduction in costs Proper evaluation of Capital expenditure projects is important before taking go a head decision. Capital expenditures differs from revenue expenditures as they involve bigger outlay of money and benefit will accrue over a long period of time
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WHY APPRAISING INVESTMENT PROJECTS? As investments involve large resources, wrong investment decisions are very expensive to correct Managers are responsible for comparing and evaluating alternative projects so as to allocate limited resources and maximize the firm’s wealth
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PLANNING STEPS FOR CAPITAL INVESTMENT DECISIONS Identification of investment opportunity Consideration of the alternatives to the project being evaluated. Acquiring relevant information. Form the basis for informed decisions otherwise projects to be abandoned at early stage Detailed planning is involved. Taking the investment decisions
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PROJECT CLASSIFICATIONS 1. Replacement of equipment: Maintenance of business – Replacement of worn out or damaged equipment done for continuing business operations. 2. Replacement of equipment : Cost reduction. Replacement of equipment with more efficient assets helping in reducing cost and increasing profitability. 3. Expansion of existing products / markets: Expenditure to increase output of existing products, or to expand retail outlets or distribution facilities in the markets now being served.
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4. Expansion into new products / markets . Involving strategic decisions that could change fundamental nature of the business– large capital outlay and delayed pay back period. 5. Safety and other environmental projects . Expenditures incurred for complying Government orders, labor agreements, or insurance policy terms – mandatory investments. Normally involve non revenue producing projects. 6. Research and development . The expected cash flows from R&D are often too uncertain to warrant a standard DCF analysis. Decision tree analysis and real option approach are used. 7. Long term contracts . For provision of products and services involving cost and revenue over multiple of years (DCF analysis done before signing contract)
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PRINCIPAL METHODS OF EVALUATING CAPITAL PROJECTS The return on investment method, or accounting rate of return method The payback method Discounted cash flow method(DCF) (i) The net present value method (NPV) (ii) The internal rate of return method (IRR) (iii) MIRR (Modified internal rate of return) Profitability Index
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The accounting rate of return method The accounting rate of return method of appraising a capital project is to estimate the accounting rate of return or return on investment (ROI) that project should yield. If it exceeds a target rate of return, the project will be undertaken.
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