Capital investment appraisal - part 1

　　by Samuel O Idowu

　　01 Aug 2000

　　Organisations operate in a dynamic environment. They must therefore continually make changes in different areas of their operations in order to meet the challenges that the dynamic nature of the environment brings and also in order to survive and prosper. It is believed that continuous change could improve the way things are done, thereby putting the organisation at an advantage over their competitors. Most changes involve capital expenditure, which can invariably involve large sums of money. The expenditure might involve replacing existing fixed assets with something more efficient and up to date or to acquire an entire business.

　　The decision to go ahead with any capital expenditure of a significant amount could necessitate spending a large sum of money. Managers must give careful thought to every step that they need to take before a final decision is made on whether or not to invest money on such a project. Most investments will have one form of return or another. The question to address is whether or not the future returns will be sufficient to justify the sacrifices the investing entity would have to make.

　　The intention of this article is to demonstrate how organisations justify capital investments using different appraisal techniques. It is hoped that the reader will supplement the knowledge gained from it with that gained elsewhere.

　　The article will be of interest to students taking paper 8, Managerial Finance, at the certificate level and also to those taking Paper 9, Information for Control and Decision-Making at the professional level.

　　Payback method

　　Super Model

　　Cost￡500,000

　　YearCash inflowsAccumulated Cash inflows

　　1250,000 250,000

　　2 100,000 350,000

　　3 100,000 450,000

　　4 50,000 500,000

　　Payback Period = 4 years

　　Deluxe Model

　　Cost ￡800,000

　　YearCash inflows Accumulated Cash inflows

　　1 150,000150,000

　　2 200,000 350,000

　　3 250,000 600,000

　　4 100,000 700,000

　　5 100,000 800,000

　　Payback = 5 years

　　By comparing four years for the super model with five years for the deluxe model, one would recommend AICO Plc to buy the former, as its payback period is shorter than the latter.