Investment appraisal terms

For the first time you approach investment appraisal topic, you might find that the terms used are technical. This article clarifies the meaning of certain basic terms. A number of sentences will be used as examples.

1. Payback method can be used for initial screening of the projects.
As we normally identify a number of projects, calculating the payback periods (the time of breakeven) for each project help in determining which project covers the investment cost in the shortest time. As payback period is simple to calculate, it is normally used at the initial stage to scan through all projects.

2. Discounted cash flows take into account time value of money.
Discounted cash flows mean that the future cash flows are converted to the value now (present value). As the value of money drops each year, discounting the cash flows will take into account the effect of time value of money.

3. We can discount the cash flows at company's cost of capital.
Cost of capital is expressed in percentage. The cost of the company's capital is actually the need of repaying the investors, ie. required rate of return of the investors. So for example, if the cost of capital is 10%, we can refer to the present value table to identify the rate of discount at 10%. Time period of cash flows will be taken into account.

4. Positive net present value (NPV) project generates wealth for shareholders.
NPV is the present value of cash flows less investment cost. As NPV also takes into account time value of money, positive NPV represents the value added to the shareholders and also the value of the company.

5. If internal rate of return (IRR) is greater than cost of capital, project is acceptable.
IRR is the rate where net present value (NPV) is zero. This means that if the IRR rate is used for discounting, NPV will be zero. IRR should be greater than cost of capital so that the margin of safety to meet the required rate of return by investors is large enough. If IRR is less than cost of capital, that means the project reduces the wealth of shareholders as discounting at higher rate (cost of capital) will result in negative NPV.

The above may be some of the new things faced in investment appraisal topic. You need to focus on understanding them as they are useful for future papers. It is okay if you can't understand everything here because you will get a more detailed explanation in class. :)