Use this method to make the best capital investment appraisal for your business
Management uses capital investment appraisal to analyse and evaluate investment projects (and this might include simply replacing a business asset, such as the company delivery van). But without a sound appraisal method in place, you won't get a true picture of the risk versus the returns. And this could severely impact your cash flows. Here's some great advice from the experts...
The accounting experts at the Practical Accountancy Loose Leaf
explain why the Nett present value (NPV) method is an efficient capital investment appraisal method for your business.
Here's why the Nett present value (NPV) method is a powerful capital investment appraisal method
This method essentially addresses the issue of time value of money (the principle that acknowledges that the value of money changes over time) and provides a more accurate view of your assets and the capital investments you make in them.
The NPV is the present value of future returns (cash flows), discounted at an appropriate cost of capital, less the cost of the investment. The discount rate referred to is actually an opportunity cost of investing your money somewhere else.
The hurdle rate is the minimum rate that a company expects to earn when investing in a project.
Why it's important to compare funds invested andreceived at the same time
When evaluating your investment it's important tocompare funds invested and received at the same .Assume that from a certain investment, you can generatethe following cash flows into the future:
Year 1 R5 000
Year 2 R4 000
Year 3 R6 000
The value of each of these amounts won't be the sameright now. This means that the value of R5 000 in oneyear's time won't be the same as that of R5 000 today.
Using a financial calculator, you can calculate the valuesof each one of the above amounts at today's date usingthe hurdle rate as the discount factor.The decision rule:
NPV > 0 → ACCEPT
NPV < 0 → REJECT
Now you know how to evaluate your company's capital investments, confidently!