Importance of Investment Appraisal

Whether considering starting or acquiring a business, or contemplating an investment in a new or ongoing enterprise, you will want to inform your decision with an investment appraisal. Such an appraisal is important for several reasons. The investment usually involves committing substantial resources. In addition, the decision requires an understanding of the feasibility of both strategic and tactical objectives. Understanding the relative risk depends upon an analysis of cash flows using a range of probabilities, such as different inflation rates.

A capital investment appraisal will reveal the project's general feasibility. This will include the projected cash flows and projected quarterly or annual profits. It will normally include a net present value analysis. These will give you a good idea of the probable profitability of the project in both the near and long terms.

A proposed investment almost never exists without alternatives. When considering an investment, you need to understand how it ranks in relation to others like it. Therefore, the investment appraisal should include a review of similar available investments and a comparison between the proposed project and the alternative projects.

One critical aspect of the investment appraisal assesses capital resources. Once your analysis reveals the initial capital requirements and the additional capital contributions the project will require going forward, you'll be able to determine whether the available capital resources make the investment feasible.

The investment appraisal also should describe the process required to move the project from the initial investment appraisal to its inauguration. In most cases, this will involve a description of the authorizations required. Most projects will require internal company authorizations, including in some instances the board of directors and CEO, in other instances departmental or regional agencies. Understanding these internal authorization requirements early on becomes critically important for the project's timely development. In other cases, authorizations will include various public agencies and review boards. The investment appraisal enumerates these authorizations and estimates the approval costs. In some cases, this kind of review reveals that a project that seems otherwise feasible will cost far more than anticipated because of the difficulty and expense of obtaining necessary authorizations.

Another important function of the investment appraisal concerns uncertainty. Projecting discounted cash flows over a period of time requires assigning specific values to inflation rates, future regulatory costs and other factors that, in reality, remain uncertain. The investment appraisal includes these variables by assigning probabilities to ranges of outcomes. This analytical technique provides a realistic model that includes risk assessments.

An investment appraisal not only will demonstrate a project's relative financial feasibility, it also will assess how well the particular project fits into a company's strategic plans. Ultimately, how well a proposed project moves forward strategic objectives or how well it fits into the company's social fabric will have wider financial implications. A book publisher, for example, may have a roster of prominent authors that favor a specific part of the political spectrum. A contemplated book project may promise generous cash flows going forward, but if its political message opposes the general orientation of the company's current authors and offends them, this will weaken the bond between the company and its valuable current roster. Over the long run, the contemplated project does not fit well within this company, as the investment appraisal will point out.