Investment appraisal involves some or all of the following steps.

Defining the objectives

The objective of the firm is to make profits and/or to satisfy the preferences of its management and or owners. Investments have the same objectives. However, just as the firm has to decide what product to produce, so it has to decide the type of investment projects that will support the goal of making a profit. Projects might be classified as follows:

1.Replacement investment: where equipment has to be replaced if production is to continue. Old equipment might not be replaced by similar equipment, but by more up-to-date machinery, enabling the firm to increase efficiency and reduce unit production costs.

2. Expansionary investment: where the firm expands its capacity to meet growing demand for its existing products or wishes to produce new products or enter new markets.

3.Other investments: such as those required for health and safety or environmental reasons.

Identifying options

Once the objective of an investment programme has been set, the firm or organization can then consider the various ways in which the objective might be met. If the investment is of a simple replacement type, then the range of options may be limited to replacing like with like; otherwise, the rest of the equipment may not work. If the old equipment is to be replaced by more up-to-date equipment, then there may be a broader range of options.

Identifying the costs, benefits, timing and uncertainties of each option

Once each option has been identified, it is necessary to quantify the timing and size of the streams of costs, as well as the revenues accruing as a consequence of the project. For each year of the project, a schedule should be constructed showing the expenditure and expected income. The initial costs of the project may be known with certainty, but the net revenue stream will depend on future economic conditions. It may be necessary either to estimate different streams of revenues depending on projected market conditions or to estimate the likelihood of different conditions prevailing. The prices to be used to value sales have also to be assessed and allowance made for real changes. It is also necessary to identify the length of time during which the project is expected to operate.

Choosing the method of appraisal

Theoretically (as will be shown), the soundest method of appraising a proposed project is by discounted cash flow techniques. However, the data requirements for such analysis may lead managers to use other methods, such as payback or the rate of return.

Choosing the cost of capital

The cost of capital is a crucial variable in evaluating projects. The choice of value to represent the opportunity cost of the resources to be used is important as too high or too low a value will distort choice.

Test of viability

When all the information is gathered, projects should be assessed to see whether they are individually worth while and ranked in order of merit. ‘‘Worthwhileness’’ is taken to mean that the expected revenues exceed the expected costs of each project, given the cost of capital

Presenting the results

The present value of each of the projects should be presented to the decision makers in a form that allows them to rank them in order of desirability to the firm. Information regarding uncertainties in the estimates or crucial assumptions should also be identified.


For example, if an electricity supplier has decided to build a new power station to meet an expected growth in demand, then the steps outlined above could be implemented as follows. Initially, the alternative technologies available should be considered for similar sized increments in capacity. The costs of undertaking each alternative plan should then be estimated. Once operational, the variable costs of producing electricity including fuel, labour, and management should be estimated based on the expected output together with expected revenues over the anticipated life of the project. For a power station this might be 25 years or more. At the end of its life, there may be significant costs in closing the power station, particularly if it is of the nuclear type. The four key elements in estimating the cash flows of a project are capital costs,operating costs, revenues and decommissioning costs.

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