There are a number of appraisals and financial techniques in place for assessing the financial terms of an investment proposal. When appraising new investments in technology, the methods of evaluation and analysis are based on the project’s future cash flows that investments would be able to generate for the organization.
In this article, we take a look at financial appraisals and the techniques that can be used here. The processes and investment appraisal techniques used here include:
- Payback Period: The payback period calculates the number of years it will take for the business to recover the original amount that is invested in the plan.
- Accounting Rate of Return: Accounting Rate of Return or ARR calculates the return from the project as a percentage of the capital that is employed in it.
- Net Present Value: Net Present Value is a discounted technique used to convert all future earnings through the project into current day cash equivalents. The NPV of a project can vary based on predictions related to the discount rate.
- Discounted Payback: Discounted payback is similar to the payback period, only that the cash flows considered in this method are discounted before the actual payback period is found out.
- Internal Rate of Return (IRR): The Internal Rate of Return or IRR of a project is determined by calculating the appropriate discount rate of the product. The IRR is the discount rate at which an NPV of zero will be recorded.
We discuss these techniques of investment appraisal in greater detail within the article below for better inference and comprehension.
Most organizations use multiple methods to appraise their investment decisions and to find out the suitability of these investment decisions for future plans. Different methods tend to give different results, which is why managers and financial analysts should carefully go through the numbers and account for results generated through each technique before reaching a conclusion.
Payback Period for Appraisal of New Investments in Technology
The payback period calculates the number of years it will take for the business to recover the original amount that is invested in the plan.
If you have multiple investment proposals to choose from, then you should definitely go for the one that produces a shorter payback period because of how it earns more in a shorter period of time.
While the payback period is simple and easy to understand for managers without a financial background, it also carries a few weaknesses, including:
- The payback period shows positive results for short-term investments that pay back the total invested sum faster than other bigger investments that take longer to pay back the initial amount but are more profitable in the long run.
- This period does not prioritize the discount rates.
Accounting Rate of Return
Accounting Rate of Return or ARR calculates the return from the project as a percentage of the capital that is employed in it. In short, the ARR compares the profit generated by the investment with the initial cost.
As per the ARR method of investment appraisal, an investment that produces a higher return after subtracting the initial cost of the investment should be preferred. While ARR is simple and can give a good picture of the future, it does carry a few weaknesses as well. These include:
- ARR completely disregards the time value of money and the future discount rates.
- Accounting conventions like depreciation are often manipulated here for better results.
Net Present Value
Net Present Value is a discounted technique used to convert all future earnings through the project into current-day cash equivalents. The NPV of a project can vary based on predictions related to the discount rate.
NPV or net present value allows businesses the ability to make more informed decisions while accounting for the concepts of the time value of money. The Net Present Value is calculated through cash inflows and outflows. As per the time value of money, $1 gained today is a lot more valuable than the $1 gained in the future because the $1 gained today can be invested elsewhere to earn interest.
Due to this method of appraisal, cash flows are less prone to manipulation and can easily be calculated. Some weaknesses of this method include:
- Cash timings are difficult to predict
- The data provided at the start of the project and the cash flow generated during it can vary
Discounted Cash Flow
Discounted payback or cash flow is similar to the payback period, only that the cash flows considered in this method are discounted before the actual payback period is found out.
The discounted cash flow is used for calculating the NPV as well, which is why it can directly be extracted from it. The results achieved through the discounted cash flow also assist in the calculation of IRR or internal rate of return, which is next in the list.
The discounted cash flow or payback period minimizes the flaws of the simple payback period mechanism we used earlier. Cash flow predictions from the investment are discounted and are calculated in present value before a decision is made.
Internal Rate of Return (IRR)
The IRR of a project is determined by calculating the appropriate discount rate of the product. The IRR is the discount rate at which an NPV of zero will be recorded.
The Internal Rate of Return is calculated by setting the PV to zero in the formula for Present Value.
IRR can be used as a tool for investment appraisal when the rate at which funding for an investment is provided is known. In such cases, the project is considered viable and productive if the rate for the investment or the project at hand exceeds the rate at which the funding for the project is provided.
Conclusion to Appraising New Investments in Technology
All of these methods of tech investment appraisals can help determine the suitability of a new project. Contact us for services and solutions about Appraising New Investments in Technology.
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