Chapter 4 • Investment appraisal methods
l individual projects frequently involve relatively large and irreversible commit-
ments of finance; and
l they involve this commitment for long, often very long, periods of time.Clearly, the investment decision is a central one. Costly and far-reaching mistakes
can, and probably will, be made unless businesses take great care in making their
investment decisions. Bad decisions usually cause major financial loss, and any par-
ticular business can make only a limited number of misjudgements before collapse
occurs.
In this chapter we consider how investment decisions should best be made, after
which we shall go on to consider how they appear to be made in practice.
Note that, for the time being, we shall continue to assume that all cash flows can be
predicted with certainty and that the borrowing and lending rates of interest are equal
to one another and equal between all individuals and businesses.4.2 Net present value
A basis for decision making
Given the crucial importance of businesses’ investment decisions, managers need
a logical and practical assessment procedure by which to appraise the investment op-
portunities that come to their notice. This procedure must promote the shareholders’
wealth maximisation objective, though in the final decision other objectives may well
be taken into account.
We discovered in Chapter 2 that if we assume that interest rates are equal, both
as between borrowing and lending and as between businesses and individuals, an
investment project undertaken by the business that will increase the spending power
of any one particular shareholder in the business, at one particular point in time, will
also increase the spending power of all other shareholders at any other point in time.
(We may remember that in our example in Chapter 2 all three of our shareholders
were advantaged by acceptance of Project X, despite having different attitudes to the
timing of their spending.)
It seems, therefore, that it does not matter whether our assessment procedure
focuses on the effect on present wealth or on wealth in a year’s time, or indeed at any
other time. If undertaking a particular project will increase present wealth, it will also
increase future wealth; that project that will most increase present wealth will most
increase future wealth. Thus, both for accept/reject decisions and for ranking projects
in order of desirability, it does not matter in respect of which point in time the effect
on wealth is assessed, provided that consistency is maintained.
Since we are always at ‘the present’ when making the decision, to consider a pro-
ject’s effect on present wealth is probably most logical. This tends to be the approach
taken in practice.The time value of money
Suppose that a business is offered an opportunity that involves investing £10 million
which will give rise to a cash receipt of £12 million. Should it make the investment?
Obviously if the cash expenditure and the cash receipt are to occur at the same time