By Graham Mott
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Additional info for Investment Appraisal for Managers
The simplest is to rank them by the size of their DCF yields. When firms use only the NPV method the size of the NPV surplus is not related to the amount of capital invested to earn that surplus. To compare the relative profitability of projects on the NPV method we go a step further and calculate a profitability index by dividing the NPV inflow by the NPV outflow. 0755. ooo but its relative profitability against other projects can be measured by the size of the index number. Care must be taken when ranking in the two special situations of capital rationing and the choice between alternative projects.
Firms may sometimes calculate the rate of return expected in the first year of operation and compare this with the actual return earned for monitoring purposes. This monitoring or post-audit appraisal is an important part of project investment and is discussed in the concluding chapter. However, the complexities of taxation, grants, working capital and other items reduce the validity of the rate of return method in many cases. Ranking of projects There are two ways to rank projects in order of attractiveness.
In the case of cost saving investments, say in the automation of a manual process, the appraisal should be for the life of the new equipment. If the new equipment's life is longer than will be required a residual value can be assumed at the end of the project's life. This will show as a cash inflow in the last year. 40 When appraising new products the project life can be taken as either the product life or the plant life, whichever is the shorter. If the plant life exceeds the product life a residual value, if any, can be assumed as above.