Investment Appraisal Techniques Used in Nigerian Firms

Last Updated on November 3, 2023

Introduction

Investment Appraisal Techniques in Nigerian Firms to evaluate potential investment opportunities.

These techniques aid in decision-making and help firms select the most profitable investments.

Investment appraisal plays a crucial role in determining the success or failure of businesses in Nigeria.

A brief overview of investment appraisal techniques

The methods used to assess the viability and profitability of investment projects.

Some commonly used techniques include payback period, net present value (NPV), internal rate of return (IRR), and accounting rate of return (ARR).

Each technique provides different insights into the potential returns and risks associated with an investment.

Importance of investment appraisal in Nigerian firms

Appraisal is necessary due to the challenging business environment, aiming to make informed decisions effectively.

These techniques aid in identifying profitable opportunities, managing risks, and ensuring sustainable growth.

They evaluate projects aligned with objectives, maximizing shareholder value and optimizing resource allocation.

Appraisal tools assess financial feasibility, minimizing losses, and impacting cash flow, profitability, and risk.

Ultimately, Nigerian firms employ accurate techniques, fostering competitiveness and sustainable growth in the business environment.

Payback Period Technique

Investment appraisal techniques assess Nigerian firms’ potential returns and risks in various investment projects.

This technique determines the time required to recover the initial investment, focusing on cash flows.

It aids decision-makers in evaluating liquidity and risk associated with investments, with shorter payback periods being preferable.

An advantage lies in its simplicity, enabling quick project assessments without complex financial analysis.

Additionally, it suits Nigerian firms’ liquidity constraints, but has limitations excluding the time value of money.

This neglects long-term project value, limiting suitability for those with significant long-term costs or benefits.

For instance, ABC Manufacturing plans a ₦10 million investment in a new production line with a 2-year payback.

Though insightful, complementing it with NPV and IRR is crucial for comprehensive profitability and risk analysis.

The Payback Period Technique, vital for its simplicity and liquidity focus, should align with a mix of methods for informed decisions.

Read: The Interplay of Equity & Debt in Nigerian Corporate Finance

Net Present Value (NPV) Technique

Nigerian firms widely use the NPV technique to assess investment profitability by discounting future cash flows.

The technique aids in determining project feasibility and informs decisions by comparing present value against initial investment.

Pros

1. Provides a clear measure of profitability and financial viability.
   
   
2. Takes into account the time value of money and adjusts for inflation.
   
   
3. Enables comparison between different projects or investment options.
   
   
4. Helps in prioritizing projects based on their ability to generate positive NPV.
   
   
5. Considered to be a comprehensive and reliable technique among finance professionals.

Cons

1. Requires accurate estimation of cash flows and discount rates.
   
   
2. The method heavily relies on assumptions, which may introduce biases in the result.
   
   
3. Discount rate selection can be subjective and impact the outcome.
   
   
4. May not consider qualitative factors that contribute to the success of an investment.

Case Study/Example

A Nigerian firm demonstrates NPV by evaluating a manufacturing company’s plan to invest in new machinery.

The machinery costs ₦10,000,000, projecting cash inflows for five years.

1. Year 1: ₦2,000,000
   
   
2. Year 2: ₦3,000,000
   
   
3. Year 3: ₦4,000,000
   
   
4. Year 4: ₦3,500,000
   
   
5. Year 5: ₦2,500,000

Assuming a discount rate of 10%, we can calculate the NPV as:

NPV = ₦2,000,000/(1+0.10) + ₦3,000,000/(1+0.10)^2 + ₦4,000,000/(1+0.10)^3 + ₦3,500,000/(1+0.10)^4 + ₦2,500,000/(1+0.10)^5

Calculating the NPV gives:

NPV = ₦2,000,000/1.10 + ₦3,000,000/1.21 + ₦4,000,000/1.33 + ₦3,500,000/1.46 + ₦2,500,000/1.61 = ₦12,919,647

Based on the positive NPV of ₦12,919,647, the company should proceed with the machinery investment, expecting returns to exceed the initial investment.

Nigerian firms employ NPV to assess investment profitability, offering a clear measure incorporating the time value of money.

Yet, limitations arise from assumptions and discount rate selection.

The application of NPV in a Nigerian firm shows how it assists in making informed investment decisions.

Read: How Nigerian Firms Optimize Capital Budgeting Decisions

Internal Rate of Return (IRR) Technique

Firms primarily use it as an investment appraisal tool.

The IRR Technique

The IRR technique measures the profitability of an investment by calculating the rate of return at which the net present value (NPV) of the investment becomes zero.

This method presumes that the investment reinvests cash flows at the same rate as the IRR.

How Firms in Nigeria use it

1. Nigerian firms use the IRR technique to assess investment projects’ appeal by comparing calculated IRR with the required rate.
   
   
2. Projects surpassing the required rate are financially feasible, while those below may face rejection or scrutiny.
   
   
3. They gauge the calculated IRR against the required rate to judge project viability.
   
   
4. Projects having an IRR below the rate could encounter rejection or require additional scrutiny for approval.

Pros and Cons of the Technique

1. Pros

1. The IRR technique considers the time value of money and provides a measure of the project’s profitability.
   
   
2. It allows for easy comparison between different investment projects.
   
   
3. IRR takes into account all cash flows throughout the project’s life, providing a comprehensive evaluation.

2. Cons

1. The reinvestment of all cash flows at the same rate as the IRR may not be realistic.
   
2. It can result in multiple IRRs for complex projects with non-conventional cash flows.
   
   
3. IRR does not consider the scale of the investment, which may lead to incorrect decision-making.

Case Study/Example of its Application in a Nigerian Firm

ABC Ltd., a Nigerian manufacturing company, is considering investing in new machinery.

The initial investment is $500,000, and the projected cash flows over five years are as follows:

1. Year 1: $100,000
   
   
2. Year 2: $150,000
   
   
3. Year 3: $200,000
   
   
4. Year 4: $250,000
   
   
5. Year 5: $300,000

Using the IRR technique, ABC Ltd. calculates an IRR of 15% for the investment.

The project becomes financially feasible due to the 12% required rate of return.

ABC Ltd. chooses to invest in the new machinery based on the expected profitable return indicated by the IRR.

Nigerian firms use the IRR technique as a valuable tool to evaluate potential investment profitability.

When combined with other investment techniques, it empowers decision-making and maximizes shareholder value effectively.

Read: Nigerian Case Studies: Successful Corporate Finance Moves

Accounting Rate of Return (ARR) Technique

Nigerian firms widely utilize this investment appraisal tool.

The ARR technique

1. ARR is a method that measures the average annual profit or return in relation to the initial investment.
   
   
2. This technique calculates the ratio of average annual profit to the initial investment cost.
   
   
3. It expresses the ARR as a percentage, signifying the investment’s profitability throughout its useful life.
   
   
4. ARR is a simple and easy-to-understand investment appraisal technique.

How firms in Nigeria Use this

1. Nigerian firms utilize the ARR technique to assess the profitability of potential investment projects.
   
   
2. They calculate the average annual profit generated by the investment and compare it with the initial cost.
   
   
3. The firm establishes a target rate, and if the ARR exceeds this rate, they consider the investment acceptable.
   
4. ARR helps Nigerian firms in making informed decisions regarding which investment projects to pursue.

Pros and cons of the technique

1. Pros

1. Easy to understand and calculate.
   
   
2. Provides a clear measure of the profitability of an investment.
   
   
3. Helps firms compare different investment projects based on their ARR values.

2. Cons

1. Does not consider the time value of money, as it only focuses on average profits
   
   
2. Does not consider the cash flows generated by the investment over its lifespan.
   
   
3. Relies heavily on accounting profit, which may not reflect the actual financial performance of the investment.
   
   
4. Does not account for the risk associated with the investment project.

Case study/example of its application in a Nigerian firm

ABC Nigeria, a manufacturing company, is evaluating a new production line investment using the ARR technique.

The investment incurs an initial cost of $500,000, with an anticipated average annual profit of $100,000.

Calculating the ARR by using the formula (Average Annual Profit / Initial Investment) results in:

ARR = ($100,000 / $500,000) x 100 = 20%

Based on ABC Nigeria’s set target rate of 15%, the ARR of 20% indicates that the investment is acceptable.

The new production line exceeds the required return, prompting ABC Nigeria to proceed, expecting profitable returns.

Despite its simplicity and limitations, Nigerian firms commonly use the Accounting Rate of Return (ARR).

Analyzing a case study showcases its application.

Ultimately, it assists firms in making informed decisions and evaluating potential project profitability in Nigerian businesses.

Read: Managing Risks & Returns: Corporate Finance in Nigeria

Profitability Index (PI) Technique

Nigerian firms use this financial analysis tool to assess investment projects.

It measures the relationship between the initial investment and the present value of expected future cash flows.

The PI technique

1. The PI technique calculates the ratio of the present value of cash inflows to the present value of cash outflows.
   
   
2. A PI greater than 1 indicates a favorable investment, expecting positive net cash inflows.
   
   
3. Conversely, a PI less than 1 indicates an unfavorable investment, expecting insufficient cash inflows.
   
   
4. A PI value equal to 1 means the project’s expected cash inflows are just adequate to cover the initial investment.

How Nigerian firms make use of it

1. Nigerian firms utilize the PI technique to identify and prioritize investment projects with the highest potential for profitability.
   
   
2. The technique helps management make informed decisions on resource allocation and capital budgeting.
   
   
3. Companies often combine the PI technique with other investment appraisal methods to deliver a comprehensive evaluation.

Pros and cons of the technique

1. Pros

1. Easy to understand and calculate.
   
   
2. Considers the time value of money by using discounted cash flows.
   
   
3. Allows for direct comparison of projects with different cash flow patterns.
   
   
4. Helps identify projects with high potential for value creation.

2. Cons

1. Relies heavily on estimated cash flow projections, which may be subject to uncertainty and bias.
   
   
2. Does not consider the project’s risk or the cost of capital.
   
   
3. May undervalue long-term projects with significant future cash inflows.
   
   
4. Does not account for qualitative factors that may impact the project’s success.

Case study/example of its application in a Nigerian firm

Company XYZ, a manufacturing company in Nigeria, is considering investing in new production equipment.

The initial cost of the equipment is ₦10 million.

The company estimates that the equipment will generate net cash inflows of ₦3 million per year for the next five years.

PI technique, You can calculate the present value of the cash inflows..

Assuming a discount rate of 10%, the present value of each year’s cash inflow is as follows:

1. Year 1: ₦3 million / (1 + 0.10) = ₦2.727 million
   
   
2. Year 2: ₦3 million / (1 + 0.10)^2 = ₦2.479 million
   
   
3. Year 3: ₦3 million / (1 + 0.10)^3 = ₦2.254 million
   
   
4. Year 4: ₦3 million / (1 + 0.10)^4 = ₦2.049 million
   
   
5. Year 5: ₦3 million / (1 + 0.10)^5 = ₦1.863 million

To calculate the PI, we sum the cash inflows: ₦11.372 million, then PI = ₦11.372 million / ₦10 million = 1.1372.

With a PI exceeding 1, Company XYZ views the investment as profitable according to the Profitability Index technique.

Nevertheless, final investment decisions should consider factors like risk, market conditions, and strategic alignment.

Conclusion

We have discussed various investment appraisal techniques used in Nigerian firms.

These techniques include payback period, net present value, internal rate of return, and profitability index.

These techniques are significant in Nigerian firms as they help in evaluating the profitability and feasibility of investment projects.

By employing these techniques, Nigerian firms can make informed financial decisions.

Effective investment appraisal is crucial for Nigerian firms as it allows them to assess the potential returns and risks associated with investment projects.

This assessment guarantees efficient resource allocation and alignment of investments with the company’s objectives.

Effective investment appraisal crucially influences Nigerian firms’ financial decision-making processes.

Allowing sound investment choices, leads to long-term success and growth in a competitive environment.

Therefore, emphasizing technique adoption can enhance their financial decision-making processes, improving chances of sustainable growth and profitability in the dynamic Nigerian market.