Investment appraisal: An overview of static and dynamic methods

Capital budgeting is an essential part of financial management in companies. It helps to evaluate the profitability of investments and to make well-founded decisions about the allocation of resources. There are various methods of capital budgeting, including both static and dynamic approaches. In this article, we take a look at these two types of investment appraisal and their differences.

Investment appraisal: an introduction

Capital budgeting is concerned with evaluating the expected future returns of an investment and comparing them with the associated costs. The aim is to find out whether an investment is profitable and whether it meets expectations. This process enables companies to make informed decisions about the allocation of resources and be successful in the long term.

Static methods of capital budgeting

• The net present value method (NPVM): In the net present value method, the expected future cash flows of an investment are discounted to the present value. The decision to accept or reject an investment is based on a comparison of the net present value with the investment volume. An investment is accepted if the net present value is positive.
• Internal rate of return (IRR) method: The internal rate of return method searches for the interest rate at which the net present value of an investment is equal to zero. This interest rate is referred to as the internal rate of return and represents the return that the investment would generate. An investment is accepted if the internal rate of return is higher than the required rate of return.

Dynamic investment calculation

• Dynamic net present value method (DKWM): In contrast to the static net present value method, the dynamic net present value method takes into account the time value of money by calculating the discount factors for each point in time of the cash flows. This determines the net present value more accurately and enables a more precise valuation of the investment.
• Amortization calculation: The amortization calculation considers the time required to recover the initial investment through the expected cash flows. It provides a simple way to evaluate the profitability of an investment by indicating how long it will take for the investment to be amortized.

Conclusion

Capital budgeting is an indispensable tool for companies to make informed decisions about their investments. Both static and dynamic methods offer different approaches to evaluating investments. While static methods allow for a simple valuation, dynamic methods take into account the time value of money and provide more precise results. Ultimately, it is important to select the appropriate method according to the specific situation and requirements of the company.