PurposeTo provide a critical review on the development and evolution of different appraisal methods, their significance to a company and the need for the company to revise the existing policy for evaluating future capital projects. RecommendationThe company should use DCF techniques for investment appraisal.
Prepared byManaging Director INVESTMENT APPRAISAL DECISIONS A BRIEF REVIEW
Companies in todays world are always looking at ways to develop and change. This compels the senior management to be faced with a variety of different proposals. This is of critical importance as the companies only have limited resources available with investors only willing to offer limited amounts of finance. The managers are therefore face the need to decide which proposals to undertake. Investment appraisal refers to a process of identifying investments that result in maximizing the profits of a company from its investments, resulting in an increase to the wealth of shareholders.
The has been defined as
The theory of capital budgeting reconciles the goals of survival and profitability by assuming that management takes as its goal, the maximization of the market value of the share holders wealth via the maximization of the market value of ordinary share (Drury 2000)
The investment appraisal decisions usually involve planning for the expenditures required to undertake a project (initial and over its total life), and the revenues a company expects to generate from such investment. Investment appraisal can also be defined as a trade off between current funds for future benefits.
Almost every capital investment project passes through 3 stages of development
Project definition
Financial valuation
Implementation and review.
The techniquesmethods generally used by the managers for evaluating capital budgeting decisions can be categorized into two basic methods
Traditional Non-DCF methods
Payback method.
Accounting Rate of Return (ARR).
DCF methods
Net Present Value method.
Internal Rate of Return.
Discounted payback.
NEED FOR HAVING A CORPORATE POLICY FOR INVESTMENT APPRAISAL
The process of making capital investment decision policy is critical to companies because it has an impact on the availability of resources and shareholders wealth. It is of utmost importance that a company should make best possible use of its resources and make best possible decisions. This is only possible when the financial managers are aware of the risk and uncertainties in the environment. Such decisions necessarily involve an element of risk as there is always some uncertainty relating to the future cash flows of the project and the companys cost of capital.
It is therefore necessary for a company to have a corporate policy for the identification of investment appraisal projects that takes in to account the related risks and expected cash flows associated with the project and provide information that is relevant for decision making.
SIGNIFICANCE OF INVESTMENT APPRAISAL DECISIONS TO A COMPANY
Investment decisions are considered as the most critical aspect when defining success for a company. These decisions affect the future profitability and the availability of resources for a company. If not taken prudently they might endanger the continuity of a company and may exhaust availability of cheaper sources of finance for a company. The success of many businesses mainly depends on the utilization of resources available to them. The choice of choosing between capital investment projects for a company starts with the objective of adding to the market value of the company by choosing viable investment and financing decisions.
The key responsibility of the financial managers is to select the most profitable choice among all the available capital investment options. This is critical to the companies in two ways first, such decisions have an effect on the operations and profitability of the company in periods beyond current year, secondly one of the major concepts in modern financial managements associates the market value of a company as equal to the discounted value of the future cash flows it expects to yield from its investments in projects.
For organizations, decisions regarding commitment of resources have implications on many aspects of operations in a corporation. Investment appraisal is not only critical to the financial managers but is also essential to people throughout the company.
The investors of a company prefer to get rich not poor, this is why they expect from the managers of the company to invest in every project that is expected to pay more than what it is actually going to cost. (Richard and Stewart 2007)
ANALYSIS OF THE INVESTMENT APPRAISAL METHODS
A) PAYBACK Payback method compares the amount of time a project takes to recoup its initial investment in other words, it is the period of time taken by a project to equate projects inflows to the projects outflows.
The payback method for evaluating investment appraisal projects is one of the most popular techniques used by managers. Payback method is mostly as a first screening method when deciding for investment in a capital project. The payback for a particular project is compared with the companys targeted payback.
This method however has certain drawbacks, such as
The method doesnt incorporate the effect of time value of money when comparing projects.
It ignores the future profitability of projects i.e. cash flows from the projects after it recoups its initial investment are not taken in to consideration at all.
It is unable to distinguish between projects with same payback period.
Payback method should not be used in isolation as it may cause the company to invest in projects that have a negative NPV.
B) ACCOUNTING RATE OF RETURN
This method attempts to calculate the rate of return an investment should yield if it has to be undertaken. If this rate exceeds the companys targeted rate of return the investment is undertaken.
This method provides the financial managers a quick and simple way of calculation and looks at the entire life of a project (investment), however there are certain disadvantages such as
It is based on accounting profits and not cash flows (accounting profits are based on certain cash and non cash income and expenses, or both)
It ignores the time value of money.
C) NET PRESENT VALUE
Net present value differentiate between products, recognizing the concept of time value of money, i.e. 1 received today worth more than a 1 received tomorrow. This is because 1 received today, can be invested by a company in a project that starts earning immediately. The method discounts (present value) the future cash flows that a company expects to earn from a project using it cost of capital. This present value is then compared with the present value of all the cash outflows (initial and subsequent), thus if the discounted value of the future cash flows exceed the required investment, the investment is considered worthwhile.
D) INTERNAL RATE OF RETURN
Internal Rate or Return (IRR) method of investment appraisal attempts to determine the total yield on an investment, by attempting to find a rate that equates the initial cost of an investment with its cash flows in the future years, i.e. it is the rate at which the NPV is zero. IRR is calculated using interpolation and rationalizes accepting the investments for which the IRR exceeds the target rate of return.
IRR is easily understood by both financial and non financial managers, however one of the drawbacks of IRR is that it ignores the relative size of the investment, i.e. two projects with different volumes of initial cash outlay and future cash inflows may have same IRR.
E) DISCOUNTED PAYBACK
Discounted payback method takes in to account the time value of money and calculates the time for a project to pay for its initial investment based on the present value of the cash flows expected from the project. The method however, cannot estimate how profitable any investment would be.
F) OTHER METHODS
In addition to the techniquesmethods discussed above there are other advanced techniquesmethods for e.g. CAPM, which also account for the risk in an investment before analyzing it viability for the company.
SURVEYS OF CURRENT PRACTICES
Many survey authors and books have expressed concerns over the use, of techniques that do not use discounted cash flows, by the respondents. As Dopuch et al. (1974) states it seems reasonable that a discounting approach to investment analysis is to be preferred over a non-discounting approach.
Further Bierman and Smidt (1993) argued that measures which, do not involve the use of discounted cash flow method can give rankings of investments that are obviously incorrect.
Similarly, they concluded that non-discounting methods are inappropriate and that the net present value rule should be employed in preference to other techniques discounting cash flows. (Brealey and Myers 1991)
In a survey of large UK companies carrying on capital budgeting decisions, it has been noted that there has been a significant increase in the number of companies switching to Discounted Cash Flow (DCF) methods of investment appraisal for evaluating their capital investment decisions. They identified that 75 and 85 of UK firms are now applying Net Present Value (NPV) and Internal Rate of Return (IRR) respectively. (Pike 1996)
A most recent study in UK by Arnold and Hatzopoulus (2000) revealed that DCF techniques have taken over as most widely used techniques by larger firms they reported almost 96 of the firms using NPV or IRR techniques.
Based on the evaluation of the above discussed investment appraisal methods and current practices evident from various survey results it is an obvious step for the company to change its policy of evaluating investment proposals from traditional Pay Back and Accounting Rate of Return methods to DCF methods for investment appraisal as DCF techniques apply discounting arithmetic to the expected future cash slows from an investment to determine whether the investment is expected to earn a satisfactory return for the company.
They also offer a number of benefits over the other appraisal methods.
They explicitly and systematically incorporate the time value of money concept.
They take in to account all relevant cash flows of the project.
Payback method however can be used as the first screening method in conjunction with DCF methods of investment appraisal.
Also based on the discussion above, the company should undertake investment in the proposed project as it has a positive NPV of 5.088 million, with an IRR of 24.02 that is higher than the current cost of capital for the company.
Prepared byManaging Director INVESTMENT APPRAISAL DECISIONS A BRIEF REVIEW
Companies in todays world are always looking at ways to develop and change. This compels the senior management to be faced with a variety of different proposals. This is of critical importance as the companies only have limited resources available with investors only willing to offer limited amounts of finance. The managers are therefore face the need to decide which proposals to undertake. Investment appraisal refers to a process of identifying investments that result in maximizing the profits of a company from its investments, resulting in an increase to the wealth of shareholders.
The has been defined as
The theory of capital budgeting reconciles the goals of survival and profitability by assuming that management takes as its goal, the maximization of the market value of the share holders wealth via the maximization of the market value of ordinary share (Drury 2000)
The investment appraisal decisions usually involve planning for the expenditures required to undertake a project (initial and over its total life), and the revenues a company expects to generate from such investment. Investment appraisal can also be defined as a trade off between current funds for future benefits.
Almost every capital investment project passes through 3 stages of development
Project definition
Financial valuation
Implementation and review.
The techniquesmethods generally used by the managers for evaluating capital budgeting decisions can be categorized into two basic methods
Traditional Non-DCF methods
Payback method.
Accounting Rate of Return (ARR).
DCF methods
Net Present Value method.
Internal Rate of Return.
Discounted payback.
NEED FOR HAVING A CORPORATE POLICY FOR INVESTMENT APPRAISAL
The process of making capital investment decision policy is critical to companies because it has an impact on the availability of resources and shareholders wealth. It is of utmost importance that a company should make best possible use of its resources and make best possible decisions. This is only possible when the financial managers are aware of the risk and uncertainties in the environment. Such decisions necessarily involve an element of risk as there is always some uncertainty relating to the future cash flows of the project and the companys cost of capital.
It is therefore necessary for a company to have a corporate policy for the identification of investment appraisal projects that takes in to account the related risks and expected cash flows associated with the project and provide information that is relevant for decision making.
SIGNIFICANCE OF INVESTMENT APPRAISAL DECISIONS TO A COMPANY
Investment decisions are considered as the most critical aspect when defining success for a company. These decisions affect the future profitability and the availability of resources for a company. If not taken prudently they might endanger the continuity of a company and may exhaust availability of cheaper sources of finance for a company. The success of many businesses mainly depends on the utilization of resources available to them. The choice of choosing between capital investment projects for a company starts with the objective of adding to the market value of the company by choosing viable investment and financing decisions.
The key responsibility of the financial managers is to select the most profitable choice among all the available capital investment options. This is critical to the companies in two ways first, such decisions have an effect on the operations and profitability of the company in periods beyond current year, secondly one of the major concepts in modern financial managements associates the market value of a company as equal to the discounted value of the future cash flows it expects to yield from its investments in projects.
For organizations, decisions regarding commitment of resources have implications on many aspects of operations in a corporation. Investment appraisal is not only critical to the financial managers but is also essential to people throughout the company.
The investors of a company prefer to get rich not poor, this is why they expect from the managers of the company to invest in every project that is expected to pay more than what it is actually going to cost. (Richard and Stewart 2007)
ANALYSIS OF THE INVESTMENT APPRAISAL METHODS
A) PAYBACK Payback method compares the amount of time a project takes to recoup its initial investment in other words, it is the period of time taken by a project to equate projects inflows to the projects outflows.
The payback method for evaluating investment appraisal projects is one of the most popular techniques used by managers. Payback method is mostly as a first screening method when deciding for investment in a capital project. The payback for a particular project is compared with the companys targeted payback.
This method however has certain drawbacks, such as
The method doesnt incorporate the effect of time value of money when comparing projects.
It ignores the future profitability of projects i.e. cash flows from the projects after it recoups its initial investment are not taken in to consideration at all.
It is unable to distinguish between projects with same payback period.
Payback method should not be used in isolation as it may cause the company to invest in projects that have a negative NPV.
B) ACCOUNTING RATE OF RETURN
This method attempts to calculate the rate of return an investment should yield if it has to be undertaken. If this rate exceeds the companys targeted rate of return the investment is undertaken.
This method provides the financial managers a quick and simple way of calculation and looks at the entire life of a project (investment), however there are certain disadvantages such as
It is based on accounting profits and not cash flows (accounting profits are based on certain cash and non cash income and expenses, or both)
It ignores the time value of money.
C) NET PRESENT VALUE
Net present value differentiate between products, recognizing the concept of time value of money, i.e. 1 received today worth more than a 1 received tomorrow. This is because 1 received today, can be invested by a company in a project that starts earning immediately. The method discounts (present value) the future cash flows that a company expects to earn from a project using it cost of capital. This present value is then compared with the present value of all the cash outflows (initial and subsequent), thus if the discounted value of the future cash flows exceed the required investment, the investment is considered worthwhile.
D) INTERNAL RATE OF RETURN
Internal Rate or Return (IRR) method of investment appraisal attempts to determine the total yield on an investment, by attempting to find a rate that equates the initial cost of an investment with its cash flows in the future years, i.e. it is the rate at which the NPV is zero. IRR is calculated using interpolation and rationalizes accepting the investments for which the IRR exceeds the target rate of return.
IRR is easily understood by both financial and non financial managers, however one of the drawbacks of IRR is that it ignores the relative size of the investment, i.e. two projects with different volumes of initial cash outlay and future cash inflows may have same IRR.
E) DISCOUNTED PAYBACK
Discounted payback method takes in to account the time value of money and calculates the time for a project to pay for its initial investment based on the present value of the cash flows expected from the project. The method however, cannot estimate how profitable any investment would be.
F) OTHER METHODS
In addition to the techniquesmethods discussed above there are other advanced techniquesmethods for e.g. CAPM, which also account for the risk in an investment before analyzing it viability for the company.
SURVEYS OF CURRENT PRACTICES
Many survey authors and books have expressed concerns over the use, of techniques that do not use discounted cash flows, by the respondents. As Dopuch et al. (1974) states it seems reasonable that a discounting approach to investment analysis is to be preferred over a non-discounting approach.
Further Bierman and Smidt (1993) argued that measures which, do not involve the use of discounted cash flow method can give rankings of investments that are obviously incorrect.
Similarly, they concluded that non-discounting methods are inappropriate and that the net present value rule should be employed in preference to other techniques discounting cash flows. (Brealey and Myers 1991)
In a survey of large UK companies carrying on capital budgeting decisions, it has been noted that there has been a significant increase in the number of companies switching to Discounted Cash Flow (DCF) methods of investment appraisal for evaluating their capital investment decisions. They identified that 75 and 85 of UK firms are now applying Net Present Value (NPV) and Internal Rate of Return (IRR) respectively. (Pike 1996)
A most recent study in UK by Arnold and Hatzopoulus (2000) revealed that DCF techniques have taken over as most widely used techniques by larger firms they reported almost 96 of the firms using NPV or IRR techniques.
Based on the evaluation of the above discussed investment appraisal methods and current practices evident from various survey results it is an obvious step for the company to change its policy of evaluating investment proposals from traditional Pay Back and Accounting Rate of Return methods to DCF methods for investment appraisal as DCF techniques apply discounting arithmetic to the expected future cash slows from an investment to determine whether the investment is expected to earn a satisfactory return for the company.
They also offer a number of benefits over the other appraisal methods.
They explicitly and systematically incorporate the time value of money concept.
They take in to account all relevant cash flows of the project.
Payback method however can be used as the first screening method in conjunction with DCF methods of investment appraisal.
Also based on the discussion above, the company should undertake investment in the proposed project as it has a positive NPV of 5.088 million, with an IRR of 24.02 that is higher than the current cost of capital for the company.
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