‘What are the different appraisal techniques available to finance managers to make decisions relating to investment projects? Discuss each of them and recommend, giving your reasons, which of them you consider as the best technique applicable to your company’.
Investment appraisal also known as capital budgeting. As finance manager one of the important areas of decision-making for the long-term is must to tackle the investment – the need to committed funds by buying buildings, machinery and land. Finance manager have to check of the size of the inflows and outflows of funds, for handling these types of decisions, the degree of risk and the lifespan of the investment cost of obtaining funds are despatched.
The capital budgeting cycle can be summarised in some stage which are as follows:
Expecting investment needs
Identifying project to satisfy needs
Examine the alternatives
Choose the best alternatives
Making the spend
Monitor the project
Looking at investment appraisal involves us in stage 3 and 4 of this cycle. We can classify capital expenditure projects into four broad categories:
Maintenance – replacing old or obsolete assets for example.
Profitability – quality, productivity or location improvement for example.
Expansion – new products, markets and so on.
Indirect – social and welfare facilities.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project’s aims. So investment appraisal may help to find the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company.
WHAT ARE THE INVESTMENT APPRAISAL TECHNIQUES?
Investment Appraisal also known as Capital Budgeting is used to assess whether capital
Expenditure on a particular project will be beneficial for the entity or not. These techniques can be used to evaluate projects both in the private and public sector companies. Most commonly used the following techniques.
A: Traditional Methods
1: Payback Period
2: Accounting Rate of Return (ARR)
B: Discounted Cash Flow Methods
3: Discounted Payback Period
4: Net Present Value (NPV)
5: Internal Rate of Return (IRR)
6: Modified Internal Rate of Return (MIRR)
7: Adjusted Present Value (APV)
Payback and Accounting rate of return (ARR) period are non discounted methods while all other mentioned methods are discounted. By discounted it is meant that the time value of money is considered in these methods.
1: Payback Period
Payback period calculates the time taken by a project to recoup the initial investment. For a finance manager, evaluating projects by this technique would prefer projects with short payback period than those with longer payback periods.It is simple to calculate and easy to understand.
‘Payback’ is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is mostly used as a starting screening method.
Payback period = Initial payment / Annual cash inflow
So, if £12,000000 is invested with the aim of earning £12,00000 per year or net cash earnings, the payback period is calculated thus:
P = £12,000000 / £12,00000 = 10 years
This all looks fairly easy! But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.
Payback with uneven cash flows:
Of course, in the real world, investment projects by business organisations don’t yield even cash flows. Have a look at the following project’s cash flows with an initial investment in year 0 of £120,000
The payback period is precisely 6 years.
The shorter the payback period, the better the investment, under the payback method. We can appreciate the problems of this method when we consider appraising several projects alongside each other.
We can see that the payback period for two of the projects (3, 5) is six years. In this case, then, the two projects are of equal merit. But, here we must face the real problem posed by payback: the time value of income flows.
Put simply, this issue relates to the sacrifice made as a result of having to wait to receive the funds. In economic terms, this is known as the opportunity cost. More on this point follows later.
So, because there is a time value constraint here, the two projects cannot be viewed as equivalent. Project 3 is better than 5 because the revenues flow quicker in years five and six. Project 4 is better than Projects 1 and 2, because of the earlier flows and because the post-payback revenues are concentrated in the earlier part of that period.
So it’s clear that the payback method is a bit of a blunt instrument. So why use it?
Advantages of payback:
1st, it is popular because of its simplicity. Research over the years has shown that UK firms favour it and perhaps this is understandable given how easy it is to calculate.
2nd, in a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential.
3rd, the investment climate in UK in particular demands that the investors got fast returns. Mostly long-term profitable possibilities investments are viewed due to longer wait for revenues flow.
Disadvantages of payback:
It has not enough real facts, which choose the length of best payback time? No one from other does – it is planned by pitting one investment opportunity against another. Cash flows are regarded as either pre-payback or post-payback, but the latter tend to be ignored. Payback takes no account of the effect on business profitability. Its sole concern is cash flow.
It is probably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions.
2: Accounting Rate of Return (ARR):
This technique compares the profit earned by the project to the initial investment required for the project. Thus a project with higher rate of return is preferred.
The Accounting rate of return expresses the profits arising from a project as a percentage of the initial capital cost. However the definition of profits and capital cost are different depending on which textbook you use. For instance, the profits may be taken to include depreciation, or they may not. One of the most common approaches is as follows:
ARR = (Average annual revenue / Initial capital costs) x 100
Let’s use this simple example to illustrate the ARR:
A project to replace an item of machinery is being appraised. The machine will cost £550,000 and is expected to generate total revenues of £80,000 over the project’s seven year life. What is the ARR for this project?
ARR = [(£ 90,000 / 7) / 550,000] x 100 ARR = 2.37%
Advantages of ARR
As with the Payback method, the chief advantage with ARR is its simplicity. This makes it relatively easy to understand. There is also a link with some accounting measures that are commonly used. The Accounting rate of return is similar to the Return on Capital Employed in its construction; this may make the ARR easier for business planners to understand. The ARR is expressed in percentage terms and this, again, may make it easier to use.There are several criticisms of ARR which raise questions about its practical application:
Disadvantages of ARR:
1st, the ARR doesn’t take account of the project duration or the timing of cash flows over the course of the project.
2nd, the concept of profit can be very subjective, varying with specific accounting practice and the capitalisation of project costs. As a result, the ARR calculation for identical projects would be likely to result in different outcomes from business to business.
3rd, there is no definitive signal given by the ARR to help manager to decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective.
Discounted Cash Flow Methods
3: Discounted Payback Period
This technique works similar to payback period, the difference here is that discounted values of cash flows are used for calculation of the payback period.
4: Net Present Value (NPV)
The NPV method calculates the present values for all future cash flows. The discount rate may be the Weighted Average Cost of Capital (WACC) or it may be any cost of capital depending on the risk of the project in consideration. This type of appraisal is regarded superior to the ARR and the payback period, however there are certain assumptions, on which this technique is based, making its evaluation less reliable.
The Net Present Value (NPV) is the first Discounted Cash Flow (DCF) technique covered here. It successes on the idea of situation cost to put a value on cash inflows increasing from capital investment.
Keep in mind that opportunity cost is the calculation of what has been given or forward as a result of a special decision. It is also referred to as the ‘real’ cost of taking some action. We can look at the concept of present value as being the cash equivalent now of a sum receivable at a later date. So how does the opportunity cost affect revenues that we can expect to receive later? Well, imagine what a business could do now with the cash sums it must wait some time to receive.
Looked at another way, it is simply that the business have to receive the capital to invest in the project. So, it has to wait for the revenues arising from the investment, the interest is paid on received capital.
NPV is a technique where cash inflows expected in future years are discounted back to their present value. This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.
Present Value Table
Net Present Value tables provide a value for a range of years and discount rates. Notice the time scale used in the table:
The present value for 0 years is always 1, and this is not included in the present value table.
If we are looking to find the present value of £ 10, 0000 which you expect to receive in 5 years time, at a rate of interest of 7 %, we should use the following table:
Step 1 Look down the top column of the table (‘After n years’) and find 5 years.
Step 2 Look across the row titled ‘At rate r’ for the rate of interest of 7 %.
Step 3 Where the row for 5 years intersects with the column for 7 % in the table, there is the relevant present value factor. In this case this is 0.713.
Step 4 Multiply £ 10, 0000 by 0.713 = £ 71300
Calculate the present value of the following project’s cash flows, using a 10 % discount rate.
Assessing the value of NPV calculations is simple. A positive NPV means that the project is worthwhile because the cost of tying up the firm’s capital is compensated for by the cash inflows that result. When more than one project is being appraised, the firm should choose the one that produces the highest NPV.
5:Internal Rate of Return (IRR):
IRR calculates the rate at which the NPV of a project equals zero. According to this method if the cost of capital of a company is more than the IRR, the project will be rejected and if it is lower than the cost of capital it is likely to be accepted. IRR and NPV concepts are correlated.
We know that when a positive NPV is produced by our DCF calculations, a project is worthwhile. We have also seen that when there are competing projects, we should select the one that produces the highest NPV. But sometimes a finance manager will wants to know how well a project will perform under a range of interest rate scenarios. The aim with IRR is to answer the question: ‘What level of interest will this project be able to withstand?’ Once we know this, the risk of changing interest rate conditions can effectively be minimised.
The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is same to the sum of the capital invested. Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
Making the investment decision
Let’s set out the criteria for accepting or rejecting investment opportunities, using the NPV and IRR.
As a Finance manager, considering whether to accept or reject an investment project, on the basis of their acquiring the funds necessary at a known rate of interest.
1: The NPV approach asks if the present value of cash inflows less the initial investment is positive, at the current borrowing rate.
2: The IRR approach asks if the IRR on the project is greater than the borrowing rate.
Illustration of NPV
Advantages of Traditional Budgeting Systems
Traditional budgeting is one the first budgeting systems created. Traditional budgeting system is still commonly used in many organizations today. The reasons why organizations still using traditional budget, this is due to framework of control. The role of the budget is to give focus to an organization, and help the coordination of activities and enable control. Large companies might struggle to plan, coordinate and control their dealings without a budgetary system. Even smaller companies can benefit from the budgetary system to ensure the direction of the business, and how it can reach its goals.
Second reason is its organizational culture; for the fundamental method of operating, it may not be possible for the organization to move away. Moreover, by their nature, budgets are a centrally coordinated activity within a business, and often the only one which brings together all aspects of the company. Budgets are often the one process which covers all areas of organisational activity (Otley, 1999).
Third reason of an organization still using traditional budgeting system is the need to decentralise; this is recognized that banks institutions and other financial institutions are more suitable candidates for decentralisation than other types of businesses. For an example, Norman Macintosh observed that branch managers at Transamerica Finance Corporation had a great deal of freedom to run their operations according to standard operating procedures. Similarly, another example is Svenska Handelsbanken, the largest bank in Sweden sets parameters for branch managersâ€™ discretion and then motivates its staff using competitive devices such as branch league tables (Alexa Michael and Technical Information Service, 2007). This approach can be successful in organizations where people work in similar but in independent units. However, it does not follow that this level of decentralization can be adopted by all organizations. Every organization is unique and it may be impossible to change the company culture to provide the necessary decentralisation. Successful decentralisation also depends on a great deal of trust being invested in teams throughout the organisation.
Due to economic uncertainty, traditional budgeting has its limit. The disadvantage of traditional budgeting is it has insufficient external focus. Traditional budgeting is seldom focusing on strategy and is often conflicting. Besides that, it is time consuming and costly to put together, and also limit responsiveness and flexibility, whereby this is not good for economic uncertainty situation. This is because it often discourages change and only adds little value, budget tend to be bureaucratic and discourage creative thinking and requires too much valuable management time. Traditional budgeting system has an adverse impact on management behaviour, which can become dysfunctional with regard to the objectives of the organisation as a whole. Johnson (2005) explains that most budgets are not based on a rational, causal model of resource consumption, but are often the result of protracted internal bargaining processes. Conformance to budget is not seen as compatible with a drive towards continuous improvement.
Under economic uncertainty, inflexibility is somehow seen as the key failing factor of traditional budgeting, and organizations are being urged to move towards continuous budgeting systems to enable speedy and coordinated adaptations to actual and anticipated changes in the economic (Neely et al, 1997). Continuous budgeting system gives companies the agility and capability to follow changes in market situations, and to cope with economic uncertainty while keeping an eye on strategic objectives (Lorain, 2010).
Continuous budgeting system solves problems associated with infrequent budgeting and hence results in more accurate forecast. It is also more responsive to changing circumstances under economic uncertainty. Some companies use a continuous budget which means that a ongoing 12 months budget is presented by consecutively adding a new budget as each current month expire, such a process allow management to work at anytime, within the present 1 month component of a full 12 month annual budget. Continuous budgeting system make the planning process less irregular, rather than having managers go into the budget getting period at a specific time, managers are continuously involved in planning and budgeting process. The advantages of a continuous budget under economic uncertainty situation include, eliminating a fiscal year mind set by recognizing that business is an ongoing operation and should be managed accordingly. It also allows management to make corrective steps as forecast business condition change such as in economic uncertainty. It helps to reduce or eliminating the budget planning process that occurs at the end of each fiscal year.
Another recent survey jointly conducted by the American Productivity Quality Centres and IBM Global Business Services has found that companies focusing on planning, budgeting and forecasting as a business strategy are higher performers in all area than those focusing on cost accounting, control and cost management. The study also showed that high performing organizations tend to complete their budgeting cycle in 30 days compared to 90 days in low performing organizations and most of the high performers used continuous budgeting system when the economic in uncertain (Kinney and Raiborn, 2008).
Another example in the article author has mention how Kenyan business sail through under economic uncertainty. Kenyan have experience challenging times with business struggling to plan and price their product carefully so as not to erode the profit margins that they had planned for. Having exchange rate problems. Smart cfos employ a budgeting, principally a set of procedures used to develop budget. Author mention that Kenyan organization have limited resources and and they need to effectively plan and use them. This is why they implement budgets to help provides a means to achieve this. Budgets provide a useful benchmark of performance and help control profit and operations when compared to actual performance. The resulting variance guide management in appreciating what they need to do in the subsequent period. Employee performance and managerial performance is usually measured on qualitative terms, but budget gives a new meaning to evaluate performance through numbers and helps in rewarding high performers and correcting the low performers. Due to the economic downturn, a number of well run companies have adapted to their specific circumstances and prepare master budget that comprises of performance financial statement, a capital budget, and a financial budget. However, some organizations have adapted to the concept of continuous budgets. With the fluctuation of the dollar, business are emploting a variety of techniques of budgeting to ensure that they make profits.