Investment Appraisal - Essay Example

RECENT TRENDS IN INVESTMENT APPRAISAL INTRODUCTION In business management, capital budgeting decisions pertain to assets which are in operation and yield a return over a period of time. There are often situations where the management has to involve current outlay of resources in return for an anticipated flow of future benefits. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. The decisions regarding the long term investments have a bearing on the survival of the business and the competitive position of the firm. The capital budgeting decisions are pertaining to investment decisions which will create assets which will in turn create products/ services which create the profits. Generally, current assets are not earning assets but they act as a buffer for the smooth operations of the business. But the long-term investment decisions includes the mission and visions of the company and hence is of strategic importance. There are various techniques available for the appraisal of investment proposals. They include the traditional methods, discounted cash flow methods. But recently there is a tendency to shift to value management models and modified versions of DCF models is reflected among companies. This essay explains the nature of each method of appraisal and also explains the recent trends to use the value management models with examples. METHODS OF CAPITAL BUDGETING For considering this proposal the management can use the investment appraisal techniques which can be segregated into two groups, first group comprising of traditional methods such as payback period method and average rate of return method and second group comprising of time adjusted methods/ discounted cash flow(DCF) methods such as net present value method, internal rate of return method, net terminal value method and profitability index method. The payback period method is the simplest of all methods and it answers the basic question, how many years will it take for the cash benefits to pay the original cost of investment. Cash benefits under this method represent CFAT ignoring interest payment. The payback period of the investment is compared with the payback period predetermined by the management beforehand. If the proposal has a payback period less than the predetermined payback, then the investment proposal is selected. The major advantage with this method is that it is very simple to understand and calculate. But the serious drawback here is that it ignores all the cash inflows after the payback period and it does not differentiate between the projects based on the timing and magnitude of cash flows. The next method is the Accounting rate of return (ARR) method. The ARR is calculated as (Average annual profits after taxes / Average investment) x 100. If the Average rate of return is higher than the predetermined minimum rate of return then the investment proposal is selected. The advantage of this method over the payback period method is that it takes into account entire cash flows over the life time of the project unlike the former. But the major drawback here is that it takes the accounting income for the analysis but not the cash flows. Like the payback period method also does not take into account the time value of money. When the time value of money is not taken into consideration when evaluating investment proposals the chances of choosing the wrong proposals are more. From the information provided Hence, the Time adjusted methods/ discounted cash flow (DCF) methods are widely used for making decisions in corporations. The Net present value method is described as the summation of the present values of cash proceeds (CFAT) in each year minus the summation of the present values of the net cash outflows in each year. The decision rule for this method is that when NPV> zero, accept the prpoposal and if NPV < zero, reject the proposal. The first and foremost advantage of this method is that it takes into account the time value of money and it also takes into account all the cash inflows of the project throughout the lifespan of the project. But the major defect with this method is that it is very difficult to estimate the rate of return which is used to calculate the time value of money. Then the next DCF method is the internal rate of return. Internal rate of return is the generated by the investment. Here the rate of return of the project is calculated by interpolation and it is compared with the required rate of return. If the IRR is greater than the predetermined rate of return then the project is selected, if not the investment is rejected. This method is considered better than the net present value method because, it does not use the concept of required rate of return, instead it analyses the rate of return generated by the investment proposal. Also IRR method is in line with the objective of the management to increase the wealth of the shareholders, because, the rate of return generated by the investment proposal is compared with the profitability of the company, hence, the increase in wealth of shareholders is ensured. The last method that is mentioned here is the Profitability index method. Using this method, the ratio between the present values of cash inflows and present values of cash outflows is calculated. If the ratio is more than 1 then the project is accepted and if the ration is less than 1 then the project is rejected. This method is widely accepted and used by everybody because it takes into account all the aspects of capital budgeting, such as the time value of money and totality of benefits. For example, the Lenicheshire manufacturing company has to decide whether to purchase machine A or machine B to increase the production if the required rate of return is 10%. The cost details of machine A and machine B are as follows: Machine type Purchase Set up Cost Currently used (A) $120,000 New type (B) $250,000 The estimated cash inflows from the machines are: Machine A Year 2007-8 2008-9 2009-10 2010-11 Operational Cash flow $ 50,000 $ 65,000 $ 75,000 $ 55,000 Depreciation $ 30,000 $ 30,000 $ 30,000 $ 30,000 Accounting Profit $ 20,000 $ 35,000 $ 45,000 $ 25,000 Machine B Year 2007-8 2008-9 2009-10 2010-11 Operational Cash flow $ 80,000 $ 85,000 $ 110,000 $ 100,000 Depreciation $ 62,500 $ 62,500 $ 62,500 $ 62,500 Accounting Profit $ 17,500 $ 23,000 $ 47,500 $ 37,500 When payback period method is applied, machine A is preferred because it has shorter payback period. Machine A has payback period 2 years and 1 month, machine B has payback period 2 years and 8 months. When NPV method is used machine A is preferred as it has a positive NPV of $102705, where as the NPV for machine B it is just $ 9065. Both the payback period method and NPV method prefer the machine A, but the calculation of IRR shows a different result, i.e., IRR method shows that machine B has 34% return which is much higher than the project A which has only 17.4%. When there is contradiction between the results from various methods it causes confusion about which machine to buy. The reasons for these kinds of contradicting results are due reasons such as disparity in size, disparity in time and unequal expected lives. The size disparity problems can occur when the projects are mutually exclusive and when the initial investments are different as in this example given above. To overcome such confusions the management has to decide which method is suitable for the objective of the project. Te method which is suitable for the purpose of the project should be selected. In the above example, if the objective of the company is to recover its investment at the shortest time then machine A should be selected and if the company is more concerned about the wealth of the shareholders then the management should purchase machine B which has a high IRR. According to Akalu(2003), there is shift in the methods used for investment appraisal. It is mentioned in his report that companies adopt methods like, Return on Net assets(RONA) , Net Contribution to Value(NCV) and Economic Value Added(EVA) methods to analyse investment proposals. NCV = EAIT - (exceptional amortizations) - (Capital charges). The next method of calculation of EVA is done to calculate the value that is added to the company through that particular investment proposal. Here, EVA = Profit - capital charges, where capital charges is the weighted average cost of capital x adjusted capital How are these methods different from the traditional methods and the DCF methods. If we read through the research reports, it is clear that these ,methods take into account two major items, i.e., the capital charges and the real cash flows. When the cash inflows and cash outflows are determined to analyze the investment proposal, then the real cash flows are calculated. It means that the noncash expenses such as depreciation are added back and noncash incomes are deducted. From the EBIT, taxes are deducted and depreciation is added back. This earnings after tax with depreciation added back, the gross value of investment and the net increase in working capital is subtracted. Free Cash Flow FCF = (R - C - T) - Inv(gross) - Increase in WC + (Net Non-Op. Inc) This helps the management to get a picture of the cash flows in an dout of the organization when the project proposal is selected. Then the next factor that is considered seriously in the value management models is the capital charges. The cost of capital/ capital charges are very important to get an idea about the cost of project. It is not enough if we calculate the present values of cash inflows and outflows but it is essential to find out the sourcing of finance and the cost associated. ('After tax')Weighted Average Cost of Capital WACC, WACC = (1-z) RS + z RB (1-t) z = B / V = propn of debt(bonds) , (1-z) = S / V V=market value of firm = S+B 'weights', z, sum to 1. This WACC is used to discount the free cash flows. This approach shows how to determine the required rate of return for a project. Under NPV method it is ambiguous about how to determine the required rate of return. It is suggested under the value management models that the required rate of return should be based on the cost of capital to increase the value of the company. According to K. Cuthbertson and D. Nitzsc(2001) the value of a company can be increased by the mangers through two ways, one by investing in projects which has a high FCF and the next is by reducing the WACC. Based on these approaches the value management models of EVA and the NCV methods are incorporated into investment appraisal which helps to create value for all the stakeholders. But it is observed by researchers that companies adopt a combination of methods for analysis. For projects with shorter duration of time, pay back period method is used and for other projects NPV method is widely used. NPV method along with the value management models are very effective in increasing the value of the shareholders. CONCLUSION It is evident from various studies by Akalu, etal, about the investment appraisal techniques used by companies in various industries that, there is definite change in the type of technique used. The traditional methods are used widely but the new value management models are used in addition to the traditional methods. The type of methods used depends on the duration of the project. If the investment is for a short period of time, then the payback method is used and for projects which are strategically important, NPV and IRR methods along with the value management models are used. The reason for this shift in the methods used is that companies are focussing more on creating value for the shareholders and the traditional methods are not precise in assessing the exact effect on the value for the shareholders. There are chances that there will be confusions and contradictions when various methods are used, but the quantum of investment, period and objective of the investment proposal can be considered important to make decisions clearly. REFERENCES 1. Akalu, M. M (2003) "The process of investment appraisal: the experience of 10 large British and Dutch companies." 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