Investment Appraisal and NPV Analysis - Example

Investment Appraisal and NPV Analysis Table of Contents Introduction 3 Investment Appraisal Approaches 4 NPV as a method of Investment Appraisal 6 NPV – Its Strengths and Weaknesses 8 Alternative to NPV 9 Conclusion 10 References 11 Bibliography 13 Introduction Capital Budgeting is the other name for Investment Appraisal. Every firm, company or enterprise is faced with the decision about which investment opportunities they are to choose from all the options available. The primary task of any enterprise is to maximize the wealth of its shareholders. So taking the right decision at right time is one of the key roles of any company. It is required for the profitability and sustainability of the company. More often than not every enterprise has to invest in assets, mainly capital assets, so that they get returns out of it which they can utilize either to reinvest again or to pay back its owners (Peterson & Fabozzi, 2002, p.3). Investments in assets can be of both short-term and long-term types but every firm is primarily concerned with long-term investment requiring huge amounts of money. Thus, decision on capital budgeting have a long-term effect on the performance of the firm and are critical to the firm’s success or failure. Financial appraisal or investment appraisal of a proposed investment in a firm is one of the key steps in capital budgeting and quite complex too (Dayananda, 2002, p.2). Thus proper valuation of the proposed investment projects of a company is required before coming to the conclusion about which investment proposal to accept. Some of the tools or techniques used by firms for investment appraisal are: a) Net Present Value (NPV), b) Internal Rate of Return (IRR), c) Profitability Index (PI), d) Accounting Rate of Return, e) Payback Period, etc (Shapiro, 2008, p.33). Of these NPV and IRR techniques are mostly used by companies for investments which are capital intensive and Pay Back Period technique, which is more of a traditional technique and mostly used by companies which are less capital intensive (Bedi, 2005, p.14). Now, NPV being one of the most widely used conventional tools for investment appraisal uses the Discounted Cash Flow (DCF) technique for the evaluation of proposed investments. But it can always be argued about DCF technique used in NPV analysis as being the effective and adequate technique and its relevance with business environment in reality. NPV option is always questionable when uncertainty is involved in the real business environment. Once an investment has already begun, it is very difficult to revise the investment decisions of a company using NPV analysis for its investment project appraisal. Thus, NPV analysis has its own merits and demerits in the evaluation of investment projects which have been discussed further in this study. A comparative study of two other alternative appraisal techniques to NPV is also discussed in this study. Further, what can be a more realistic approach to investment appraisal has also been discussed in details. Investment Appraisal Approaches Different approaches are adopted by different companies for evaluating their investment proposals in order to come to a decision about which investment proposal will be best for the company. Out of the many, Pay Back Period technique is one of the traditional approaches in this regard. NPV analysis and IRR techniques are commonly used investment evaluation techniques which uses the DCF technique. Risk-adjusted Present Value (RPV) analysis is one of the recently used investment appraisal technique which takes into account the risk factors involved in the investment valuation due to uncertainties present in real business environment. The concept of break-even analysis in investment is applied through the Pay Back Period method of investment appraisal technique (Banerjee, 1990, p.317). This method takes into consideration the fact that it is important to identify the recovery period of investment made originally by a company. Pay Back Period can be calculated from the following relation: Pay Back Period = (Cost of investment) / (Net Cash Flow per year) Pay Back Period thus can be defined as the period in years which is required for the cash flows generated from the investment to recover the initial cost of investment. This method is used because it is can be easily understood and quite easy to operate as well. With the assumption that investment proposals having the shortest payback period are chosen by a company because it takes into account the liquidity option of the company. Moreover, a company can encounter the rapid technological growth and innovations occurring in the industry by choosing investment proposals having short payback period. This method also takes into account various risks involved in implementing a project like, the risk of instability in political environment or the risk of a particular product becoming obsolete due to new substitutes available. But it has its disadvantages like; it does not take into account the rate of return on capital invested. It also does not consider the number of years after the payback period for which the given investment project will be profitable to the company. NPV and IRR are two other methods of evaluating an investment proposal by a company, where in it takes into account or applies Discounted Cash Flow (DCF) technique while calculating the cash flows generated from the investment. The NPV of an investment project is nothing but the net cash inflow generated, that is the difference between the cash inflows and cash outflows. Normally, an investment proposal which yields positive NPV is selected. Positive NPV implies that the investment project gives a return at a rate greater than the discounted rate which is used to calculate the DCF. NPV is discussed in details later. Similarly IRR also takes into account DCF in order to calculate the discounting rate which makes the NPV of the investment project zero. IRR can thus be referred to as the true rate of return which the given investment project yields. Thus, comparing with the required rate of return which is needed to raise capital for the project, an investment project having higher IRR than the minimum rate of return is selected. But, IRR has its own difficulties too. IRR is not always the actual rate of return because it is not always possible that the cash flows generated from the investment will be reinvested in the project at the same rate as IRR. So, there is a problem in the interpretation of IRR (Baker & English, 2011, p.128). Next, Profitability Index is also one of the tools used for evaluating investment projects. Profitability Index (PI) is the ratio of discounted sum of cash inflows to the discounted sum of cash outflows. PI is very much in accordance with NPV analysis, with the fact that for PI1, NPV is also greater than zero. But NPV is more useful than PI while taking into account the projects which are mutually exclusive. In other cases, an investment proposal which is having PI greater than or equal to 1 are chosen. NPV as a method of Investment Appraisal Net Present Value or NPV as discussed earlier is a method of analysis of investment proposals which takes into account the calculation of future cash flows generated from an investment at a discounting rate, using appropriate discounting rate. NPV of an investment project is nothing but the sum of all the future cash flows which the project generates, including cash inflows and cash outflows. These cash flows are discounted at a rate which is in accordance with the risk involved in the investment project (Megginson & Smart, 2008, p.335). The decision to accept an investment project lies on the fact that whether the NPV calculated for a particular investment proposal is greater than zero or not. If the NPV is greater than zero, then the project is accepted. Thus, we can say that NPV is greater than zero only when the sum total of discounted cash inflows is greater than the sum total of discounted cash outflows, which is again the criterion of discounted payback method. But the reverse is not always true. That is, some investment projects can have huge cash inflows after the payback cut off period. So, discounted payback is a very conservative approach of investment appraisal than NPV analysis, wherein it can even result in rejection of projects having positive NPV. Now, if we compare NPV with IRR method of evaluating investment projects, we find that in case of NPV, the future cash flows generated in the project are converted to present values by taking the discounting rate of return as equal to the cost of capital of the company. But in case of IRR we find that there are no discounting rates available and one has to select the discounted rate in such a way that the discounted or present value of the cash inflows generated is exactly equal to the cash outflows. The method of IRR depends on the fact that it is best to invest in a proposal which yields maximum return while equating the present values of cash outflows and cash inflows. Both, NPV and IRR will result in same decision regarding acceptance of investment proposal as long as it is only a single project that we are considering. But, in case of multiple investments which are mutually exclusive to each other, these two methods can result in conflicting ideas regarding which investment to accept and which to reject. This conflict between NPV and IRR can be resolved by giving preference to NPV method of evaluating the investment proposal (Banerjee, 1990, p.332). NPV – Its Strengths and Weaknesses NPV being the most widely used technique or method of evaluating an investment proposal does have its own merits and demerits. Coming to its advantages or strengths, NPV is preferred because it helps in maximizing the benefits earned from the investment proposal calculated in terms of present value. So it is very much in accordance with the corporate objective of a company which is to maximize shareholder’s wealth. Secondly, NPV also has also a logical assumption of taking the reinvestment rate of return being equal to the cost of capital of the company. Moreover, through NPV, investors will get a clear picture about the benefits earned in terms of money value. Thus, NPV gives a much more realistic view. Next, coming to its limitations or weakness, NPV analysis has got some limitations too. NPV analysis requires the discounting factor or the cost of capital and its estimated value may not always adhere to the perfect figure. The method of investment appraisal using NPV is vulnerable in case of some investment decisions in uncertain environment, where risk is involved. Whenever risk premium is allowed in the discounting rate in NPV, it is assumed that the charges for risk are directly proportional to the value of the assets involved, which may not be true always. Next, we need to calculate and work on future cash flows in NPV which are forecasted and expected values, and these expected values can have diversified risks attached to it, which is completely ignored in case of NPV analysis. Furthermore, the size of the investment project is also not measured in case of NPV analysis (Peterson, n.d.). Also we get the value in monetary terms, and not in percentage terms, so it can be an issue while comparing investment projects having different sizes. The method of NPV analysis for investment appraisal can be misleading in case of investment projects having different lives or having different cash outflows (Siddiqui, 2006, p.325). More often than not, the manager of the company who comes up with the idea of the investment project, has the responsibility to find the estimated figures of future cash flows and hence there is always a possibility of biasness creeping up in the mind of the manager while calculating the estimated figures in a way that suits the acceptance of the project (Eldenburg & Walcott, 2007, p.473). Alternative to NPV NPV is considered to work well in case of evaluation of projects in nearly perfect markets and not in case of imperfect conditions in market. As an alternative to NPV analysis while evaluating investment proposals, Risk-adjusted Present Value (RPV) analysis could be a better option in this modern era. Previously cash was considered to be directly related to investment. But in today’s world, cash is used more like a commodity and the concern is more on the value of risk involved rather that the cost of cash. NPV does not take into consideration the type of risk known as idiosyncratic risk. In reality, companies find that it is very difficult to have the availability of capital at any reasonable price within a short-term, and this compels them to take into account the risk while taking any investment decision. RPV analysis takes into account the risk involved in investment appraisal decision of firms. There is always an uncertainty in the estimated figures of future cash flows and is risky as well. So in order to counter these risks involved, RPV analysis help adjusting the risk either in the cash flows involved or in the discounting rate used in NPV analysis. In RPV analysis, expected values of cash flows are considered or a risk adjusted discounting rate is considered in place of Weighted Average Cost of Capital (WACC) as was considered in case of NPV analysis. But again in this case risk is compounded with time. To counter this problem, an approach involving certainty equivalent can be used, where it decides upon the expected values of cash flows that the managers who takes the decision will be able to accept it with certainty. Thus, the risk adjustment will lead to accepting higher discounting rates in case of assets measured to contain higher values of risk (Damodaran Online, n.d., p.1). Valuation using the mark-to-market concept to measure the risk is the basis or cornerstone for RPV analysis. Conclusion Thus, it can be concluded that NPV analysis is a very good tool to do investment analysis and can be useful when it is used as an initial starting tool for evaluating investment projects, but it cannot be used as definitive tool that can be relied upon in every investment decisions taken by the company. The tool or technique to be used to evaluate investment project depends on the risk associated with the investment project. NPV is always a better option when the company can afford to provide capital as and when it is required during the span of the investment project. But in most cases, there is a constraint of capital in the company, and then RPV can be a better option to evaluate investment proposals involving more risky assets. Although, most of the companies or firms consider NPV to be the best tool in most cases of investment appraisal even today, but time has come to consider superior ways to evaluate investment proposals by considering more modified versions of NPV, like RPV analysis (Ross, 1995, p.96). In order to cope with the ever changing social, economical or technological environment, an effective decision making is the key to success of an organization. Investment decision is one such decision which every company has to make and inadequacy in taking an effective decision can reduce its competitiveness and lead to its downfall in the market (Bilici & Benli, n.d, p.79). References Baker, H. K. & English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. NJ: John Wiley and Sons. Banerjee, B. (1990). Financial Policy and Management Accounting (Ed.8). New Delhi: PHI Learning Pvt. Ltd. Bedi, A. (2005). Capital Budgeting India: Deep and Deep Publications. Bilici, H. & Benli, O.S. (no date). Capital Budgeting with Risk Adjustment for Large-Scale Interdependent Projects. [Pdf]. Available at: http://fbe.emu.edu.tr/journal/doc/78/05.pdf [Accessed on: March 6, 2012]. Damodaran Online. (no date). Risk Adjusted Value. [Pdf]. Available at: http://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch5.pdf. [Accessed on: March 6, 2012]. Dayananda, D. (2002). Capital Budgeting: Financial Appraisal for Investment Projects. Cambridge: Cambridge University Press. Eldenburg, L.G. & Wolcott, S.K. (2007). Cost Management: Measuring, Monitoring And Motivating Performance. USA: John Wiley & Sons. Megginson, W. L. & Smart, S. B. (2008). Introduction to Corporate Finance (ED.2). USA: Cengage Learning. Peterson, P. (no date). Advantages and Disadvantages of the Different Capital Budgeting Techniques. [Pdf]. Available at: [Accessed on: March 6, 2012]. Peterson, P. P. & Fabozzi, F. J. (2002). Capital budgeting: theory and practice. Canada: John Wiley and Sons. Ross, S. A. (1995) Uses, Abuses And Alternatives to the Net-Present-Value Approach. [Pdf]. Available at: http://www.jstor.org/discover/10.2307/3665561?uid=3738256&uid=2129&uid=2&uid=70&uid=4&sid=47698715574207 [Accessed on: March 6, 2012]. Shapiro, A.C. (2008). Capital Budgeting And Investment Analysis. India: Pearson Education India. Siddiqui, S. A. (2006). Managerial Economics and Financial Analysis. New Delhi: New Age International. Bibliography Brigham, E.F. & Houston, J.F. (2009). Fundamentals of Financial Management. (Ed.12). USA: Cengage Learning. Brigham, E.F. & Ehrhardt, M. C. (2010) Financial Management Theory and Practice. (Ed.13). USA: Cengage Learning. Read More