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Explanation Of Two Investment Appraisal Techniques Finance Essay

Nowadays, investing is very important for a company to survive. According to UoS (2007) “an investment involves the outflow of cash at a point in time in order to obtain benefits in the future”. Companies make these investment decisions in order to increase the value of the firm and maximizing shareholders wealth. However, funds are limited, thereby, companies cannot invest all projects, they must choose between alternative investment. There are four commonly techniques for appraising capital investment projects.

Payback

Accounting rate of return (ARR)

Net present value (NPV) also known as Discounted Cash Flow or DCF

Internal rate of return (IRR) also known as Discounted Cash Flow technique

In this report, we choose payback and NPV as two investment appraisal techniques to find out how they can inform future projects, their merits and limitations, and which technique the company would prefer.

Explanation of two investment appraisal techniques

Payback

“Payback is the number of years required to recover the original cash flow outlay investment in a project” (Brealey, Myers and Marcus, 2001). The payback is a commonly used method of evaluating investment proposals.

If the cash flows are constant, the formula is: Payback period =

If the cash flows are not constant, the calculation must be in cumulative form.

How to assess? Among alternatives, the company should decide to invest into project which payment period is shorter, in other words, the project can be repaid quicker.

Example: Project A of ABC Ltd has cash flow as follows. Calculate payback period.

Year

Cash flow (£)

Cumulative (£)

0

(100,000)

(100,000)

1

10,000

(90,000)

2

20,000

(70,000)

3

30,000

(40,000)

4

30,000

(10,000)

5

40,000

30,000

Using in cumulative form, after five years, the original investment has recovered and project A also got £30,000 of profits, so the payback period of this project is:

Payback period = 4 + = 4.25 years

Thus, payback period of project A is 4.25 years.

Net present value (NPV)

According to Professional Management Education (2010), “The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is discounted cash flow technique that explicitly recognizes the time value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present values are found out”.

The formula is: NPV = Initial Investment +

With r is the rate of interest.

It should be clear that the acceptance rule using the net present value (NPV) method is to accept the investment project if NPV is positive, to reject it if NPV is negative and may accept the project when NPV is zero.

Example: Discount the original proposal of ABC Ltd using a discount rate of 10%. Using the data in the tables below, calculate NPV of project A.

Year

Cash flow (£)

10% Discount factor

Present Value (£)

0

(100,000)

1.0

(100,000)

1

10,000

2

20,000

3

30,000

4

30,000

5

60,000

Before calculating NPV, we need to determine the present value PV by using the formula:

Present value PV =

PV of year 1 = = £9,091

PV of year 2 = = £16,529

PV of year 3 = = £22,539

PV of year 4 = = £20,490

PV of year 5 = = £37,255

 NPV of investment = Initial investment +

= -100,000 + 9,091 + 16,529 + 22,539 + 20,490 + 37,255 = £5,904

Because NPV of this project is positive, so it should be accepted.

Analyzing of two investment appraisal techniques

Compare and contract

In every company, payback period and NPV are very important to evaluate the value of a proposed project before investing on it. Both of two investment appraisal techniques can measure the sustainability and value of long-term projects. From that, the company can make right financial decisions.

About calculate technique, payback period is used to calculate a period within which the initial investment of a project is recovered (UoS, 2007). It is equal to the initial net investment divided by annual expected cash flows. For example, a company wants to invest £10,000 in a new project and they expect to have annual cash flows of £2,000, so the payback period of this project will be = 10,000/2,000 = 5 years. The shorter payback period, the better investment is. A long payback period means that the investment will be locked up for a long time, thereby this project is relatively ineffective.

While, net present value (NPV) uses the time value of money to appraise long-term projects. According to UoS (2007), “NPV uses the opportunity cost of capital to discount the flows of cash in and out, over the life of a project to give their value at the present day”. The most important thing to remember about NPV is present value (PV) because NPV equates to the sum of present values of individual cash flows. For example, a project invests £1,000 and it will be brought cash flows of £2,000 in the next year, so PV of £2,000 = 2000/(1+0.1) = £1,818 with interest rate as 10%. Thus, the NPV of this project = -1000 + 1,818 = £818. When choosing between alternative investments, NPV can help define the project with highest present value, and also apply the acceptance rule of NPV, if NPV>0 accept the investment, if NPV<0 reject the investment, and if NPV=0 may accept this project.

Ross et al. (2007) stated that NPV method removes the time element in weighing alternative investment, while payback period is focused on the time required to recover the initial investment. From that, payback period method does not assess the time value of cash, inflation, financial risks, etc. as opposed to NPV, which measures the investment’s profitability.

In addition, although payback period method indicates the acceptable period of investment, it does not care about what will be happened after the payback period and their impact to total incomes of this project. But NPV cares about it. So, NPV will be provided better decisions than payback when the company makes capital investments. In fact, companies usually use NPV method than payback period method.

Merits and limitations

Merits

The most significant merit of payback period is that it is simple to understand and easy to calculate than other appraisal investment techniques. Comparing with NPV method, payback method uses fewer costs and less analysts’ time than NPV. For this method, an investor can have more favorable short term effects on earnings per share by setting up a shorter standard payback period. Professional Management Education (2010) believed that payback period can control investment risks because the longer it takes to recover the initial investment, the more uncertainties there will be during the recovery period. In addition, payback method focuses on the time to recover of the initial investment, so it gives an insight into the liquidity of the project. The shorter payback period, the higher liquidity is.

On the other hand, Brealey et al. (2001) stated that NPV is more accurate and efficient as it uses cash flow, not earnings and results in investment decisions that add value. By discounting the flows, NPV can create the comparison between alternative investments, and then, making right capital decisions. NPV method is always consistent with the long-term objective of the shareholder value maximization. We can say that this is the greatest merit of this method.

Limitations

Payback

Example: ABC Ltd has two projects A and B with the same three years payback period, whose flows are as follows.

Year

Cash flows from Project A (£)

Cumulative (£)

Cash flows from Project B (£)

Cumulative (£)

0

(100,000)

(100,000)

(100,000)

(100,000)

1

20,000

(80,000)

50,000

(50,000)

2

30,000

(50,000)

30,000

(20,000)

3

50,000

0

20,000

0

4

30,000

30,000

100,000

100,000

Payback Period (Year)

3

3

Ross et al. (2007) stated that the first limitation of payback method is the timing of cash flows within the payback period. Looking at the table above, from year 1 to year 3, the cash flows of project A increase from £20,000 to £50,000, while the cash flows of project B decrease from £50,000 to £20,000. Because the large cash flow of £50,000 comes earlier with project B, its NPV must be higher. However, as mentioned before, the payback periods of the two projects are identical. Thus, a problem with the payback period is that it does not consider the timing of the cash flows within the payback period. It also shows that the payback method is inferior to NPV because NPV method discounts the cash flows properly.

The second limitation is payment after the payback period (Ross et al., 2007). Let's consider between projects A and B with the same three years payback period, but project B is clearly preferred because it has a cash flow of £100,000 in the fourth year. Thus, a problem in here is that payback method ignores all cash flows occurring after the payback period. For the short-term orientation of the payback method, some valuable long-term projects may be rejected. NPV method does not have this limitation because this method uses all the cash flows of the project. Because of the first two limitations, the payback method cannot maximize shareholders wealth.

According to UoS (2007), the payback period method ignores inflation and discriminates against large capital-intensive infrastructure projects with long times, because it only cares about the earliest time to recover the initial investment.

Net present value (NPV)

NPV is the true measure of an investment’s profitability. But, in practice, it still has some problems. The first limitation of NPV method is cash flow estimation (Professional Management Education, 2010). The NPV method is easy to use if forecasted cash flows are known. However, it is quite difficult to obtain the estimates of cash flows due to uncertainly. The second limitation of NPV is unrealistic assumptions (UoS, 2007). Under NPV method, there is a single market rate of interest for both borrowing & lending and an individual can borrow or lend any amount of money at that rate. It is unrealistic, in practice, the interest rate for borrowing and lending is different and everyone has to follow the interest rate for each kind. For example, for Vietnam market in 2011, the interest rate for borrowing at 9% and for lending at 17% per year (Trading Economics, 2012). NPV also ignores transaction costs or taxes.

Conclusion

In a survey carried out by Graham and Harvey (2001), it was found that 74.9% of respondent companies that use net present value (NPV), and 56.7% use payback period method when they appraise the investment projects. It means that in fact, NPV method is used more than payback period method.

Techniques

% Always or Almost Always

Internal Rate of Return (IRR)

75.6

Net present value (NPV)

74.9

Payback period

56.7

Accounting rate of return

30.3

Source: Graham and Harvey, “The theory and practice of corporate finance: Evidence from the Field”, Journal of Financial Economics 60 (2001), based on a survey of 392 CFOs

According to the survey of Graham & Harvey (2001) and Sandahl (2003), payback period method is often used in small size companies. The major reason for this can be that payback period method is simple, cheaper costs and easy to calculate. Small companies are only interested in the shortest time to recover initial investment because they often lack the source for fund. Moreover, the complexity of the other investment appraisal methods always is a barrier for the small company.

While net present value (NPV) is often used in medium and large size companies (Graham and Harvey, 2001). The major reason for this can be that these companies are interested in the profitability and time value of money than the payback period. They have the source of funds and consider maximizing shareholders wealth as their long-term objective.

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