Methods Used to Evaluate Investment Projects
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Evaluation of the attractiveness of an investment proposal, using methods such as average rate of return, internal rate of return (IRR), net present value (NPV), or payback period. Investment appraisal is an integral part of capital budgeting (see capital budget), and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training
Average Rate of Return (ARR) Definition:
Method of investment appraisal which determines return on investment by totalling the cash flows (over the years for which the money was invested) and dividing that amount by the number of years
Internal Rate of Return (IRR) Definition:
One of the two discounted cash flow (DCF) techniques (the other is net present value or NPV) used in comparative appraisal of investment proposals where the flow of income varies over time. IRR is the average annual return earned through the life of an investment and is computed in several ways. Depending on the method used, it can either be the effective rate of interest on a deposit or loan, or the discount rate that reduces to zero the net present value of a stream of income inflows and outflows. If the IRR is higher than the desired rate of return on investment, then the project is a desirable one. However, it is a mechanical method (computed usually with a spreadsheet formula) and not a consistent principle. It can give wrong or misleading answers, especially where two mutually-exclusive projects are to be appraised. Also called dollar weighted rate of return
Net Present Value (NPV) Definition:
NPV is the difference between the present value (PV) of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return (also called minimum rate of return)
For example, an investment of $1,000 today at 10 percent will yield $1,100 at the end of the year; therefore, the present value of $1,100 at the desired rate of return (10 percent) is $1,000. The amount of investment ($1,000 in this example) is deducted from this figure to arrive at NPV which here is zero ($1,000-$1,000). A zero NPV means the project repays original investment plus the required rate of return. A positive NPV means a better return, and a negative NPV means a worse return, than the return from zero NPV. It is one of the two discounted cash flow (DCF) techniques (the other is internal rate of return) used in comparative appraisal of investment proposals where the flow of income varies over time
Payback Period Definition:
Time required to recover an investment or loan.
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
- Forecasting investment needs.
- Identifying project(s) to meet needs.
- Appraising the alternatives.
- Selecting the best alternatives.
- Making the expenditure.
- Monitoring project(s).
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.
Investment appraisal methods:
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.
This 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 often used as an initial screening method.
Payback period = Initial payment / Annual cash inflow
So, if £4 million is invested with the aim of earning £500 000 per year (net cash earnings), the payback period is calculated thus:
P = £4 000 000 / £500 000 = 8 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 £4 000):
The payback period is precisely 5 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.
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 payback method can become complicated. In this case, the earlier flow of revenue is a key factor. Also if post-payback revenues occur earlier in the lives of competing projects, that can be a decisive factor.
OK, so it's clear that the payback method is a bit of a blunt instrument. So why use it?
Arguments in favour of payback
Firstly, 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.
Secondly, 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.
Thirdly, the investment climate in the UK in particular, demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow.
Arguments against payback
It lacks objectivity. Who decides the length of optimal payback time? No one does - it is decided 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.
Average Rate of Return:
The average 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) * 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 £240 000 and is expected to generate total revenues of £45 000 over the project's five year life. What is the ARR for this project?
ARR = (£45 000 / 5) / 240 000 * 100
= (£9 000) / 240 000 * 100
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 Average 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 for managers to use.
There are several criticisms of ARR which raise questions about its practical application:
Arguments against ARR
Firstly, the ARR doesn't take account of the project duration or the timing of cash flows over the course of the project.
Secondly, 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.
Thirdly, there is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective.