Evaluating projects involving the use of investment appraisal

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The objective of this paper is twofold. The first section seeks to ascertain whether investment appraisal adds any value to a business. It will also include an analysis of the main discounted cash flow techniques used by managers to assist them decide if a project is worth undertaking or not. The second section of this paper comprises of an evaluation of four mutually exclusive projects

Investment Appraisal

According to Arnold (2005) investment appraisal can be defined as the evaluation of the attractiveness and viability of an investment project using appropriate investment appraisal methods such as the net present value, internal rate of return, average rate of return or the payback period. The appraisal of an investment is considered to be the most important form of decision making within a company. This is so because investment appraisal techniques are used to provide managers with information on the credibility of undertaking a potential project. Whilst this view is commonly shared amongst several researchers, some researchers argue that the investment appraisal techniques do not solely add value to a business organisation. The view that investment appraisal adds value to a business organisation can be supported by the fact that the main investment appraisal techniques used such as the net present value, the internal rate of return generated by a project all provide an organisation with an indication as to what projects are likely to yield a profit. Therefore this fulfils the objective of maximising shareholder wealth within an organisation. Based on the result of the net present value, there’s a clear indication as to whether a project should be accepted or not. Value is being added to the organisation where the result of the NPV shows a zero or positive outcome or the highest positive value amongst other projects. Despite the significance of these investment appraisal techniques and their contribution towards the value added in the business organisation, they have been hugely criticised referring the contrary. According to Akalu, 2001; Remer and Nieto, 1995a, 1995b; the investment appraisal techniques have their shortcomings which make them unsuitable to accommodate current changes in business environment, especially, where increasing shareholder value is of importance.

Furthermore, their continuous application reveals significant limitations in their capacity to address the basic problems of investment appraisal (Akalu, 2001, P.379; Dramodaran, 1994). In addition, some of these methods involve complex decision making processes. Thus, the choice for an appropriate appraisal method is becoming a difficult task for managers, which requires critical analysis of various tools. Scholars propose various options to solve this basic problem of investment management. The traditional discounted cash flow (DCF) methods are the most commonly used techniques (Graham and Harvey, 2001). Some researchers such as Dixit and Pindyck, 1995; Boer, 2000; have proposed the real option model, while Rappaport, 1986 contend that the value management tools better add value to a business organisation instead of the investment appraisal techniques. However, most of these proposals have got their own demerits. The DCF method is the main investment appraisal method used suitably to add value to a business organisation. However, its techniques have been widely condemned for their inadequacy to appropriately appraise soft projects, such as research and development, as such management are inclined to select such projects on intuition, experience and rule of thumb (Tam, 1992; Tyrrall, 1998). On the other hand, the Real Option method is found complex, it demands enormous computational work and requires additional data for companies which are not listed in stock markets (Cheung, 1991). Furthermore, the value management tools, such as the economic value added, are criticized for its inability to measure the creation of shareholder value (Fernandez, 2001).

There are a variety of methods that firms that are available to management which they can use to determine whether their investment proposals are worthwhile. These include accounting rate of return (ARR), payback period, internal rate of return (IRR) and the net present value (NPV). The ARR is a measure of the investment’s average return on the initial investment. Before accepting the project, the firm must determine a target ARR and compare each project’s forecasted ARR against the target. If the ARR is greater than the target, then the project is accepted. If the ARR is lower than the target, the investment is rejected (Myers and Brealey, 2002; Ross et al., 1999). For competing projects, the one with the highest ARR is accepted. The payback period measures the time taken to recover the initial investment. Firms usually have a target payback period for their investment. The payback period is calculated and compared to this target to determine whether the project should be accepted or rejected. For competing projects, the project with the highest payback period is accepted. Both ARR and Payback period have a number of shortcomings. They ignore the time value of money and are not based on discounted cash flow techniques. The ARR in particular is based on accounting profit which may be subject to accounting manipulations (Penman, 2007). The payback period on its part ignores cash flows after the payback period. Consequently, most firms prefer making use of IRR and NPV which are based on discounted cash flow techniques.

Discounted cash flow (DCF) analysis simply refers to the methods used by managers in valuing a project, company, or asset using the concepts of the time value of money. The calculations involve the estimation of all future cash flows and discounting them to give their present values (PVs). The sum of all the future cash flows is referred to the net present value (NPV), which becomes the value or price of the cash flows in question. The IRR is the discount rate that makes the NPV of the investment equal to zero. It is the discount rate that equalises the present value of cash inflows to the present value of cash outflows thus making the net present value to equal to zero. The decision rule based on the IRR is to accept all projects with an IRR that is above the cost of capital (Myers and Brealey, 2002; Ross et al., 1999). For competing projects, the project with the highest IRR is accepted. The IRR is not free from flaws. Some of which include the fact that there may be a multiple number of IRRs and this may make investment decision difficult; the IRR may also give conflicting signals for mutually exclusive projects; where cash flows are irregular, there may be a likelihood of multiple IRRs being generated, which raises conflicts. The IRR is often confused with the accounting rate of return. As a result of the conflicting flaws of the IRR, the best investment appraisal approach to date is the NPV.

The NPV is the difference between the present value of cash inflows and the present value of cash outflows that are expected to be generated from the project (Myers and Brealey, 2002; Ross et al., 1999). It can also be defined as the net of all positive and negative present values of the cash flows, resulting from the whole life of an investment. (Arnold, 2005) The decision rule is to accept projects with positive NPVs. For competing projects, the project with the highest positive NPV is accepted. (Arnold, 2005) The NPV has been widely considered as the best investment appraisal project because it provides a clear indication of whether shareholder wealth has been increased or not. This is so because a project with positive NPV increases the shareholder wealth while a negative NPV decreases shareholder wealth. The NPV also takes into account the time value of money and the risk factor associated with different project levels as the discount rate can be adjusted to take into account the different levels of risks associated with different projects. (Graham and Harvey, 2005)The NPV is also more efficient because unlike the ARR, it is based on the cash flows rather than profits. The NPV is also used to determine the optimum policy for asset replacement (Arnold, 2005)

However, the NPV has been criticised of its complexity for which non-financial managers may find difficulties in understanding the concept. Some suggest that the NPV may be less efficient in that the discount rate used in its calculations may be incorrect as they often prove to be difficult to be derived. The NPV will be difficult to be calculated where mid-period cash flows are present in a scenario, because it only assumes cash flows that begin a the beginning or end of the year.