Methods of Investment Appraisal Used by Businesses - Assignment Example

?Assignment: Finance and Accounting Management Accounting Methods of investment appraisal use by Businesses Comparing and contrasting the four main methods of investment appraisal that business use: It is prudent for organizations to completely evaluate every capital investment decisions through sound appraisal methods. The main reason for doing this is that, these investments involve commitment of large sums of funds; they take a long time, require much commitment from the management and are irreversible. The four major techniques used for evaluating investment in capital projects include: accounting rate of return (ARR), Payback period technique, net present value (NPV) technique, and internal rate of return (IRR) (Gotze, et al., 2007). Each of the method has a different approach to evaluating the worth of an investment or project for an organization. Whereas the last three techniques focus on cash flow, the first technique (the accounting rate of return (ARR) also called return on investment (ROI) uses accounting profit during its appraisal calculation, offering a view of the general profitability of the investment project. 1. The accounting rate of return The accounting rate of return also referred to as the return on investment method calculates the estimated general profit or loss concerning an investment project and connects that profit or loss to the amount of capital injected in the project as well as the period for which that investment is required to go. The profit referred to in the appraisal process here is the one that is directly linked to the investment project and, therefore, costs or revenues made elsewhere in the business are not included. There is a minimum rate of return required for any investment that a business wants to undertake. This is connected to the business’s cost of capital. If an investment results into a return that is greater than the related cost of capital, then it would be considered appropriate and profitable. The formula for calculating the accounting rate of return is as follows: Accounting rate of return=Average rate of return = average yearly profit/average investment x 100% (Rohrich, 2007). The average yearly profit is found by adding the annual profits for the years of life of the investment project and dividing the total life of the investment project in years and the average investment is found by adding the investment in the first year to the remaining value at the end of life of the project and dividing by two. With these two values, we can comfortably calculate the ARR. This calculation gives the uniqueness of product as well as its drawbacks as we can see in the subsequent discussions and comparisons. The main advantages of accounting rate of return are: Accounting rate of return considers the general profitability of the investment project. The method is simple to understand as well as easy to use. The method’s end outcome is expressed in form of a percentage, permitting projects of varying sizes to be compared. The major drawback is: The method is based on the accounting profits and not the cash flows. Calculation of profit as well as capital employed is based on expenditure items, which are treated as revenue (those appearing on the profit & loss account) and as capital (appearing on the balance sheet). Even though there are guidelines relating to this area, this practice can be quite subjective. Various accounting policies, for instance, relating to depreciation can generate different figures of profit and capital employed, therefore permitting the profit as well as balance sheet numbers to be manipulated in some way. This is why capital projects are also appraised in terms of cash flows. Accounting rate of return method does not consider the timing of cash flows of the project. For instance, we may have two projects M, and N. Project M may result in an accounting rate of return of 19 percent whereas project N may have ARR of 17 percent. Nevertheless, investment M may be a six year investment whilst investment N may be a four year investment. Project N will likely be preferred to project M by investors since they want a project that generates cash earlier even if it is slightly less profitable (Rohrich, 2007). The accounting rate of return does not consider the “time value of money”. A seven percent return on a capital investment project of $ 35, 000 m might be okay; nevertheless it may not be good enough return where the initial investment was $ 100 billion. 2. The payback method The payback technique is an investment appraisal method that seeks to answer the question of how long it would take to get the money invested back. This is the time it will take for the cash flows coming from the project to accurately equal the investment amount. In terms of comparing projects, the pay back method is concerned with how fast this will happen. It is an easy method that is commonly applied in businesses and it is based on concern of the management to get repaid on the initial investment outlay as fast as can happen. The payback method is not concerned with the general profitability or profitability level (Lumby, 1988). Using the method a business will just reject an investment project that has a payback period exceeding the required. The main advantages accorded to payback include: Being simple to understand as well as apply, and the fact that it promotes caution as a policy in investment. However, it also has drawbacks as follows: Payback does not consider timing of cash flows ($200 received now cannot have the same value as $200 received in a year). In other words, time value of money is not considered. Payback is only concerned with how faster the initial investment is repaid and therefore it neglects the general profitability of the investment. The following method solves the aspect of time value of money that proves a challenge to the first two methods of investment appraisal. 3. The Net Present Value (NPV) The Net Present Value (NPV) method involves discounting of the entire inflows and outflows of a capital investment at a selected aimed cost of capital or rate of return. An investment projected is accepted when it gives a positive NPV. A positive NPV means the project is expected to be profitable. On the other hand, a project with a negative NPV is rejected as it is expected to be unprofitable (Lumby & Jones, 2001). The main advantages of NPV method are: The method considers the “time value of money”. With NPV, profit and the problems related to profit measurement are debarred. Use of cash flows gives emphasis to the importance of liquidity, and finally it is simple to compare different projects’ NPV. The main drawback of this method is that understanding it is not as easy as it is for accounting rate of return and payback. Besides, the NPV method requires knowledge of the cost of capital of a company, which is not easy to calculate. 4. The Internal rate of return (IRR) The fourth method of investment appraisal is the IRR method. Internal rate of return calculates the precise rate of return that the investment project is expected to attain based on the estimated cash flows. The discount factor that will result in an NPV of zero is the IRR. It is the return a company gets from a project, after considering the “time value of money”. In decision making, you accept an investment project if the IRR of the project is greater than the related cost of capital. The main advantage associated with the IRR method is that the information it gives is better understood by managers, particularly non-financial managers (Lumby & Jones, 2003). However, it has the following disadvantages: There is a possibility of calculating more than two dissimilar IRRs for an investment project. This happens where the cash flows throughout the project’s life are a mixture of negative and positive values. This means when this situation happens, then it is not easy to recognize the real IRR and it is advisable to avoid the IRR method. Another drawback is that in certain situations the NPV and the IRR can produce conflicting outcomes. The cause of this situation is that IRR neglects the relative investments’ size as its calculation is based on percentage return instead of the return’s cash value. Due to this, when taking into account two investment projects, chances are that one may produce an IRR of 12 percent while the other may produce an IRR of 14 per cent. Nevertheless, the project having a lower IRR may result into a higher NPV in terms of cash, therefore, would be preferable or profitable. Summary comparisons of the techniques of investment appraisal As happens with other financial modeling areas, every technique of investment appraisal has its drawbacks and many companies use more than one technique. As indicated above, ARR neglects both the “opportunity cost of capital” and the “timing of cash flows”, however, it is utilized in practice in circa half of all firms (Lumby & Jones, 2003). The payback technique neglects the “the time value of money” together with the entire cash flows over the life of an investment project immediately the payback period is arrived at. Nevertheless, it is usually utilized as a device screening, being considered to offer a fair estimation of NPV if cash flows occur in a pattern. Firms may find it useful when they are facing liquidity difficulties or are perhaps creating novelty products that require fast reimbursement of investment. As mentioned above, in general it is preferable to make use of a technique of investment appraisal that discounts cash flows, and the two main techniques that can be used include NPV and IRR. Both methods are acceptable in undertaking capital investment appraisal if a firm can accept the entire projects that are useful to it. Nonetheless, in a situation where capital is being rationed, NPV becomes the better technique, because IRR can rank the projects wrongly (Gotze, et al., 2007). This distinction of superiority is visible when considering incremental cash flow approach. In other words, NPV and IRR result in different rankings and to find the better technique between the two we need to make use of the approach of incremental cash flow. As it has been noted, NPV is also helpful in evaluating interrelated investment projects and shows the size of the extra generation by an investment project. The problem of the IRR is that it can produce multiple IRRs but this problem can be rectified by doing the calculation of the modified version of IRR. Regardless of the advantages that NPV has over IRR, IRR continues to be used widely since it is considered better at emphasizing the rate of return in opposition to the cost of capital. Internal Rate of Return can be calculated basing on the cash flows only. NPV requires a discount rate and some companies are not familiar with their cost of capital. Still if they are not familiar with, mangers may possibly determine that an IRR produced such as 6 percent is excessively low, or the one of 27 percent is suitable. IRR may be instinctively more attractive to non-specialists (Lumby, 1988). It might be easier for a person who is not an account to read something out of the information that a project A produces a return on capital of 27 percent as compared to the same project giving an NPV of $9, 250. Generally, the four techniques offer different approaches to carrying out appraisal of investment projects and can give a dissimilar outlook on a planned investment. Therefore, it would be wise that management must utilize the entire four techniques in evaluating their investment projects (Lumby & Jones, 2001). Nevertheless, the NPV approach as mentioned above is the one approach that has least amount of drawbacks or weaknesses and thus this approach must be utilized as the main guide during evaluation of investment projects. Operating cash cycle It is calculated as follows Operating cash cycle=average collection period of inventory + average processing period of receivables – average payables period (Khan, 2004). In other words operating cash cycle is also known as cash conversion cycle that is calculated as follows: Cash conversion cycle= (average stockholding) add (average receivables processing period) less (average payables processing period) Where; Average receivables processing period (denoted in days) = Accounts receivables ? average daily credit; The sales average stockholding period (denoted in days) = closing stock ? average daily purchases And Average payable processing period (denoted in days) = accounts payable ? average daily credit purchases (Badenhorst-Weiss, et al., 2008) Redken Ltd Sales ?2700 Purchases ?1800 Cost of goods sold ?1830 Average trade debtors outstanding ?300 Average trade creditors outstanding ?160 Average stocks held ?305 Average inventory collection period=365/inventory turnover ratio Inventory turnover ratio=cost of goods sold/average stock held=?1830/?305=6 times Therefore, Average inventory collection period=365/6=60.83 days Average receivables processing period=365/receivables turnover ratio Receivables turnover ratio=sales/average trade debtors outstanding=?2700/?300=9 times Therefore average receivables processing period=365/9=40.56 days Average payables period=365/payables turnover ration Payables turnover ratio=purchases/average trade creditors outstanding=?1800/?160=11.25 times Average payables period=365/11.25=32.44 days Redken Ltd operating cash cycle =60.83 + 40.56-32.44=68.95 days This not acceptable operating cash cycle to the company because it shows that the company can at one time lack enough cash to run its daily operations or replenish inventory (Weaver & Weston, 2008). Definition of operating cash cycle Operating cash cycle has been described in different words to underscore the same definition or application. It is defined as the time it takes an organization in business to convert its inputs resource into cash. This means that operating cash cycle measures how effective an organization is able to manage its working capital. In other words, it is a function of how fast an entity pays back its accounts payable, how fast an entity sell its inventory and to how fast an entity collects its accounts receivables. Hence, the formula is as follows Operating cash cycle=average days’ inventory (add) average days’ accounts receivable (less) Average days’ accounts payable (Baker & Powell, 2009). How the operating cash cycle can be improved at Redken Ltd There are several ways in which Redken can improve its operating cash cycle. First, according to the calculation above, Redken’s average inventory collection period stand at 60.83 days, which is a very long period of time considering that this is not a big company. This could imply that the company is at the risk of becoming bankrupt, especially considering the entire operating cash cycle. The company has to find a way of selling its inventory more quickly. To achieve this, it will be essential to put in place proper inventory management procedures including proper technology and knowhow to ensure effective and efficient management of inventory (Jr, 1995). This is because keeping less or more inventory cause crisis in the availability of cash. Secondly, Redken has to ensure that it collects its account receivable/sales more quickly. This may include encouraging its customers to pay what they owe it on time. This may include giving them cash discounts if they pay in a period less than the usual stipulated 30 or 60 days. This will reduce the average accounts receivable processing period and in turn affect the cash operating cycle positively. Thirdly, Redken can improve its operating cash cycle by making arrangements to pay accounts payable in a period slightly more than the 30 or 60 days. In other words, they need to pay their creditors slower than usual. This will ensure that the company has cash to meet its day to day operations (Jr, 1995). However, this should be well managed to avoid the company running into negatives. Generally, it is essential that the organization’s management understands the company’s operating cash cycle and ensure that it is under control. Proper understanding of each of three components of the operating cash cycle can assist pinpoint the pattern not only in the operating cash cycle, but also concerning the individual processing periods on their own. Reducing Redken stockholding period Some of the ways of reducing the stockholding period include making arrangements with the company’s suppliers so that can be involved in the company’s operating cash cycle. This can be done by encouraging suppliers of Redken to accept longer period of debt repayment, more than what is usual in accounts receivable relationships. Instead of repaying in 30 to 60 day periods, the creditors can extend the time of payment beyond what will permit the company to have either on hand or bank. Another method involves making arrangement with customers. Customers can use present relationship with their customers to get rid of time amid cash flow cycles. By understanding its customers, the company can time its billing procedures such that it coincides with their customer’s usual pay cycle (Weaver & Weston, 2008). This can be coupled with enticing customers of the company to pay quickly by offering them some kind of incentive to pay faster rather delaying. Also the company can get its bills out to its customers sooner to assist speed up the process of payment. Efficiency is another way of reducing stockholding period. In most cases, process relating to handling and controlling stock is handled by many people especially in the process of billing and invoicing (Badenhorst-Weiss, et al., 2008). It is possible to expedite this process by increasing the efficiency of those employees who manage the process. One key way of doing this is automating the process. This will result in faster turnaround times on repayment received from debtors of the company. The other way of reducing stockholding period is through inventory improvement. Inventory always ties up a substantial amount of a company’s potential working capital, up to the time when it is sold. Those businesses that employ inventory optimization technologies as well as collaboration tools can reduce their lag time amid cash flow cycle (Baker & Powell, 2009). The design of inventory optimization technologies are such that they offer businesses a tool that informs them what the ideal mixture of cash on hand and inventory happens is. In essence, having too much of either of the two can unfavorably affect cash flow in either short term or long term. It should be noted that the length of the operating cash cycle depends on balancing profitability and liquidity. Shortening the cash cycle may adversely affect sales since customers buy from those suppliers who offer more credit period. Therefore, there must be an optimum level as far as operating cash cycle is concerned. Reference list Badenhorst-Weiss, H., Brevis, T. & Cant, M., 2008. Business Management: A contemporary Approach. 2 ed. New York: Junta and Company Ltd. Baker, K. H. & Powell, G., 2009. Undrstanding Financial Management: A practical Guide. 1 ed. Boston: John Wiley & Sons. Gotze, U., Northcott, D. & Schuster, P., 2007. Investment Appraisal: Methods and Models. 1 ed. New York: Springer. Jr, P. J. F., 1995. Understanding Cash Flow. 2 ed. Washington: john Wiley & Sons. Khan, M. Y., 2004. Financial Management: Text, Problems And Cases. 1 ed. London: Tata McGraw-Hill Education. Lumby, S., 1988. Investment Appraisal and Financing Decisions. 1 ed. New York: VNR International. Lumby, S. & Jones, C., 2001. Fundamentals of Investment appraisal. 2 ed. Pennsylvania: Thomson Learning. Lumby, S. & Jones, C., 2003. Corporate Finance: Theory and Practice. 1 ed. Chicago: Cengage Learning EMEA. Rohrich, M., 2007. Fundamentals of Investment Appraisal: An Illustration Based on a Case Study. 1 ed. Olden Bourg Verlag: London. Weaver, C. S. & Weston, F. J., 2008. Strategic Financial Management: Applications of Corporate Finance. 2 ed. London: Cengage Learning. Read More