Evaluation of Investment Appraisal Techniques - Research Paper Example

I. Introduction This paper focuses on capital investment decisions by companies and requires knowledge of both the application and evaluation of the following investment appraisal techniques:  Payback Method (PB),  Accounting Rate of Return(ARR),  Net Present Value (NPV), and  Internal Rate of Return (IRR) II. Aims The aim of this report is to test the application and evaluation of investment appraisal techniques. This report will therefore address to answer the question whether Midland Manufacturing Ltd, a manufacturing company may continue using one of the techniques which is the Payback Method in evaluating proposal in relation . Please see appendix I for the factual scenario pertain to the company. III. Methodology The discussion and analysis of the different techniques will start with definitions of the important terms, followed by the discussion of the rationale and application of the techniques or methods. The financial information from Midland Manufacturing Ltd. will be used as inputs in testing the application of the techniques. The advantages and disadvantages will be discussed in the light of the results of the application of the appraisal methods and finally a recommendation will be made based on a conclusion that will be made from the discussion and analysis previously made. IV. Discussion and Analysis Proper IV. A. Definition of Cost of Capital and its importance to decision making. Cost of Capital means  firms cost of capital can be defined as the rate of return that could be earned in the capital market on securities of equivalent risk. In general, the higher the riskiness [sic] of the firms activities, the higher its cost of capital, since investors typically require compensation for greater risk. For a firm financed by debt and equity, the cost of capital will be a weighted average of its cost of capital from both sources. www.ofcom.org.uk/consult/condocs/mobile_call_termination/wmvct/annexf/  The discount rate that should be used in the capital budgeting process. strategis.ic.gc.ca/epic/internet/insof-sdf.nsf/en/so03148e.html An example is when a businessman borrows money to put some business. When the money was borrowed at say 10% interest rate, this rate is the discount rate or cost of capital that the said businessperson must earn in the conduct of his business, other wise he should not go into business because he will be just wasting money and resources. Cost of capital is important because it is used as benchmark in evaluating various investment proposals that a businessperson may come to meet. Business life is a road of many decisions and not to have at least one tool or vehicle to endure the travel would be a big failure. Knowledge of the cost of capital therefore finds a great advantage. IV.B. Rationale of the Different Investment Appraisal Methods and Concept of Time Value of Money Knowing the rationale behind each of the following investment appraisal methods, namely: payback method, accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR) requires one to relate the same with the cost of capital as discussed earlier. What then the relationship of the cost of capital is as expressed in percent or rate with these appraisal methods? Will each of the methods show some way of measuring cost of capital so that if the required cost of capital expressed in rate is not met, then the project would just be rejected? A doctor uses a thermometer to measure a body’s temperature of a patient if the latter is above the normal temperature so does a business man needs also some tool to determine whether financially he has reason to go into business or when he is already in business, to adopt or reject a proposal that may come his way. There are two approaches for doing the same, one is to consider the time value of money and the other one is to disregard the same. A question will now then be asked: why not just consider the time value of money and just forget the one which does not consider the time value of money? Before the said question is answered, the "time value of money" must be defined. What is its relevance in decision-making? From the phrase itself, “time value of money” means the value of money varies with time. In simple language, a $ 10 dollar today is not the same is $ 10 one year after or $ 10 dollar a year ago. From here, it is easy to proceed with the argument: if there is a difference in the value of money in relation to time, how will a businessperson then measure the values of money in relation to time? This is the purpose of then of having discounted cash flow methods. This answer to the argument will be made clearer with the discussion of discounted cash methods, which include the NPV and the IRR. At this point, the question: Why do some businessmen still use non-discounted cash flow methods when there is time value of money? Common knowledge posits simplicity as reason for the use. This will be proven as discussion is continued. IV. C. The Payback Method and the Accounting Return Method A work by NetTel@Africa Off-Line Content(http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) on Session 2: Project Evaluation and Selection Analysis Techniques tells us about the Payback method (or Payback Period), and the Accounting rate- of-return (ARR) method, the net present value method and the internal rate of return (IRR) method. The first two are the non-discounted cash flow methods while the last two are the discounted cash flow methods. The work reads: "The payback period is the number of years required to return the original investment from the net cash flows (net operating income after taxes plus depreciation). Example. Assume the firm is considering two projects; project A and project B, each requires an investment of $100 millions. The cost of capital is 10%. Below is the summary of expected net cash flows in millions. The payback from the two projects is project A: 2 and 1/3 years project B: 4 years. If the firm has the policy of employing three years payback period, project A will be accepted but project B will be rejected." (http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) The work further says: "Accounting rate of return (ARR) is the other method for non discounted cash flow. ARR is also known as accrual accounting rate of return, unadjusted rate of return model and the book value model." The ARR formula includes the return on assets (ROA) or return on investment (ROI). Return on assets equals net income divided by the average total assets as of a given time which is measured yearly based on financial statements. The information as to net income is readily available in financial statements, which include the income statement and balance sheet. For example, if the net income is $ I0 M and the Average total assets is $ 100 M, then we have a return on assets of 10%. The use of non discounted cash flow methods are obviously easy to use. Comparison will be made after discussing the discounted cash flow methods, the NPV and IRR. IV. The NPV NetTel@Africa Off-Line Content, in discussing the NPV, said: “The NPV is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money. This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project. In case the present value is positive, the project will be accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen.”(http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) Note however, that not every method is perfect because there is a problem with NPV, which will be discussed later. IV. The IRR The IRR also is a method that uses time value of money but uses rates to express the answer. It is closely related with NPV in the sense that if NPV is set to zero, the discount rate that is used in computing the NPV, is actually the IRR of the project. For purposes of using this method of whether to accept a project proposal, the IRR of said proposal must be higher than the cost of capital; otherwise, the proposal must be rejected. Please see Appendix IV for the formula. However, since the discounted cash flow methods use the time value of money, they appear to be more complicated than the non-discounted cash flow methods. IV. B.2. Relationship of ‘the time value of money’ with ’discounted cash flow’. To understand better the meaning of time value of money, an attempt is made here to relate the same with the concept of “discounted cash flow”. First, there must be a clear definition of cash flow. How is it computed? Is it also given, like in the case of computing the accounting rate of return? A book by Eugene F. Brigham and Joel F. Houston in Fundamentals of Financial Management , admits that “ the most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows---the investment outlays and the annual net cash inflows after a project goes into operation. Many variables are involved and many individuals and department participate in the process.” From this statement, it can be seen that the preparation of cash flow is based on estimates from the different departments of an organization. However, it should allow a person who has a good background in finance, to prepare cash flows under given sets of data. Mr. Brigham and Mr. Houston give the following formula to compute cash flow (page 539): “Free cash flow= After-tax operating income plus depreciation less capital expenditure less change in operating working capital.” The after-tax operating income requires the knowledge taxation and accounting. Accounting could be complicated if information are not reliable. The time value of money as discussed earlier assumes that the value of certain amount of money from now is different from its value 10 years ago or 10 years after. The concept of discounted cash flow assumes the money at present will be reinvested under a uniform and compounded interest rate and the value of the present money was actually the result of money in the past that was also reinvested at a uniform compounded interest rate. At this point, although, there is an admitted difficulty in the estimation of cash flows, an attempt is made here to clarify the concepts of time value of money and discounted cash flow. D. Application Of Appraisal Methods Or Techniques With A Given Problem D. 1. Results of Calculation of PB, ARR, NPV, IRR Table I. Machine A Machine A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sales 1,000,000 1,210,000 1,440,000 1,800,000 1,950,000 Variable cost 300,000 440,000 600,000 750,000 900,000 Fixed Cost 200,000 200,000 210,000 215,000 220,000 Depreciation  400,000 400,000 400,000 400,000 400,000 Net Income 100,000 170,000 230,000 435,000 430,000 Less : Tax at 0%* - - - - - Net income after tax 100,000 170,000 230,000 435,000 430,000 Add back: Depreciation** 400,000 400,000 400,000 400,000 400,000 Annual Cash flow, net of tax (2,000,000) 500,000 570,000 630,000 835,000 830,000 * 2000000/5 Initial Outflow NPV (£) 313,279.04 IRR 18% ARR 0.05 0.09 0.12 0.22 0.22 Pay back 3.36 years Machine B year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sales 1,000,000 1,210,000 1,440,000 1,800,000 1,950,000 Variable cost 600,000 770,000 960,000 1,200,000 1,350,000 Fixed Cost 120,000 130,000 150,000 150,000 150,000 Depreciation* 200,000 200,000 200,000 200,000 200,000 Net Income 80,000 110,000 130,000 250,000 250,000 Less : Tax at 0% - - - - - Net income after tax 80,000 110,000 130,000 250,000 250,000 Add back: Depreciation* 200,000 200,000 200,000 200,000 200,000 Annual Cash flow, net of tax (1,000,000) 280,000 310,000 330,000 450,000 450,000 NPV (£) 244,056.08 IRR 22% ARR 0.08 0.11 0.13 0.25 0.25 Pay back 3.18 years D. 2. Analysis of Application of the Techniques Case facts state that the company usually makes its capital expenditure decisions based on the Payback Method, the rationale being that this method reduces investment risks. Hence, there is need to evaluate the payback period results, which yielded 3.36 for Machine A, and 3.18 for machine B. The case facts do not state anything as to the company policy of what project could be accepted within a given number of years, hence, there is no clear basis to choose which of the two machines could provide the faster period of recovery of investments. In this case, B should be chosen over A because 3.18 years is shorter than 3.36 years if 3.18 years is within the company policy. If the ARR is used for Midland, choosing B is better than machine A because the rates are higher for the duration of life of the investment. If the NPV is used, A is a better option because the net present is higher than that of B. However, if the IRR is used, machine B has a higher rate at 22% compared with A with IRR of 18%. It appears therefore that there is a conflict between the two discounted cash flow methods and between discounted cash flow methods and non-discounted cash flow methods. “The key to resolving conflicts between mutually exclusive projects is this: how useful is it to generate cash flows sooner rather than later? The value of early cash flows depends on the return we can earn on those cash flows, that is, the rate at which we can reinvest them. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital. Whereas the IRR method assumes that the firm can reinvest at the IRR. These assumptions are inherent in the mathematics of the discounting process. The cash flows may actually be withdrawn as dividends by the stockholders…., but he NPV method still assumes that the cash flows can be reinvested at the cost of capital, while the IRR method assumes reinvestment at the project’s IRR. Which is the better assumption- that cash flows can be reinvested at the cost of capital, or that that they can reinvested at the project’s IRR…. Therefore, we conclude that the best reinvestment rate is the cost of capital, which is consistent with the NPV method…. We should reiterate that, when projects are independent, the NPV and IRR methods both lead to the same accept/reject decision. However, when evaluating mutually exclusive projects, especially those differ in scale and/or timing; the NPV method should be used.” (Brigham and Houston, page 515.) Having resolved therefore the conflict between the NPV and IRR that is to use NPV, machine A is a better option than machine B. However, if we go back the non-discounted cash flow methods led us to choose machine B, hence there is still an issue on which to choose. The issue could be resolve on whether the decision maker believes in time value of money. If it believes in time value of money, machine A is better than machine B but if it does not believe then, machine B is better. However, an educated mind would believe in time value of money, hence the conclusion would be to adopt NPV method and recommend machine A. Relationship Between IRR and the NPV, NetTel@Africa Off-Line Content gives us an easy guide in understanding the relationship between NPV and IRR and in deciding conflict between NPV and IRR below: “Relationship between IRR and the NPV Profile 1) When the IRR = the firms hurdle rate, NPV = 0 2) When the IRR < the firms hurdle rate, NPV < 0 3) When the IRR > the firms hurdle rate, NPV > 0 NPV and IRR Methods: Possible Decision Conflicts. An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept" Note: When projects are independent, no accept/reject conflict will arise. A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR. Note: Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects. Ranking conflicts arise because of: 1) Timing differences in incremental cash flows 2) Magnitude differences in incremental cash flows. When a conflict arises among mutually exclusive projects, pick the one with the highest NPV.” (http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) Limitations NPV and IRR are not perfect in themselves hence an understanding of their limitations is necessary to guide the decision maker. NetTel@Africa Off-Line Content talks about the limitations of Internal Rate of Return (IRR), saying: “The Internal Rate of Return (IRR) concept has several limitations and although the concept is somewhat simple, it can be easily misinterpreted and confused with the actual project rate of return.” These limitations include (a.) Timing of Costs and Benefits and difference between Relative vs. Absolute Values..”() (Emphasis mine) As to whether the use of the IRR in this study must be viewed be with apprehension because of the limitations cited by NetTel@Africa Off-Line Content may not applicable because the IRR concept is best suited for projects or investments having positive cash flows throughout their lifetime. D. A DISCUSSION OF THE ADVANTAGES AND DISADVANTAGES OF EACH METHOD. The work of NetTel@Africa Off-Line Content cites the advantages and disadvantages of the different techniques: “Advantages of PB method. • It is very easy to calculate, but it can lead to wrong decision • Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in meeting other needs. • Easy to apply (Simple to understand Problems with the Payback Method • Does not consider post-payback cash flows • Does not consider time value of money • Does not explicitly consider risk • The "acceptable" time period is arbitrary Advantages of using ARR • It is simple to calculate using accounting data • Earning of each year is included in the calculating the profitability of the project Disadvantages of using ARR • It is inconsistency [sic] with wealth maximization as the objective of the firm • Since it uses the accounting data it includes the amount of accruals in calculating the earnings “net profit”. • It is based on the familiar accrual accounting. • It ignores the time value of money i.e. expected future dollars are erroneously regarded as equal to present dollars. Advantages of NPV • It is consistent with wealth maximization as the objective of the firm • It considers the time value of money i.e. expected future dollars are erroneously regarded as equal to present dollars. (These conclusions are made by this author.) Problems with NPV • Difficult to explain to non-finance people • Solution is in dollars, not percentage rates of return IRR--Advantages/Disadvantages 1) Advantages  Considers all cash flows  Considers time value of money  Comparable with hurdle rate 2) Disadvantages • Does not show dollar improvement in value of firm if project is accepted • IRR can be affected by the scale (size) of the project, i.e., Io • Possible existence of multiple IRRs” (http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) V. Conclusion and Recommendation A. 1. Conclusion Based on the comparison made among the different appraisal methods there is a trade off between simplicity and logical analysis if non discounted is compared with discounted cash flow methods. For one who can not understand, who does not believe or who prefers simplicity over logical analysis NPV and IRR may not considered but one who understands, believes and prefers logical analysis, NPV and IRR over pay back and ARR would be chosen. However, choosing between the IRR and NPV could arise if there is conflict between the two and the issue was already resolved earlier. There are however guides which would help a decision maker to use the better in case of conflicts. This was proven in this case where although IRR is higher for one option while the other has a higher NPV, it was resolved that the one with higher NPV should be chosen in case of mutually exclusive projects like in this case. The advantages and disadvantages and limitation of each model was also observed in the light of the case involving Midland Manufacturing Ltd. A. 2. Recommendation The decision to accept a proposal to invest in either machine A or machine B depends on what appraisal method is used. Each method may yield a different conclusion with those of the other methods because of the different assumptions under which the techniques are formulated. As such, it is not an easy decision to just use one and leave the other. In choosing the non-discounted cash flow methods, there must be a good reason to do so like the unavailability of financial information to be used in calculating cash flows to justify the use of the NPV and IRR. However, if return on assets, (ROA) or return on investments (ROI) is used, and then there is basis to believe that there must be enough information to estimate the cash flows, it becomes necessary to apply NPV and the IRR techniques. It does not mean however, that there is no use for payback and ARR. They serve their own purpose by being there, easy and convenient to apply if estimate of cash flows are not available. But if enough time is allowed, it is always wise to use the discounted cash flow methods. A.3 Other factors to consider . Inflation is a factor that should left behind in making financial decision involving interest rates. According to Brigham and Houston, “expectations for future inflation are closely but not perfectly correlated with rates expected in the recent past. Therefore, if the inflation rate reported for the last month increase, people would tend to raise their expectation of future inflation, and this change in expectations would cause an increase in interest rates.”(Brigham, page 198). This statement would mean that interest rates could change depending on what is happening in the economy and if interest rates increase abnormally this might affect the cost of capital that was used in the computation of the NPV that gave us the go signal to choose machine A over machine B. In other words, if interest rates increase because of expectation of people for higher inflation, then the NPV computations made using 12 % cost capital would have to readjusted then, most probably the NPV could be lower because the higher the discount rate, the lower the NPV. It would be surprising that the project would have not been acceptable if interest increased. However, if there is stability in the economy and there is basis to assume or expect that interest would be normal, then such assumption may factored in computing the cost of capital for NPV and IRR calculations. • APPENDICES. Appendix I - The Scenario Appendix II for Problem - Cost and Income data for each project Appendix III, Worksheet detailing the computation using different methods) • BIBLIOGRAPHY. Bibliography: 1. (.www.devunit.gov.ms/taxes.htm) 2. () 3. (http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) 4. . (www.answers.com/topic/depreciation) 5. .( www.marrak.com/resource/glossary.html ) 6. Brigham, E and Houston, J. Fundamentals of Financial Management , ninth edition, published by Thomson, South-Western. 7. strategis.ic.gc.ca/epic/internet/insof-sdf.nsf/en/so03148e.html 8. www.ofcom.org.uk/consult/condocs/mobile_call_termination/wmvct/annexf/ xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Appendix.I. The Scenario You are currently employed as a trainee accountant in Midland Manufacturing Ltd, a small manufacturing company in the car components industry. The company is considering expanding production. This would involve the purchase of a new machine. Currently there are two machines, A and B, on the market, which would be suitable for their purposes. The accountant has produced forecast cost and income data about each of the projects (see appendix 1). Usually the company makes its capital expenditure decisions on the basis of the Payback Method, the rationale being that this method reduces the investment risk associated with capital investment decisions. The accountant shows you the data and asks you to calculate the payback of each of the projects. Having just completed a management accounting course as part of your training, you inform the accountant that in making any capital investment decision, the firm’s Cost of Capital should be considered. In order to do this, other investment appraisal techniques should be considered. The accountant was interested in what you said and asked you to draw up a report, which covers the Tasks outlined below. Appendix. II - Cost and Income data for each project Machine A B £000 £000 Capital Outlay 2000 1000 Capacity (units per annum) 200000 150000 Expected Life 5 years 5 years Forecast Data Year Expected Demand (Units) Sales Price Per Unit (£) 1 100000 10 2 110000 11 3 120000 12 4 150000 12 5 150000 13 Forecast Cost Data MACHINE A MACHINE B YEAR Variable Cost Per Unit (£) Fixed Cost (£) Variable Cost Per Unit (£) Fixed Costs (£) 1 3 200000 6 120000 2 4 200000 7 130000 3 5 210000 8 150000 4 5 215000 8 150000 5 6 220000 9 150000 The fixed costs do not include depreciation. Assume all cash flows arise at the year-end. The company’s cost of capital is 12%. Extracts from Present Value Tables Year 12% 25% 1 0.8929 0.8000 2 0.7972 0.6400 3 0.7118 0.5120 4 0.6355 0.4096 5 0.5764 0.3277 Appendix III. See attached XLS. File , Appendix IV- IRR formula (reference: ( http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page15.htm) ) Read More