Project Appraisal Techniques and Decision Making - Term Paper Example

Project Appraisal Techniques and Decision Making Introduction Managers are faced with situations, which require selection of one or two projects from the many that are available. Therefore, they require decision making tools to aid them make appropriate choices for their companies or firms to be more competitive in the environment in which they exist. Various decision-making tools exist. According to Baker et al (2003), project appraisal techniques are important in assessing projects before economic decisions are made. The technique weighs the total expected monetary cost and benefits associated with the project. The manager or an analyst collects relevant information in the market and use it to estimate monetary costs and benefits realized by a project. They include payback period tools and the net present value method. Both decision-making tools are comprised of logical sequence process and steps that enable a manager or another person or institution choose the project to undertake. The decision-making tools require information. Therefore, before a manager decides to use any of the decision-making tools, he or she should ensure that the information on costs and benefits concerning projects under consideration are available. The available information are processed and the net values obtained. The net values computed aid the manager to rank independent projects from those with the highest positive values to those with the least values. Those with the highest net values are chosen for implementation. The selection of projects is based on the cost efficiency and benefit efficiency. Net present value The first decision-making tool is the net present value. Net present value is a capital budgeting decision method used to select independent projects for business or non- business entities. According to Brigham and Houston (2007), net present value is a direct measure of how much the projects will contribute to its shareholders in future time as compared to the present. Net Present Value method is computed using the discounted cash flows. The total discounted cash flows is the Net Present Value. The formula of calculating the net present value is as follows: NPV= ∑ (CFt –)÷((1+ r)t-1 ) Where NPV is net present Value, ∑= summation sign, CF= Expected net cash flows, t= time when cash flows were realized, r= project cost of capital (discounted rate). The rationale (theory) behind the net present value method The net present values determine whether the projects are profit or loss making. According to Madura and Fox (2007), if net present value is less than zero (NPV0), the project would add value to the organization. The revenues would be more than the cost of the project in the end. Therefore, the manager of the organization may decide to implement the project under consideration for the benefit of the organization and its shareholders. Two numerical examples: Example A, Softcare Company would like to introduce a new cream (supercream) into their product line. The manager would like to decide whether to introduce the new product line or not. The new product line is expected to last for five years after which will be faced out. The new product will have a start up cost of £ 25,000, which covers the cost of machinery, setting up the primary infrastructure and employees training cost. The cash outflow is expected to be £ 8,000 annually for the first and second year while cash outflows for the remaining years will be £ 9500 annually. The cash inflows for the first two years will be £ 25,000 annually and the cash inflows for the remaining years are £ 31,000 (years 3), £ 39,000 (year 4) and eventually £15,000 (year five). All the cash flows are after tax and no cash flows are expected after five years. The discount rate is 12% annually and inflation has been considered. Therefore, net present value is computed as follows: NPV= ∑ (CFt –)÷((1+ r)t-1 ) The discount rate (r) is 12% Figure 1 shows the computation of the net present values of projects 1A Period (t) Cash inflows Total cash outflows (CFt-1) Net Cash Flows t-1 1+r (1+r)t (CFt )÷((1+ r)t-1 ) 1 £25,000 £33,000 £-8,000 0 1.12 1.00 £-8,000.00 2 £25,000 £8,000 £17,000 1 1.12 1.12 £15,178.57 3 £31,000 £9,500 £21,500 2 1.12 1.25 £17,139.67 4 £39,000 £9,500 £29,500 3 1.12 1.40 £20,997.52 5 £15,000 £9,500 £5,500 4 1.12 1.57 £3,495.39 £48,811.15 The above project has net present value of £48,811.15. This implies that the project is profitable and the manager may implement the project because it adds value to the organization. Project B Project B, Softcare Company would like to introduce balm (naturebalm) into their product line. The manager would like to decide whether to introduce the new product line or not. The new product line is expected to last for four years after which will be faced out. The new product will have a start up cost of £ 12,000, which covers the cost of machinery and setting up the primary infrastructure. The cash outflow is expected to be £ 5,000 annually for the first and second year while cash outflows for the remaining years will be £ 3,500 annually. The cash inflows for the first two years will be £ 18,000 annually and the cash inflows for the remaining years are £ 24,000 (years 3) and £ 26,000 (year 4). All the cash flows are after tax and no cash flows are expected after five years. The discount rate is 12% annually and inflation has been considered. Therefore, net present value is computed as follows: The discount rate is 12% annually and inflation has been considered. Figure 2 shows an example of project appraisal technique (net present value) Period (t) Cash inflows Total cash outflows (CFt-1) Net Cash Flows t-1 1+r (1+r)t (CFt )÷((1+ r)t-1 ) 1 £18,000.00 £17,000.00 £1,000.00 0 1.12 1 £1000.00 2 £18,000.00 £5,000.00 £13,000.00 1 1.12 1.12 £11607.14 3 £24,000.00 £3,500.00 £20,500.00 2 1.12 1.25 £16400.00 4 £26,000.00 £3,500.00 £22,500.00 3 1.12 1.4 £16071.43               £45078.57 The above project has net present value of £45,078.57. This implies that the project is profitable and the manager may implement the project because it adds value to the organization. Decision making between project A and B The manager will choose project A because it has higher net present values. The advantages and disadvantages of the cost benefit analysis There are a number of both advantages and disadvantages associated with the net present value as project appraisal method. The advantages are as follows. First, the net present value technique quantifies the value of projects in monetary terms. This enables the manager to know with certainty the amount of money the project will either add to or subtract from the organization. It is easy to interpret the results because the net present values are in monetary terms. Secondly, net present values take into considerations the time value of money. The method considers economy factors such as the inflation and other price changes. The disadvantages of the net present value include the following. First, risks such as inflation are considered in the net present values by adjusting the discounting rate. If the manager anticipates that there will be general rise in the price of goods and services, the discount rate will be adjusted upwards and if drop in general prices is projected, there will be reduction in the discount rates. Adjusting the discount rate influences the net present values and may lead to overestimation or underestimation of net present values. Non-accurate net present values are a significant planning risk and should be handled with a lot of care to prevent distortions of projections. Secondly, net present values use compounding techniques. Compounding the risk premiums will automatically reduce the net present values than it should be. Thirdly, the rationale behind the net present value method is that the projects with the negative net present values should be rejected automatically. However, some projects with negative net present values could be having indirect monetary and non-monetary benefits. Such projects may be preserving the value of the organization or positioning the organization to be better equipped and stronger to undertake its mandate in future. Other projects may be producing goods or services such as medicines and education. Projects that produce necessities should not be rejected on the basis of negative net present values because rejection may have dire consequences to the country and population as a whole. Discounted Pay back period Discounted pay back period is the second decision-making tool. Discounted pay back period is the number of years it takes to recover the amount of money invested using discounted cash flows (Brigham et al 2007). It is a logical system guiding managers to identify preferred choices among alternatives. According to Brigham et al (2007), discounted pay back period is an improved version of the traditional pay back period. The rationale behind the discounted pay back period is that, a project with a shorter repayment period is preferred as compared to those with longer repayment periods. Therefore, if a manager prefers projects with payback period of less than four years, any project whose repayment period exceeds four years will be rejected. The advantages and disadvantages of the cost benefit analysis There are disadvantages and advantages of using the discounted pay back period in selecting various projects. The advantages include the following. According to Denhardt and Denhardt 2008, payback period is one of the most straightforward quantitative techniques. Discounted pay back period is a project appraisal technique that is easy to compute. It uses basic arithmetical procedures that can be performed by persons with basic arithmetical skills. It is appropriate for the projects whose technology changes rapidly because it emphasize on short-term return on investment rather than long-term return on investments (Crosson and Needles 2007). Furthermore, discounted pay back period considers time value of money and put into consideration the inflations and other price increases that may affect the projects. The disadvantages of discounted repayment period include the following. First, payback period ignores the cash flows after the payment period. There are costs that may be incurred after the pay back period that includes clean up cost, which are not considered after the payback period. On the other hand, it does not consider cash inflows after the payment period. Secondly, pay back period is not fair because it gives the same weight to projects with different cash flows. It uses time (number of months or number of years) as a basis of appraising the projects and favours those that have shorter repayment period irrespective of the amount of cash flows that a project generates. It does not indicate the magnitude of the profit the project may make after the pay back period. Internal rate of return Internal rate of return is the rate of return expected from an investment project over its useful life. It can also be referred to as yield on investments. It is a discount rate that makes the net present value to be equal to zero. The rationale behind the internal rate of return, the internal rate of return should be equal to or more than the required rate of return of the company. If it is less the required rate of return then the project is rejected. The advantages and disadvantages of the cost benefit analysis The advantages include the following. It is possible to compare different projects using internal rate of return. This is because it is expressed as a percentage and can easily be compared with other rate of returns. The disadvantages include; it does not take into consideration the time value of money, not expressed in monetary terms and is complex to compute. Accounting rate of return This is the expected return on investment and computed by dividing the expected future annual net income by the amount of investment of the projects. If the ARR is equal to or more than the required rate of return, the project is accepted and if lower, the project is rejected. The advantages and disadvantages of the cost benefit analysis The advantages include; it easy to compute, and understands and directly shows the rate at which stakeholders can create wealth. The disadvantage, it does not take into account the time value of money and does not apply if a project makes losses. Cost- benefit Technique The second decision-making tool is the cost-benefit analysis. Cost benefit analysis method is a logical system that helps managers to identify preferred choices among the many alternatives. It involves a wide range of factors that include political, natural, environmental and social environment. The decision-makers are enabled to identify streams of benefits and costs associated with a specific project and how those benefits and costs are distributed among the shareholders (Dompere 2004). The technique weighs the total expected monetary cost and benefits associated with the project. The manager or an analyst collects relevant information in the market and use it to estimate monetary costs and benefits realized by a project. During the use of cost benefit analysis, monetary costs and benefits are assigned to non-tangible effects such as reputation, market penetration, opportunity costs and other risks associated with the project. Furthermore, according to Baker et al (2003), cost benefit analysis considers time, scope and quality of products or services produced. Cost benefit analysis uses time value for money. The future streams of costs and benefits are converted into the present value amount. The formula for the cost benefit analysis is as follows: Net benefit = Present Value benefits – present value costs The rationale behind the cost benefit analysis is that every project has associated costs and benefits. The selection of projects is based on the cost efficiency and benefit efficiency. The cost effective approach chooses the projects that have the lowest cost subject to a given benefits while benefit effective approach help manager select projects that have the highest benefits. The advantages and disadvantages of the cost benefit analysis The advantages First, it is a framework for identifying all cost and benefits associated with the project. The technique aims at quantifying all the costs and benefits that are associated with the project. Consequently, it provides a comprehensive idea and value of what the project entails. Secondly, it simplifies complex process and ideas about a given project. The method involves listing of all activities as well as associated costs and benefits. This enables the stakeholders of the projects to be aware of all activities thus giving them the capacity to decide what to do to increase the benefits on one hand and minimize costs on the other hand. Thirdly, the method is generally accepted across many stakeholders in the society. Fourthly, cost benefit analysis can be carried in many levels. It can be done at regional, national or international level. Disadvantages First, it is difficult to ascertain accurately discounts rates for the costs and benefits associated with the project. Secondly, inconsistency bedevils that technique. This is because there is no exact standards that guide estimation of cost and benefits accruing to various projects. The market methods are not reliable because they change rapidly. Thirdly, it is a time consuming and expensive exercise. This is because it requires skills and time to estimate all the benefits and costs associated with the project. Fourthly, it is not possible to quantify all cost and benefits accruing to the project. Cost benefit approach Figure 3 Cost benefit analysis example   Cash inflows Cost of machinery and setting up cost £24,000 Employees training cost £3,500 Cost of production £23,000 Opportunity costs £26,000 Administration and marketing cost £20,000 Environmental pollution £15,000 Utilities £6,500 Total cost £118,000 Revenue £135,000 Savings due to use of improved technology £10,000 Savings buying materials in bulk £12,000 Goodwill £7,000 Total benefits £164,000 Net benefits £46,000 The manager will choose the project because it has positive net present values of £46,000 Comparison between project appraisal techniques and cost benefit analysis The project appraisal techniques use ratios except the net present value while cost benefit techniques use purely absolute monetary value. The projects appraisal techniques uses the cash flows that are directly associated with the projects while the cost benefit analysis use both indirect and direct cash flows. Cost benefit and analysis is more detailed as compared to other projects appraisal techniques such as the net present value and the Internal rate of return. Both appraisal and cost benefit techniques provide a basis of making a decision whether to invest on the project or not. References Baker, S., Baker, K. and Campbell, M., 2003. Complete idiot's guide to project management. 3rdedition. USA: Alpha Books. Brigham, E. and Houston, J., 2007. Fundamentals of financial management, 11thedition. London: Cengage Learning. Crosson, S. and Needles, B., 2007. Managerial Accounting, 8thedition. London: Cengage Learning. Denhardt, R. and Denhardt, J., 2008. Public Administration: An Action Orientation, 6thedition. London: Cengage Learning. Dompere, K., 2004. Cost-benefit analysis and the theory of fuzzy decisions: identification and measurement theory. Germany: Springer. Madura, J and Fox, R., 2007. International financial management. London: Cengage Learning. Read More