Project Appraisal Is Not an Exact Science - Essay Example

PROJECT APPRAISAL IS NOT AN EXACT SCIENCE. CRITICALLY DISCUSS VARIOUS PROJECT APPRAISAL TECHNIQUES AND REFER TO REAL LIFE CASE STUDIES TO ILLUSTRATE SOME OF THE ISSUES ASSOCIATED WITH SUCH APPROACHES Students name: Professor’s name: Course code: Date: Abstract Project appraisal techniques are significant in evaluating the potential viability of a project. They help in analyzing the project both quantitatively and qualitatively. The utilized approaches are both financial and non-financial. The financial techniques are such as discount and non-discount techniques whilst non-financial methods are such as check list model and multi weighted scoring models Table of Contents Abstract 1 Table of Contents 2 Introduction 3 Discounted Techniques 3 Net Present Value and Internal Rate of Return 3 Limitations of Net Present value and Internal Rate of Return 5 Non-discount Rates 5 Payback Period 5 Advantages of Payback Period 6 Limitations of Payback period 6 Accounting Rate of Return 7 Limitations of Accounting Rate of Return 7 Non-financial Models 7 Checklist Model 7 Multi weighted scoring Models 8 Limitation of Multi weighted scoring Models 9 Conclusion 9 References 11 Introduction Project assessment is the combination of both the project evaluation and appraisal. Project appraisal concerns itself with advance assessment to determine whether the project is worth the investment channeled to it (Siriwardena 2011, p.205). After a company has carried out cost benefit analysis of a project, then it is in a position to decide on whether the project is to be implemented or rejected. Researchers have not yet identified the best techniques for project worth estimation. However, project appraisal techniques can help in deciding whether to accept or reject a project. The techniques can be broadly classified into three. The categories are such as, discounted, non-discounted and non-financial techniques. Discounted Techniques Net Present Value and Internal Rate of Return Internal rate of return (IRR) and net present value (NPV) are project appraisal techniques widely used in project decision making and capital budgeting (McClure 2010, p.527). Internal rate of return limitations have been overcome through the utilization of models that are modified such as modified internal rate of return (MIRR). Over decades, NPV criticism has been based on its failure in considering the option of the managerial team of abandoning or extending a project. Thus, the NPV technique undermines the cash flow of a project true NPV (Pinches 1994, Van horne 1995). Through investment and financial interaction, decisions have been made by various expertises and NPV method has been adjusted. In that case, the new NPV equals to the NPV sum to equity and financial impacts present value (Myers 1974, Luehrman 1997). The major reason why net present value (NPV) and internal rate of return (IRR) provides recommendations that are conflicting is as a result of inherent reinvestment hypothesis based on NPV and IRR (Solomon 1956, Rensaw 1957). On the contrary, it is argued that, in IRR or NPV methodology, there exists no reinvestment rate implicit assumption (Dudley 1972, Biedleman 1984). Nevertheless, the authors write that, it is significant to come up with reinvestment rate explicit assumption when choosing between two or more competing projects. In recent years, a net present value generalized formula has been developed (Beaves 1998, 2003). The new formula accounts explicitly for projects reinvestment cash flows. In addition to that, rate of return is overall considered. However, the new formula is based on the assumption that, cash flows (net) experienced after null time get financed positively by inflows of cash flows (net). The inflow should occur subsequently to cash outflows time zero but before cash outflow next period. In summary, total initial outlay of a project largely depends on outlay net cash expected regardless the financing source. Net present value is considered more superior than internal rate of return (IRR). NPV utilizes reinvestment rate that is correct unlike IRR. The reinvestment rate represents the weighted Average cost of Capital (WACC) of a firm. This method is effective in cases where the considered investment project is a project categorized under average risk and WACC acts as its discount rate. NPV net cash flows of a project perceived to exhibit risks below or above average are determined through the use of risk-adjusted discount rate (RADR) approach and certainty equivalent (CE) approach. RADR approach is very effective in adjusting the risk discount rate. This is achieved via adding or subtracting subjectively to or from the WACC of a firm a certain percentage. The rate received is then utilized to determine the NPV of a project. The certainty equivalent approach successfully adjusts the cash flow of a project risks. NPV of a project is then determined through the use of risk-free rate (McClure& Girma, p.530). Limitations of Net Present value and Internal Rate of Return Net present value and internal rate of return are extremely complex ways of evaluating a project value and any investment that is potential to an organization. Despite the accuracy of net present value, investment risks are never taken into account. Investment risk factors are very essential in selecting the best alternative of investment between two or more options. On the other hand, internal rate of return does not help in selecting a project that will enhance the value of a firm. It is not a valid method in choosing between two alternative projects or options. For instance, when investments decisions are made independently, internal rate of return determines adequately if to consider and investment project. However, when it’s mandatory to select among numerous possibilities, there exist situations whereby internal rate of return approach would help in highlighting the significant project (Byrne 1992, p.39). Non-discount Rates Payback Period Payback period is how long a project takes to recover its initial investment outlay cash flow. It is highly used in value determination of investment proposals. A perfect project should always generate a cash flow that is consistent yearly (Anderson 2011, p.1). Payback period can be computed by dividing two variables. These variables are such as cash outlay by annual cash inflow. Payback period= original investment/ annual cash inflow. In case companies need to rank and measure the value of investment in projects, payback period is utilized (Gitman 2005, p.420). Companies achieve this via comparing the payback period of a project with a payback standard that is predetermined. In that case, a project can only be accepted if its actual payback period is minimum than the set standard. Similarly, it can be accepted if it has a payback period that is maximum set by the management. Highest ranking is given to projects that have less payback period amount. Hence, if a company needs to choose between multiple or two projects, projects with least payback period are given a priority. Advantages of Payback Period Payback time is the widely utilized criterion in investments. This is because of its virtues that are specific. For example, it is easily understood. Furthermore, it is easy to calculate and mostly used by business executives for investment proposals appraising. It is efficient and cost effective. It’s not a technique that is complicated and takes less analyst time and does not require usage of computer. In addition to that, it shields companies from risks. Companies reduce projects risks by taking a payback period of smaller standard. The purpose for such an action is to act as a guarantee against any incurred loss. Payback period is significant in cases where the investor is uncertain about cash inflows and expectancies of projects. It is not only vital in profitability measurement, but also upper limit placing on acceptable risks. Finally, payback period is essential in giving an idea about the project liquidity (Jaek et al 2011, p.358). Limitations of Payback period Despite its advantages, payback period has its own limitations. Under various circumstances, it is not a criterion that is efficient in investment. For example, the inflow of cash is after a period of pay back. In such cases, there is no accounting of project yielded cash flows. This makes payback period not a suitable means of determining the profitability of a project investment. Lastly, cash flow patterns are not considered by payback period. Thus, the magnitude and timing of cash inflows is not considered (Gitman 2005, p.421). Accounting Rate of Return This technique is similar conceptually to payback period. However, it favors decisions that have higher risks. This is because; profits in future are inadequately risk discounted and time value. In contrast, payback period results to decisions that are excessively conservative. Investors who depend on this method are overly disadvantaged. The method does not recognize money time value and lack adjustments for items that are intangible. These make it to be flawed seriously. Despite the limitations, it has its own advantages. For example, it is easy to compute and construct. Eventually, the results are NPV distinct choices and clearly correct NPV direct decisions (Leflew 1998, p.52). Limitations of Accounting Rate of Return Accounting rate of return can results to inadequate signals to the team concerned with management. In cases of capital project investment, accounting rate of return does not consider projects’ cash flow variation or timing. Therefore, in the evaluation of major capital projects, accounting rate of return should not be considered (Lefley & Sarkis 1997, p.51) Non-financial Models Checklist Model With this model, evaluation of a project is divided into distinct parts. For instance, the projects impact, sustainability, effectiveness and transportability. If a project meets all the above, then it should reach the right beneficiaries and meet their needs. For instance, if it’s a water project, then the project should be located in close proximity to individuals in need of water. In addition to that, the benefits of the beneficiaries should be sustained. Designing of checklist purpose is to aid evaluators in evaluating programs that have goals that are long-term. Moreover, it supports the production of evaluation reports in a timely manner. The reports help in planning, carrying out, institutionalizing and disseminating of services that are effective to aimed beneficiaries (Stufflebeam 2007, p.1). Therefore, a project that is not sustainable based on the findings from the report is always rejected. Multi weighted scoring Models Financial criteria were utilized in the past thus excluding non-financial methods in project appraisal. Multi-weighted scoring model is of great significance in decision making. In these method, the management team analyzes alternatives based on complex multiple criteria. In such cases, distinct stakeholders with risks attitudes that are conflicting are involved in decision making (Fanghua & Guanchun 2010, P.2139). The models ranks and rates alternatives weighted. Thus, the alternative having a score that is highest is chosen as an option that is mostly preferred. It is perfect in analyzing environmental projects. Multi weighted scoring model is used in the assessment of a project ecological risk which is a procedure that enables the evaluation of a project ecological impact. The model is essential in the organization and evaluating of data systematically. Through data organization and evaluation, an individual establishes and predicts project ecological impacts significant in making of environmental decisions. It helps in making decisions that are risky. The decisions making process selects and develops coping strategies and managerial programs in an environment full of risks. It weighs between cost and benefits of alternative projects. Therefore, ideal alternatives are always selected based on priority (Fanghua & Guanchun 2010, P.2139). Limitation of Multi weighted scoring Models Choosing of the best alternative from decision made by stakeholders is not an easy task. This is because, the risk outcomes and occurrence possibility and cost management are not consistent. For instance, explosion of a chemical plant is categorized under events causing minimal risks to the environment. In reality the synergistic effects of the explosion can result to significant environmental damage. To overcome such a problem, a decision support system (DSS) and knowledge expertise should assist in times of decision making. This will eliminate the selecting of options that are cheaper and in the long run become expensive (Fanghua & Guanchun 2010, P.2140). Conclusion For a firm to sustain an advantage that is competitive, decision makers should include projects that are both revolutionary and incremental in their research and development (RD) portfolio (Bitman 2006, p.152). In project appraisal, non-financial methods are frequently utilized. Checklist models are mostly preferred in project selection. In this model, questions are provided for purposes of reviewing the project potential. After questions review, a project can be rejected or accepted depending on the feedback (Gray & Larson 2008,P.38). Multiple weighted scoring models play a crucial role in project evaluation. Depending on the decision made by stakeholders, a project can be implemented or rejected. The models helps in coming up with suitable alternative solutions to project impacts. Whether to reject a project or accept the project, decisions should be made based on the three projects appraisal techniques. Investors should not base of financial method alone rather, they should also consider the non-financial methods. This will enhance accepting of projects with lower risk and a limited payback period. They should not base their decisions on assumptions, because the magnitude of the impact will be adverse. Therefore, both quantitative and qualitative analysis needs to be done before accepting a project. Analysis of a project should not be based on monitory terms alone. Hence, the use of discount, non-discount and non-financial techniques in project evaluation. References Anderson, R 2001. 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