Of Capital Investment Appraisal Methods - Literature review Example

Management Accounting Assignment Table of Contents Table of Contents 2 Introduction 3 Review of Capital investment appraisal methods 3 Net Present Value (NPV) 4 Payback period method (PPM) 5 Internal Rate of Return 7 Discussion and Analysis 9 Comparison of IRR, NPV and PMM 9 Drawbacks of the payback period method 13 What non-accounting managers should do 14 Conclusion 15 Reference List 15 Introduction Capital investment appraisal methods consist of decision-making techniques essential for evaluating and selecting proposed investment projects. These methods are rooted in the assumption that the objective of the managers within a company is maximising the company’s value. For this reason, capital investment appraisal provides critical tools that financial managers can use to make critical investment decisions (Olawale et al 2010). In this case, it is important that the manager uses accurate and understandable methods that can lead to maximization of profits. According to Afonso and Cunha (2009), managers should consider capital investment projects only when they understand clearly how the projects would add to the value of the company. This means that since not all managers have a background in accounting, identifying and undertaking the investment projects that can add value to their firm may have a problem in making decisions. Several methods exist that managers can use in making such investment decisions: payback period, net present value, and internal rate of return. This report presents an argument that “the non-accounting management cannot understand any investment techniques except payback.” This paper examines the differences between payback and IRR and NPV, explains why the differences can be used to explain the CW Q, and lastly discusses the solutions and methods that companies can use ensure that different investment techniques are understood. Review of Capital investment appraisal methods Net Present Value (NPV) This technique is used for evaluation of proposed investment project by estimating the cash that flows into and out of a business. The cash flow determined is afterwards discounted to the current as this would allow it to show money’s time value (Shyam 2003). The method reflects the entire approximated future cash that reflects the current time. For instance, in a company, the cash flow estimated in the fifth year would be discounted beyond the estimated cash flows in the first year as cash received during the future tends to be less of value compared to the cash a business receives today (Beck et al 2013). This is indicated in the table below. For instance, Ruwi considers purchasing a wine-making machine to increase wine production and revenue generate. The machine would cost $6,000 and is estimated as capable of increasing annual cash inflow by US$2,200. The machine’s useful life estimated to be six 6 years, after which it would have no salvage value. The company’s management desires a 20 percent return on the project. The basic question is whether Ruwi should buy the equipment based on NPV value. Generally, the calculating the NPV appears to be complicated, as indicated below. Still, the machine should be purchased as the net present value is positive ( as found to be $1,317. Since it has a positive net present value, this implies the project guarantees the rate of return to be greater than the minimum rate of return that the management requires, which is 20 percent. This implies that when the machine is not bought and Ruwi instead invests the money elsewhere, Ruwi would earn 20 percent return on the investment. Payback period method (PPM) Payback period method calculates the time it would take for a proposed business project to get back the money invested into it. In using the payback model, an investment project would be considered based on the payback period. The payback period implies the time that the project requiring recovery the capital that has been invested into it (Olawale et al 2010). The technique is expressed on the basis of years and can be calculated using the formula below: Example In using the Payback period technique, an investment project that guarantees a fast recovery of the original investment is determined is advantageous. When an investment project is calculated using the above formula, it become shorter or even equal to the maximum desirable payback period of the manager, the project would therefore be accepted or rejected. For instance, when LG Electronics seeks to recoup the cost of a plant in five years of investing in the plant, the company’s maximum desirable payback period would be 5 years. Therefore, purchasing the machine would be considered attractive when it guarantees a payback period of a maximum of 5 years. At this level, making a decision to invest using this technique would be simple and may be used easily by non-accounting manager. For instance, the non-accounting management of a small-to-medium sized enterprise called Runners Wineries (Ruwi) seeks to purchase a new wine-making machine to increase wine production and generate additional revenues. Assuming that the machine’s useful life is estimated to be10 years while Ruwi’s maximum desirable payback period is four years, the cash inflow and outflow linked to the machine is estimated below: Considering the above estimations, a critical question would be whether Ruwi should purchase the new machine. To a non-accounting manager with limited accounting knowledge and some knowledge in arithmetic, the payback method would be the most appropriate. Therefore, to calculate the wine-making machine’s payback period, a non-accounting manager would only need to determine the net annual cash inflow by subtracting the sum of cash outflow from the sum of cash inflow linked to the machine as indicated below. Next, to determine the machine’s payback period, the amount of investment needed ($37,500) for purchasing the wine-making machine would have to be divided by the sum of the net annual cash inflow, in this case $15,000. = $37,500/$15,000 =2.5 years Hence, based on the payback method, the non-accounting managers would be persuaded to buy the equipment as the machine’s payback period is 2.5 years, which is less than their desirable payback period of 5 years. Internal Rate of Return Internal Rate of Return is a technique of discounted cash flow that measures the rate at which the net present value would be equalled zero. Put differently, it seeks to answer the question as regards the rate of return that a current business investment would earn during its lifetime (Olawale et al 2010). In this method, the entire estimated cash flows during the whole life cycle of a business investment is considered. Second, the estimated cash flows are discounted to the present. Example Unlike the payback method, the Internal rate of return method considers the time value of money by analyzing a project as it compares the internal rate of return to the minimum required rate of return of the company. Unlike the Payback model, which evaluates the investment pay off amount of a proposed project during a specified amount, the internal rate of return examines the rate at which a proposed project promises to create a return during its useful lifetime. Still, like the payback method, the management sets the minimum required rate of return. In using this method, when the internal rate of return that a proposed project promises is greater than or comparable to the minimal anticipated rate of return, the proposed project would be viewed as acceptable if not, then it would be rejected. For instance, the management of Rumi Wineries (RuWi) considers replacing an old wine-making machine with an advanced one. The new wine-making machine is anticipated to perform similar tasks, although faster. Installing the machine would be $8,475. It is would also cut the yearly labour cost by about US$1,500. At the same time, the machine’s useful life would be 10 years. The management has set the minimum required rate of return at15 percent. The question, at this level, would be whether RuWi should by the machine. To determine whether the project is acceptable or not, the internal rate of return that the machine promises should first be determined before being compared to the set minimum required rate of return of 15 percent. This requires determining the internal rate of return factor. This requires dividing the investment needed for the machine by net annual cash inflow that the machine will create using the below formula. In the example, US$1,500 is the net annual cost saving while US$8,475 is the required investment. Since the cost saving equals the revenue, it would be regarded to be the net cash inflow. Hence, the internal rate of return factor would be 5.650 Locating the discount factor is critical, assuming that $1 is the present value of an annuity. As the machine’s useful life is a 10-year period, the factor can be determined in a 10-period row. Once the factor is determined, the rate of return factor 5.650 corresponds to 12 percent. This implies that the internal rate of return the machine promises is 12 percent. When compared to the minimum required rate of return of the wine-making machine (15 percent), the it is clear that it is less than the minimum. In this case the proposed wine-making machine would not be acceptable by the management. Discussion and Analysis Comparison of IRR, NPV and PMM Managers make effective decisions as regards the number of proposed projects to invest in, the amount of money to be invested and where the capital should be sourced (Beck et al 2013). However, the complexities associated with Internal Rate of Return and Net Present Value inhibit speeding decision-making by non-accounting managers, although they provide means to securing effective decisions by accounting managers. Olawale et al (2010) also examined how small firms with managers with minimal accounting background apply complex investment appraisal techniques such as IRR and NPV, and the impact of the complex techniques on profitability of the businesses. The results showed that the investment appraisal techniques led to greater profitability. However, non-accounting managers would not find them effective. In fact, in comparing the Internal Rate of Return and Net Present Value, it is clear that the Internal Rate of Return model appears to be simpler to calculate and offers a distinctive value for every business investment or project (Balakrishnan et al 2008). However, it complexity means it cannot be used by non-accounting managers. The Internal Rate of Return model may lead to many Internal Rate of Return values for a similar investment project. In such a situation, qualitative judgement would be needed by managers in selecting the proper Internal Rate of Return. An additional difference between Internal Rate of Return and Net Present Value is as regards their assumptions regarding reinvesting in subsequent cash-flows (Balakrishnan et al 2008). While the Internal Rate of Return model would assume that a business possesses different other opportunities for investment that may bring about similar return rate as the investment project under deliberation. This is specifically so for the investments that possesses high Internal Rate of Return. The assumption at this rate is not often realistic as the opportunities for investments that tend to be highly profitable may actually not often exist (Balakrishnan et al 2008). On the other hand, the Net Present Value model tends to assume that a company's would reinvest the provisional project cash-flows depending on how its capital costs. The Net Present Value rates the projects depending on the amount of net present value. The Internal Rate of Return rates the project depending on the rate of return. In sum, these two methods may feature as a challenge for business when a business has inadequate capital. In reality, businesses with non-accounting managers may find it difficult selecting all the positive Net Present Value projects or the entire projects that have Internal Rate of Return that exceeds the capital cost. Under these circumstances, the companies would have to rate the available investment projects to allow them to select the mix of projects that can increase their profitability. It is also unfortunate that the Internal Rate of Return and Net Present Value may not agree on the right mix of projects to invest in (Shyam 2003). As the internal rate of return model generates rates that would discount the entire cash back to the net present value of zero, this method tends to be confusing to the managers as they would have to try a range of rates until they determine the real rate that provides them zero. This would demand the use of an electronic spreadsheet or calculator, which managers with non-accounting knowledge would find difficult to use. Therefore from the above analysis, it is justified to argue that except for the payback period, it would be difficult for managers with little knowledge in accounting to use Internal Rate of Return and Net Present Value. In other words, this rationalises the argument that the management only understand payback investment technique. The underlying reasons for this are because of its simplicity and tendency to focus on risk associated with an investment. When it comes to simplicity, the payback period concept is particularly simple for managers to understand and work out. In the event that managers use it for rough analysis of a certain investment project, it may be determined without even the use of an electronic spreadsheet or calculator. As regards risk focus, the analysis is centred on how fast money is able to be recouped from an investment project. This is essential in measuring risks. Therefore, the payback period is useful for comparing the comparative risks of projects that have varied payback periods. To the non-accounting managers, it is inherently an effective technique for measuring investment risk (Balakrishnan et al 2008). A business investment that has a short payback period would have relatively minimal risk compared to the project that has a long payback period. The model is therefore handy for non-accounting managers who seek to measure liquidity as integral criteria to choosing a project (Nabradi & Szollosi n.d.). Indeed, for businesses that face liquidity problems, it offers an effective technique for ranking investment projects that will return money earlier on. Therefore, payback period can be applied easily in understanding investment by non-accounting managers, in spite of their academic qualifications or fields of careers. Indeed, once applied carefully in comparing the same investments, it tends to be relatively useful. As a matter of fact, the shorter payback periods tend to be more appealing than longer payback periods. Therefore, managers can apply it as a stand-alone tool in comparing an investment. It also lacks explicit criteria for making decisions on investment (Balakrishnan et al 2008). Non-accounting managers may use payback period in varied investment areas, usually with regard to investing in energy efficiency technologies, maintaining these technologies, or even upgrading. For instance, a fluorescent light bulb appears as possessing a payback period of a many years of operation, although it assumes certain costs. As a result, the return to the investment comprises the reducing operating costs (Olawale et al 2010). Even though chiefly a financial terminology, the model of payback period is sometime applied in explaining the energy payback period, which refers to the time over that the energy savings of a project compares to the energy amounts spread as project inception. Drawbacks of the payback period method The Payback period method has two major drawbacks. The first is that cash flows do not become discounted for money’s time value of money. This means a dollar that the business project receives three years from today would have similar value compared to the dollar the business receives during the current year (Scheepers 2003). Second, the technique overlooks the business project’s profitability wholly. For instance, a project that has a fast initial payback may fail to create vast profits during its lifetime. An additional project that has a slow initial payback may as well be incredibly profitable during its lifetime as its profitability tends to rise radically following the payback period. Shinoda (2010) also argues that payback period method ignores the time value of cash flows and money past the cut-ff date. In a study by Shinoda (2010), the researcher asked the Japanese managers to classify the simplest capital budgeting methods when making investment decisions. Findings suggest that most managers selected the payback period method. Some 60% of managers thought that the payback period method is important for making decisions on equipment investment and R&D investments. Some 37% of the managers thought that NPV is important for decisions on investing in foreign businesses or long-term investment plans. Still, managers may not determine the long-term investment performance through the use of payback period methods, as the NPV is more appropriate as it evaluates cash flows. Again, Shinoda (2010) suggests that since companies face complex problems due to globalisation and need for high-value and -quality products, speedy and effective decision-making is essential. In which case, the NPV would make more sense than payback method. What non-accounting managers should do Shyam (2009) suggest that in such situations where non-accounting managers must make decisions, they should use the Discounted Payback Period (DPP), as NPV requires significant accounting knowledge. The DPP contains the entire useful features of the traditional payback method as well as possesses a significant relationship with the NPV. As the DPP accounts for time value of money and objective decision-making, it overcomes the limitations of the traditional payback method. The DPP is still appropriate for non-accounting managers as it is simple to understand and calculate. Calculating the cumulative net present value for determining the DPP is also less complex than the calculating using the NPV and IRR. This view is supported by Scheepers (2003), who suggests that since the NPV method ensures profitability rather than liquidity and is also complex, while the payback period method ensures liquidity rather than profitability and disregards the cashflow values, then the two should not be used. Instead, the discounted payback period (DPP) should be used as it meets the features of both NPV and payback period method. Hence, the managers should use the discounted payback period (DPP) as it is modified in to eliminate the limitations associated with disregarding the time value of cash-flows and money. Olawale et al (2010) also suggests that the small firms should therefore engage their managers in training and skill development, particularly in using IRR and NPV. Conclusion In the end, except for the payback period, it would be difficult for non-accounting managers to use Internal Rate of Return and Net Present Value. This rationalises the argument that the non-accounting management cannot understand any investment techniques except payback. The payback period method is relatively simple. However, it does not consider the time value of money, unlike the Net Present Value, which is however complicated for non-accounting managers. Therefore, the non-accounting managers should use the Discounted Payback Period (DPP), as it meets the features of both NPV and payback period method to eliminate the limitations associated with disregarding the time value of cash-flows and money. The non-accounting managers should as well engage in financial training and skill development, particularly in using IRR and NPV. Reference List Afonso, P & Cunha, J 2009, "Determinants of the use of capital investment appraisal methods: Evidence from the field, viewed 10 Feb 2016, Balakrishnan, R, Sivaramakrishnan, K & Sprinkle, G 2008, Managerial Accounting, John Wiley & Sons, New York Beck, C, Raj, R & Britzemaier, B 2013, "The Effects Of Capital Investment Appraisal Methods In Automotive Companies," International Journal of Sales, Retailing and Marketing vol 2 no 2, pp.3-12 Nabradi, A & Szollosi, L n.d. "Key aspects of investment analysis," Applied Studies in Agribusiness and Commerce, pp.53-56 Olawale, F, Olumuyiwa, O & George, H 2010, "An investigation into the impact of investment appraisal techniques on the profitability of small manufacturing firms in the Nelson Mandela Bay Metropolitan Area, South Africa," African Journal of Business Management vol. 4 no7, pp. 1274-1280 Scheepers, C 2003, Capital Finance Decisions for Project Managers – a Reflection on Current Methods, viewed 10 Feb 2016, Shinoda, T 2010, "Capital Budgeting Management Practices in Japan," Econ. J. of Hokkaido Univ vol 39, pp.39-50 Shyam, B 2003, "Discounted Payback Period-Some Extensions," ASBBS Annual Conference: Las Vegas vol 16 no 1, pp.1-7 Read More