Investment Appraisal and Management Control - Report Example

Investment Appraisal and Management Control Introduction: Businesses have to make large investments every year. Investments are generally made on buildings, office equipments, transport, etc. It is very essential that management make informed decisions on every investment made since these decisions are not easily reversible, and involve large sums of money, are very futuristic, and have long-term consequences (Bott, 2008). All decisions made by the management affect the company’s revenue in one way or another. Hence, it is important that managers are aware of the consequences of every decision they take, be it, buying a computer for a small company or a vehicle for delivery of goods, or manufacturing plant for the company or a company by itself (Duncan Williamson, 2003) 1. Relevance of Investment Appraisal: While investing on any project, the company normally would have a choice. The management need to have a good understanding of each of these proposals and should be able to weigh the benefits and drawbacks of each proposal. All the decisions require a detailed analysis to assess whether or not the investment is feasible for the company. The feasibility of the project depends not only on financials of the company but also partly on non- financial factors (Bized – Finance and Investment, 2008). Companies have various choices for change and development. The senior management need to ensure that all the merits and demerits of the investment are taken into consideration before investing. They need to compare all the possibilities on different bases, like if the proposal is consistent with the companies future, if the necessary funds are available for the improvement, the risk involved and most importantly which proposal provides the best returns. The process of evaluating projects is called Investment Appraisal (Bott, 2008). Based on these discussions, Investment Appraisal can therefore be defined as; “Evaluation of the attractiveness of an investment proposal, using methods such as average rate of return, internal rate of return (IRR), net present value (NPV), or payback period. Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training.” (Business Dictionary, 2008) Risk, Investment Appraisal and Management Control: Investment Appraisal is basically concerned with justification of capital expenditure. The investment appraisal process involves dealing with the cash flows generated by the project in the future. These cash flows are estimates and are future events, which are not certain. Whenever dealing with uncertain events, especially cash transactions, there is an element of risk attached to the event. Hence there is always a risk factor involved when taking investment decisions based on future cash flows. This makes the investment appraisal prone to risk and hence has to be evaluated carefully when using it as a decision making tool (Bott, 2008). Companies mainly invest, with the assumption that the investment will yield future income streams. Thus investment appraisal is assessing these income streams against the cost of investing (Ware, 1992). Management need to be extremely careful whilst making the decision since all investments that are made have an affect on the revenue of the company, hence management have to be very careful since these investments are generally very large and not easily reversible. 2. Types of Investment Appraisal: There are different techniques using which an investment can be financially justified. Methods to generate, review, analyze, select, and implement long-term investment proposals are listed below: Discounted Cash Flow Net Present Value (NPV) Payback Period Accounting rate of return (ARR) Internal rate of return (IRR) Profitability Index Discounted Cash Flow: Cash is one of the most essential aspect for any business, whether large scale or small scale. It is the main reason for failure of some businesses. Thus cash flow management is very essential (Bized – Cashflow, 2008). Cash Flow can be defined as; “A measure of a companys financial health. Equals cash receipts minus cash payments over a given period of time; or equivalently, net profit plus amounts charged off for depreciation, depletion, and amortization.” (Investor-words, 2008) Cash Flow basically refers to the money coming into a business from sales and the money that is spent on production. Time plays an important factor for any investment made. Discounted Cash Flows is a technique that is used to bring this time factor into consideration while evaluating a project. The discounted cash flow is similar to that of the present value concept. Discounted cash flow means converting future earning to today’s earning. This is calculated by estimating the cash you might have to pay out and the cash you might receive, and the period of time this would be received in also has to be estimated. Then the cash transaction is discounted by the opportunity cost of capital between now and the future date estimated. Discounted cash flows techniques include Payback period and internal rate of return (Solution Matrix, 2008). A few of the merits of cash flows are that they are based on income streams, they yield from investments, time value of money is taken into consideration and an analysis of profitability and risk is made (Solution Matrix, 2008). Net Present Value (NPV): NPV is a traditional method of valuation. Net present value is a method of comparing the current value of money to the future value of money. This method involves discounting of all future cash flows to present value this is then added up and compared to the outflow. If there are many projects that need to be compared, then the project with a positive NPV is preferred. The higher the NPV the more profitable it is to invest in a project. The NPV of a project can be derived using the following formula: NPV= PV of future cash flows – Initial Investment The main rule for accepting projects or declining projects using NPV: If NPV >0 = Accept the Project If NPV 1 = Good Investment If PI < 1 = Bad Investment If PI = 1 = May Accept. (Finance Scholar, 2008) Merits: Useful for projects that are divisible Very fexible Used for both large scale as well as small scale investments (FMAccounting, 2008) Demerits: It is very similar to NPV Can be misleading at times, i.e., the profitability index can reject projects with higher net present value though it has higher PI than others Investment Appraisal and Business: Investment appraisal plays an important role for a company’s shareholders. Methods are chosen based on the project life span and the size of the project. When the projects are large, companies prefer using quantitative methods and more advanced methods of investment appraisal. The table below (Table 1) shows the investment method used by a set of surveyed companies. Methods Of Investment Appraisal % Combined Methods 65.8 NPV 13.7 IRR 10.3 PBP 6.8 ARR 3.4 Table 1: Choice of Investment appraisal methods (Akalu, 2002) Looking at the table above it is clearly seen that most companies use a combination of methods to come to a decision for any investment. The various methods for investment appraisal have already been discussed above. It is essential that we understand which of these are the most important and which one gives the most reliable choice. The most useful and most reliable method is the discounting methods, like NPV and IRR. It is clear from the table above that most of companies use the NPV method to a greater extent (13.7%) than any other method, and the IRR method stand second in line (10.3%). Even though they are a little more complicated and may take a little more time due to the number of calculation, they are reliable. The payback method is simpler to calculate and is a shorter method; however this gives more importance to the investments that provide quick returns. Payback period is adapted by companies, however to a very less (6.8%) when compared to IRR and NPV. All the methods above have there own merits and demerits, however to get an accurate decision for an investment, the management must make sure they do a proper analysis of risks and try to use different combination of methods to arrive at a more accurate decision. There are various factors the management needs to keep in mind while choosing the investment appraisal method, like ease of use, the accuracy levels needed, extent to which the future cash flows can be measured easily, factoring in effects of inflation, etc. (Viswanath, 2008) 3. Investment on Securities: In order to understand the difference between security related investments and the difficulties in analysing them, it is first essential to know the different type of investment. Investments can be of mainly of two types: 1. Financially Justified Projects 2. Non –Financially Justified Projects. Financially Justified Projects are those for which the company can provide quantifiable benefits and the payback period and internal rate of return can be calculated. These projects are like those of investing into a new factory premises, or buying new machinery for the company, etc. Non-Financially justifies projects are those for which the company cannot provide any quantifiable benefit and the payback period and internal rate of return cannot be calculated. These projects generally include investments like company cars, mobile phone for staff, and new furniture for the company, etc.., There is no way that we could possibly calculate the benefits that can be got by investing into these types of projects. Security Project: As said in the earlier section, it is very difficult to financially appreciate an investment on security tools, vehicles, software upgrades, etc.., as all these are non-financially justifiable projects. However, they are essential for a company’s future growth and expansion factors. Also, they provide benefits in many intangible ways. These can be converted into financially quantifiable by investigating into the benefits the investments can bring to a company and then converting them into financially appreciable values. A business case is set for the same to explain how a security team can make a proposal to the management for the implementation of a security project. Business Case: The security team of XYZ Company has to submit a proposal to buy anti-virus software for the company. The security team aims at installing this anti virus software across the entire organization and hence requires an investment of $12,000 inclusive of company wide software license and the installation charges. They need to make this proposal financially justifiable to the management so that the management agrees to invest in the anti virus software. The security team faces a big challenge in doing so, since there are other processes in XYZ Company that are revenue generating and also require an investment. These processes have a steady cash flow and hence have a financially justifiable investment proposal. The main aim of the security team is to prove to the management that the investment is necessary, is a cost effective solution for the risk the company is facing and that the effects would be positive on overall productivity of the company. Securities Team’s Report: XYZ Company, as of 2008, has a total of 1000 employees working within the organization. The company’s cost of capital is 15%. According to the company policy, all the systems are upgraded once in every 4 years, the last replacement being in 2007. The security team has analyzed and figured out that the company needs an anti-virus protection system, as after the last upgrade, a number of new products have hit the market to keep the systems secure from the new attack of viruses and to provide a secure environment. As explained earlier, the total expenses involved amount to $12,000. This product also rectifies a number of other issues and bugs in the system. The following statistics were recorded during last year. The total idle time due to virus attacks and system crashes came to 600 hours in the last year. As explained earlier, the total number of employees is around 1,000 and each of them has their own terminal. Case 1: The systems were attacked due to some virus and there was employee idle time, in order to rectify the system. No. of systems affected : 200 No. of hours to rectify each system : 2 Minimum pay of employee in the organization : $ 12 / hour (the minimum wage is taken into account) Loss to the company in terms of idle time: No. of employees effected = 200 No. of hours of idle time = 2 Minimum pay = $ 12 Hence, loss to the company in terms of idle time : 200 * 2 * 12 : $ 4,800 Case 2: In some cases, the systems were not attended to on time as the infection was not detected. In these cases, the systems eventually crashed (were corrupted) and hence it has to be formatted and all the software had to be re installed. No. of systems affected : 50 No. of hours to retrieve each system : 4 Minimum pay of employee in the organization : $ 12 / hour (the minimum wage is taken into account) Loss to the company in terms of idle time: No. of employees affected = 50 No. of hours per employee = 4 Minimum pay = $ 12 Hence, loss to the company in terms of idle time : 50 * 4 * 12 : $ 2,400 Therefore, the total loss to the company last year due to idle time of employees = $ 4,800 + $ 2,400 = $ 7,200 If this case continues in the years to come, then the company will lose $ 7,200 per year for the next three years until the systems are updates. In order to justify the current investment of $ 12,000, NPV of the losses to the company in the next three years can be calculated. The company’s cost of capital (15%) is taken into account for discounting the losses. PV of future savings to the company = 7200 / (1.15) + 7200 / (1.15)2 + 7200 / (1.15)3 = 6260.87 + 5444.23 + 4734.12 = $ 16,439.22 Hence the Present Value of the future savings to the company is $ 16,440. From this value, the NPV of the project can be computed as, NPV = PV of future savings – Initial Investment = $ 16,440 - $ 12,000 = + $ 4,440 Hence it is clear from the above calculations that the investment on the security system has an NPV of + $ 4,440. Justification: The security project faces a lot of competition from other investments which generate cash flows to the company, i.e., in other words, many investment proposals are fighting for the management’s budget for the coming year. In many cases, the security team fails to convince the management about the importance of the investment in security due to no supporting evidence. Hence it is essential that the security proposals are accompanied by supporting documents which indicate monetary gains to the organization. This can only be carried out using the investment appraisal techniques. In the previous business case, when the security proposal is supported by monetary gains worth + $ 4,440. Hence it is clear to the management that it is worthwhile installing the security systems immediately instead of investing on other projects with a net NPV which is lesser than $ 4,440. Also, another important aspect, the management has to consider is that the future cash flows in other investments are uncertain and hence carry an element of risk in the returns. However, the security project is based on internal events and hence the savings are certain and substantial. Based on all these arguments, the security team can make the management understand the importance of investing on the new security systems. Conclusion: This project has explained the need for investment appraisal and also the different methods of investment appraisal. Then the difficulties in justifying non-financially justifiable projects were also discussed, followed by a business case which put forwards a security project proposal to the management indicating the monetary gains from investing on the same. Based on these discussions, it is clear that investment appraisal plays an important role in management control, in taking important decisions involving huge amounts of investment. BIBLIOGRAPHY Akalu, M. 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W., 1992, ‘Quantum Investing’, Financial Analysts Journal, Mar/Apr 1992, Vol. 48, Issue 2, p10-22 Read More