Corporate Financial Management - Coursework Example

RUNNING HEAD: Investment Appraisal Investment Appraisal - Corporate Financial Management of Tableof Contents Title page ……………………………………………………………………………………….1 This page ……………………………………………………………………………………….2 Introduction ……………………………………………………………………………………3 Discussion…………………………………………………………………………………….…3 1. A typical investment decision and the concept of investment appraisal………...……4 2. The choice discounted and non-discounted methods……………………………………4 3. The choice between non-discounted methods …………………..……………………….4 4. Net Present Value vs. Internal Rate of Return ……………………….…………………5 5. What could go wrong with the use of the investments appraisal methods?................6 Conclusion …………………………………………………………………….………………..7 References……………………………………………………………………………………….9 Introduction This paper seeks to critically discuss the various investment appraisal techniques and highlight the potential problems when each is used in real life. The paper will discuss how each method is different from each other and how will the decision maker benefit from each. A choice among the method will be made as which is best after discussing the benefits and potential problem of each is used in making decisions. Discussion 1. A typical investment decision and the concept of investment appraisal A typical investment decision would be as follows: Capital investments normally require cash outflows at the initial period and over the period of a project. An example is the propose acquisition of an equipment or building. The investment would then require working capital over life of the project as part of the cash outflows. At the same time, after the initial investment, cash inflows will eventually come in over the life of the project in terms of cash revenues and cash collections. These financial events need to be evaluated to determine whether there is net benefit to the decision maker or investor in making the investment decision. It is here where the choice of methods becomes important and which one will be more advantageous over the other. Investment appraisal therefore refers to capital budgeting decision where it is evaluated whether a proposal that may make use of resources at present may be justified on the amount of resources that would be received in return in the future. It should answer the question whether the investment option should be made. To decision will have to use method to arrive at the best decision hence the different investment appraisal are evaluated in this paper to know which one will lead to better if not the best decision in making investments. This is on the theory that capital investment decisions argue for what will maximize wealth for the decision maker or investor (Brigham and Houston, 2002). 2. The choice between discounted and non-discounted methods The tools that could be used for investment appraisal or capital budgeting techniques available include the net present value (NPV) method and internal rate of return (IRR), payback method (PB) and the accounting rate of return (ARR) method. The four methods could actually be divided into discounted cash flow (DCF) methods and non-DCF methods (Albrecht, et al, 2007). NPV and IRR belong to the DCF while PB and ARR belong to non-DCF. Between DCF and non-DCF methods, a choice should be made on which one is more scientific and logical. This researcher takes the first as the better one since makes use of the time value of money concept. The time value of money concept assumes that a hundred British s received today should have different value from that received in the future. Thus, the concept assumes that to compare those two values – today and the future, the money in the future should be computed or brought to its present value. To do the same there is a need to have a discount rate, which is normally assumed the cost of capital. This cost of capital however may be difficult to estimate. 3. Choosing between non-discounted cash flow methods For the purpose of this paper, the non-discounting methods include the accounting rate of return (ARR) and payback method (PB). The ARR method has the benefit of simplicity since it just uses readily available accounting information. Since accounting information is normally prepared under the accrual method of accounting, the need to have average net income divided by the average total assets or investment must be very easy to make (Hansen & Mowen, 2006). Since it does not consider the time value of money, the method it does not adjust for the greater risk to long-term forecasts. It therefore necessarily favours higher risk decisions and that could be fatal to the decision maker. The main reason of course is the lack of discounting of future profits (Hansen & Mowen, 2006). The Payback method refers to the period of time when investments made need to be recovered or repaid (Hansen & Mowen, 2006). Having a project, for example, that would cost $1,000 funds with annual profit of $250, would have a payback period of 4 years. To judge whether the project is acceptable, would be based on the policy of the decision maker. If the policy is to accept all projects having payback period of 3 years, it would appear that the example would fail to qualify because it has a payback of 4 years. What makes the PB different with ARR is that the fact that it is more conservative since ARR tends to overlook the risks of profits in the future by assuming that the ARR is still valid for future years. The choice of which method is better between the two depends on the decision maker. A conservative one would choose PB while a less conservative one would choose ARR. Both however could be wrong since these methods disregard the time value of money. This would bring the discussion therefore on choosing between NPV and IRR under the DCF methods. 4. Net Present Value vs. Internal Rate of Return Since both uses the concept of discount rate and cash flows to be discounted, the two are similar in such respects. However the use of NPV method would have the result expressed in British while the use of IRR would have the result express in rates. Since cost of capital is also used impliedly in IRR, the use in internal rate of return analysis in analogous ways as that of the net present value analysis as argued earlier entails some differences. The concept of time value of money is also assumed so that the future cash values are being brought down to their present values (Brigham and Houston, 2002). In fact, using IRR may be deemed to have applied when the NPV of a project proposal is set to zero. This would mean that the discount factor under the net present value analysis would overlap with the reinvestment rate used under the IRR analysis. One difference is the use rates as expressed in percentage under the IRR as contrasted with the use of amount value in NPV analysis. Based on this difference of the two, it would appear that the use of cost of capital in IRR would appear easier to use since the acceptability of projects are normally expressed in rates of return. However, conflict between two methods – IRR analysis and NPV analysis could arise. To illustrate, conflict could come in deciding mutually exclusive projects, where the decision maker can choose either one of the project but cannot reject or accept both. Compared with the NPV method, it would still be the cost of capital that would be assumed as the reinvestment rate. Since the IRR could be too low or too high than the cost of capital, then it could turn out reinvestment under such rate was assumed throughout the life of the project, yet it could be very far already from the cost of capital as more logically assumed in NPV computation. Thus, in case conflict on the use of the two, methods, authors normally suggest the preferential use of cost of capital in NPV for accuracy reasons (Brigham and Houston, 2002). The accounting rate of return is therefore of limited application as far as using the same as criteria in evaluating investments as it does take into consideration the time value of money. It may be expressed in rates as the internal rate of return but the assumptions on its use may make the results unreliable and the decision may be as well. 5. What could go wrong with the use of the investments appraisal methods? Using non-discounted cash flow methods would result to using unreliable basis for decision making and this would give the decision maker to be right but actually he or she is wrong. This would a case of misleading and would in effect be forfeiting the benefits of correct decision making. The use of Payback method has the benefit of simplicity as one could have a project that could be easy to realize within a given period. A project may have a positive NPV but it can take longer to realize, so that from the point of view of the decision maker, the decision could still be wrong. Since DCF methods are than non-DCF methods at this and that NPV is better than IRR at this point, the most interesting then is to know what could go wrong with use of NPV. Although NPV measurement is judged to be the best among the four methods and as it could be widely used for making investment decisions, it can still be faulted for error if the cost of capital is wrong and in not accounting for flexibility/uncertainty after the decision. It cannot be assumed that one decision is made at the start about the acceptability the project, and then all is done. It deficiency therefore must give to the concept of real options. This latter concept also called as managerial options would consider the value of managerial flexibility towards strategic decisions as a way to respond in case of expected market development (Brigham and Houston, 2002). A company may therefore maximize or create shareholder value by identifying real options, managing them and exercising them when called for. Conclusion It can be concluded that between discounted-cash-flow methods and non-discounted-cash-flow methods, the former was adjudged as the better one. Between NPV and IRR under the discounted method, NPV was declared the superior one. However, NPV is the best method with the best theoretical support it is still not perfect because of certain limitations. It may fail due to error or difficult in estimating cost of capital as discount rate and/or it may fail to have flexibility once the decision is made. Fortunately, the real option is possible to address its deficiency where the use of the NPV is not altogether disregarded. References: Albrecht, et al (2007).Accounting: Concepts and Applications. Cengage Learning Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management. London: Thomson South-Western Hansen & Mowen (2006). Managerial Accounting. Cengage Learning Read More