Development of the Financial Appraisal Profile Model - Essay Example

The development of the Financial Appraisal Profile Model Introduction Managers have a variety of financial models available to them when they appraise capital projects, so deciding which ones to use requires in depth knowledge of several and the ability to choose the financial model most applicable to the situation (Christy, 1966; Vandell & Stonich, 1973; King, 1975; Pike, 1984). The academic literature provides theoretical justification for discounted cash flow models; in the field, managers commonly utilize payback and accounting rate of return to appraise capital projects (Solmon, 1962; Klammer, 1972; Hasty, 1974; Gold, 1976; Drury, 1994). Academics prefer the net present value (NPV) method because it has theoretical validity; accounting managers tend to use the internal rate of return (IRR) method (Lefley & Ryan, 2005). Surveys and case studies have been conducted to pinpoint managers’ feelings on the theoretical versus the practical applications of capital budgeting (sometimes termed capital investment appraisal). Even though considerable research has been undertaken, no definite conclusions have been drawn as to why managers reject academics’ recommendations on sound theoretical models (Lefley & Ryan, 2005). The more sophisticated theoretical models have been studied in relationship to improved firm performance (Pike, 1989), with inconclusive results. The NPV method has some shortcomings; the value added can be measured for most investment decisions. Other models such as payback and accounting rate of return are also useful in analysis, and managers continue to use their intuitive judgment and more basic financial models. Improved efficiency in project selection should logically lead to improved overall performance. Small & Chen (1997) suggest that combining a strategic and an economic approach results in greater project selection efficiency and higher success rates. Lefley & Ryan (2005) that this idea one step further and comment that there are three main considerations in any investment decision: economic, strategic, and project specific risk. By combining these three elements in one model, the impact of investment decisions can be more accurately pinpointed. The Financial Appraisal Profile Model As stated earlier, researchers and analysts have found that managers utilize a combination of risk assessment models and financial appraisals for practical investment evaluations, and prefer not to rely on any one model, no matter its theoretical soundness (Lefley & Ryan, 2005). One danger of choosing a single model could arise when subordinate managers maximize benefits and minimize costs and risks when they put together investment proposals; rather than using multiple models to justify a proposal’s selection, they may instead choose to create projections that meet a specific model’s requirements, thus leading to skewed decision making on the part of upper managers. The literature has also found that assessment and risk models are not employed as frequently as they should be or as frequently as managers assume. Levels of risk are minimized in some organizations as a result. Part of a manager’s difficulty arises because there is little agreement on which models should be combined. Lefley & Ryan (2005) point out that each individual model has positive points for decision makers, but inappropriate modelling creates confusion and frequently overcompensates for factors such as project-specific risk. Lefley & Ryan present the financial appraisal profile (FAP) model as an alternative to reduce problems which crop up in single-model or poorly-combined-model approaches. The FAP model combines the three main considerations in any investment decision: economic, strategic, and project specific risk. This model incorporates strong points from traditional models into a new technique which examines the whole complexity of the investment appraisal. Using the FAP model reinforces principles of good governance and reduces skewed decision making should subordinate managers attempt to minimize costs and risks and maximize benefits in their proposals. The FAP protocol begins by establishing a capital investment appraisal team lead by an independent group leader as facilitator. The team includes as many functional managers from the organization as are necessary to make a sound investment decision. The independent group leader ensures that the team has at least one person who can act impartially in the decision because he or she is not directly involved in the project. The group leader cannot be a “project champion” who is attempting to reach a positive decision on the project because he or she is heavily vested in a positive outcome (Cross & Brodt, 2001). Basically, the dynamic FAP protocol combines four separate protocols, which consist of capital cost, project-specific capital cost, and the useful life of the project; conventional NPVP modelling using the discounted payback period (DPB), the discounted payback index (DPBI) and the marginal growth rate; the project risk protocol which identifies and evaluates risks associated with the project; and the strategic index (SI), which links the specific project to the overall goals and strategies of the firm. These four components are discussed in the next section. 1. The capital cost of the project Capital costs are figured following standard accounting practice guidelines. Capital costs are basically the costs which are capitalized as a fixed asset. These expenditures may be capitalized over a number of years depending on the life of the project. All other costs are offset against positive cash flow generated by the project and are treated as revenue expenses. 2. The Cost of capital Corporate managers determine the cost of capital under the FAP model. This typically forms the discount rate applied to the project’s net present value profile. Because the discount rate calculates financial return and does not serve as a threshold barrier, the calculated cost of capital can represent the project’s bottom line economic return. Managers use the combined features of the FAP model to determine if the financial return is acceptable, taking into consideration the opportunity cost of capital. The opportunity cost of capital is based on alternative rate for a similar investment and the value of the best alternatives and is estimated over the life of the project. This opportunity cost of capital is weighed against the specific risks of the individual project and the overall company strategy. These calculations are not simple, and can be compounded if the managers include a premium to cover project specific risks (Lefley & Ryan, 2005). 3. The Project’ estimated life The FAP model is typically applied to projects with life spans of twenty years or fewer, but can be adapted to cover longer-term projects as needed. For projects with estimated useful lives of more than twenty years, the FAP model indicates this by using a 20+ with the full estimated life of the project in parenthesis (for instance, 20+ (35) for a project with an estimated life of thirty-five years). This flexibility is especially useful for the oil exploration and industrial extraction industries where capital investments can certainly have life spans of more than twenty years. Calculations are made only for the first twenty years, however. An estimated cash inflow is figured for year twenty and covers the residual value of the project. Residual value in this instance is calculated using either (a) the price/earnings ratio; (b) the perpetuity method; (c) the book value of the investment; or (d) the liquidation value of the investment. The Net Present Value Profile (NPVP) Under the FAP protocol, managers, group leaders and team members must always keep in mind two fundamental issues: the long-term interests of shareholders and owners and the interrelated risk and liquidity of the project. These two fundamental issues must be deciding factors in the approval or rejection of a particular project. It is possible that abandonment values (AV) may also be relevant, so these values may also need to be calculated where appropriate. Of course, the investment firm is looking for the greatest return on the cost of capital once all these considerations have been taken into account. Using the NPVP should allow the firm to determine the true costs, risks, and potential returns on projects. The determination of the (NPVP) The net present value profile (NPVP) creates a complete financial profile of the investment opportunity (Lefley & Ryan, 2005). It combines the net present value method (NPV, which is the expected economic profitability arising from the project) with the discounted payback period (DPB), the discounted payback index (DPBI) and the marginal growth rate (MGR). It must first be assumed that the discount rate has not been inflated in any way to cover project-specific risks, infrastructure costs, or any other artificial inflation. Once this has been determined, calculations are performed to extend the NPV to include the DPB, the DPBI, and finally arriving at the MGR. This process allows the FAP protocol team to put together a profile that will allow them to make a sound judgment for each project under consideration. Emphasis may be placed on different parts of the NPVP to reflect the parameters of particular investments. Once the proper profile has been obtained, management takes into account the firm’s liquidity restrictions. Abandonment values should be added in as appropriate. The NPVP method highlights abandonment values for each project, whereas using the NVP model alone may overlook abandonment values. Abandonment may result in significant cash inflows which may improve the project’s liquidity and help offset perceived risk (Lefley & Ryan, 2005). Read More