Capital Investment Appraisal Techniques - Essay Example

Capital Investment Appraisal Techniques s Principles of Finance 17 May, Capital investment appraisal Techniques: Managers in organizations face challenges of making the most appropriate and sound investment decisions. The managerial tools which help in evaluating the future potential of an investment are known as capital investment appraisal or capital budgeting techniques. The investment decision is obviously crucial because the organization has limited resources and has to invest these resources in projects that would give maximum return so as to increase the shareholder wealth. There are different techniques for investment appraisal for instance, payback period, discounted payback period, accounting rate of return, net present value, internal rate of return, modified rate of return and profitability index (Shapiro & Balbirer, 2003, pp.242). However, I find Net Present Value (NPV) as the most reliable capital budgeting technique. I will support my point by providing a thorough comparative analysis of NPV with the four most common techniques, accounting rate of return, payback period and internal rate of return. Each method is explained with the help of numerical examples found in the Appendix. Net Present Value is a technique which takes into account the time value of money. NPV for a project is calculated by finding out the present value (PV) of all the future cash flows, which the investment in the project is expected to generate. The PV of future cash flows is found by discounting them at the expected rate of return or cost of capital. Then, sum of the PV of all cash flows is compared with the cost of investment (Hampton, 1998, pp. 328). The selection criterion of a project is that, if the PV of future cash flows is greater than the initial cost of investment, the project should be selected. In other words, NPV tells us the present worth of cash flows which would be generated by the project in future; hence, if the initial investment that we make today is less that the expected cash flows present value, it means we will cover our cost, only then it will be wise to select a project. The formula to calculate NPV is sum of present values of future cash flows minus initial investment cost. A rule says that any project which has NPV greater than $0 should be selected, however, in case of mutually exclusive projects; where you have to choose one out of all the alternatives, choose the one which shows a higher NPV. The following paragraphs will carry out an in-depth analysis of the advantages and disadvantages of using this technique, so that we can have a clearer idea about situations when it can highly aid investment decision making. The biggest advantage of using NPV technique is that it takes into account the time value of money, which is one of the most important concepts in business finance. By considering the PV of all the future cash flows, it helps the managers to identify if the investment will increase the overall value of the firm. Moreover, it also helps in judging the risk associated with future cash flows, by discounting them at the cost of capital or expected rate of return (Shapiro & Balbirer, 2003, pp. 247). Therefore, this is the most widely used by companies because it enables the managers to analyze if the investment will increase the firm’s value along with safely covering the initial cost of the investment. However, an issue with NPV can be that, the manager has to be extremely sure and clear about the cost of the capital or the expected rate of return. The cost of capital is important because, this is the rate at which future cash flows are discounted to calculate the present value (Shapiro & Balbirer 2003, pp.247). Hence, if the discount rate is incorrect or inappropriate, an unwise investment decision can be made. The value of using this technique can be further highlighted by comparing it with other common methods which are employed for investment appraisal. Comparison between Payback period and NPV: Payback period simply calculates the number of years required to cover the initial cost of investment (Hampton, 1998, pp. 324). This method is quite simple in approach however, it neglects some very important aspects in capital budgeting. Primarily, it does not take into the time value of money, which means that it not only ignores the risk associated with future cash flows, but it also does not indicate if the investments will the increase the company’s overall value. Lastly, this technique completely ignores the cash flows after payback period (Hampton, 1998, pp. 324). Thus, NPV when compared to payback method is considered as a lot better option for investment appraisal, because it helps in making a wiser decision by taking into account, the risk and return associated with an investment. Comparison between accounting rate of return (ARR) and NPV: Accounting rate of return, as the name suggests, gives the rate return on the investment. It calculated by dividing profit with investment (Shapiro & Balbirer, 2003, pp.254). It is a simple method, but has various flaws. First of all, it has no benchmark against which the rate can be compared so as to choose a project. Secondly, it ignores the importance of time value of money while making investment decisions. Thirdly, it does not focus on cash flows but on profit, which is affected by different accounting policies. Lastly, it does not enable managers to assess the risk associated with investment (Shapiro & Balbirer, 2003, pp.255). Hence, it takes $10,000 received today and $10,000 received a year later, at the same level of importance and desirability. Methods like ARR are in no comparison with wise techniques like NPV, which can most certainly help finance managers to make a prudent decision by taking into account factors like, time value of money and risk-return profile of the investment. Comparison between Internal Rate of Return (IRR) and NPV: IRR is a method which enables finance managers to calculate the rate of return that would be earned on an investment. It is calculated by finding out a discount rate which equates the PV of future cash flows with the initial investment (Gitman, 2005, pp.350-351). In other words, this method calculates the rate at which NPV is zero. The selection criteria is, if IRR is greater than the required rate of return or cost of capital, the project is selected and vice versa. When comparing it with NPV, it is observed that both can help in investment appraisal by taking into account, the time value of money, the risk associated with future cash flows and the value that the investment can add to the firm. However, calculating IRR is easy until the cash flows are equal but, when cash inflows are not even, trial and error method is employed to find IRR which is not very comfortable for a lot of people. Moreover, there can be multiple IRRs for a project if cash flows change signs i.e. inflows and outflows occur during the life of the project. Thus, deciding with multiple IRRs makes it a little difficult task. It is believed that NPV and IRR are the most reliable tools for independent investment appraisals and display the same decision of either accepting or rejecting a proposal. Obviously for a project that has IRR greater than the required rate of return, will certainly have NPV greater than zero and vice versa. However, both the techniques give different decisions if mutually exclusive project’s life and size differ or there are different patterns of cash flows for each project (Gitman, 2005, pp.352). The concept is explained by an example found in the appendix. In the end, it can verifiably be said that NPV can help identify the dollar value increment which an investment will bring whereas IRR helps in expressing the same idea in terms of percentage. In businesses both the methods are employed for making decisions, however, NPV is considered superior to IRR because of its ability to express the dollar increment in the value of a firm by making an investment (Gitman, 2005, pp.353). References: Gitman, L.J., 2005. Principles Of Managerial Finance. 12th ed. New York: Pearson, pp.350-53. Hampton, J.J., 1998. Financial Decision Making. 4th ed. New Delhi: Prentice Hall, pp. 324,328 Rao, R., 2000. Fundamentals of Financial Management. 3rd ed. New York: MacMillan Publishers, pp. 359-61 Shapiro, A.C. & Balbirer, S.D., 2003. Modern Corporate Finance. 2nd ed. New York: Person, pp. 242, 247, 254-55 Appendix: 1. Calculating NPV: Project A: PV =$200/(1.07) + $1,150/(1.07)2 + $980/(1.07)3 + $3,200/(1.07)4 + $1,000/(1.07)5 PV= 187+1004+780+2441+713 PV= $5125 NPV= Present value - Initial Cost NPV= $ 5125 – 5000= $125 PV B= =$50/(1.03) + $100/(1.03)2 + $250/(1.03)3 + $150/(1.03)4 + $30/(1.03)5 PV= 48.54+94.25+228.78+133.27+25.87 PV= $530.7 NPV B= $530.71-$500= $30.71 PV C= $5000/(1.05) + $3000/(1.05)2 + $2000/(1.05)3 + $400/(1.05)4 + $120/(1.05)5 PV = 4762+2721+1728+329+94 PV = $ 9634 NPV C= $ 9634 – 10,000 = ($366) If the projects are independent that A and B can be selected. However, if they are mutually exclusive, then Project B should be selected because of higher NPV. 2. Payback Period calculation Expected Net Cash Flow Year Project A Project B 0 1 2 3 ($1000) 200 500 900 ($1000) 700 200 900 PaybackA = 2 + $300/$900 = 2.33 years. PaybackB = 2.11 years. Project B should be selected 3. Accounting Rate of Return Calculations: Project A involves the immediate purchase of plant at a cost of $100,000. It would generate annual profits before depreciation of $25,000 for five years. Scrap value will be $5,000 at the end of the fifth year. Calculate the ARR. ARR = Average accounting profit X 100 Initial investment Average profit = Profits before depreciation –depreciation = ($25,000 x 5) – ($100,000 – $5,000) 5 5 = $6,000 p.a. ARR = $6,000 X 100 = 6% 100,000 4. IRR calculations ABC Company is planning to invest in Project A. The management wants to invest in a project which can give them higher rate than their cost of capital, 10%. Calculate the IRR. Expected Net Cash Flow Year Project A 0 1 2 3 ($20,000) 12,000 6,000 5,000 $20,000 = 12,000/(IRR) + 6000/(IRR)2 + 5000/(IRR)3 Trial and error method: i. Try at 10% 20,000= 12,000/1.1 + 6000/ (1.1)2+ 5000/ (1.1)3 20,000 = 10,909+ 4,959+3,757 20,000 = 19,624.67 (low) NPV= -375.33 ii. Try at 8% 20,000= 12,000/1.08 + 6000/ (1.08)2+ 5000/ (1.08)3 20,000 = 11,111+ 5,144 + 3,969 20,000 = 20,224 (high) NPV = 224 Interpolate: Lower rate + NPV with lower rate x difference in rates NPV with lower rate – NPV with higher rate IRR= 0.08 + [{224/ (224- (-) 375.33)} x .02] IRR = .08+ [{224/ 599.33} x 0.02] IRR = 0.08 + [0.373*0.02] IRR = 0.08+ 0.007475 IRR = 8.74% CHECK: 20,000= 12,000/1.0874 + 6000/ (1.0874)2+ 5000/ (1.0874)3 20,000 = 11,035.49 + 5,074.25 + 3,887 20,000 = 19,998.5 NPV = $ 1.5 (If we try for more precision with increased decimal places in interest rates, NPV will get zero). This project should not be selected because the cost of capital or the required rate of return of the company is 10% 5. Evaluating projects by using NPV and IRR Consider a situation where a company has to choose between two projects S and T. The following holds true i. The required rate of return or cost of capital is 10% ii. NPVs = $ 7,500 iii. NPVt = $ 3, 500 iv. IRR s = 16% v. IRR t = 21% Independent project: If both the projects are independent, both the projects should be selected on the basis of NPV greater than zero and IRR greater than the cost of capital. Hence, both the techniques lead to the same result (Rao, 2000, pp. 359). Mutually Exclusive projects: However, if the projects are mutually exclusive, then project S should be selected because of higher NPV. And on the basis of IRR, project T will have more preference over project S, because 21% return is greater than 16% return for 10% cost of capital. Therefore, it can be concluded that in mutually exclusive projects, NPV and IRR lead to conflicting results (Roa, 2000, pp. 360-61). Read More