Rapidly Changing Technology, New Innovations and Globalization - Essay Example

Introduction Rapidly changing technology, new innovations and globalization are among the stronger forces that make business more competitive in modern business context. Businesses that can effectively compete against others will survive in the market and likely to earn more profits through getting more customers, hence more share capital. Organizations which have the ability to adopt to new technology and human resource training will have more advantage in the modern day competitive environment of earning more profits. Organizations without strategic investment plans often lag behind in grabbing a good part of market profits. On the other hand, having zero investment also may not be the best scenario. Therefore, managers should undertake the projects like new technology deployment, knowledge management which may give sustainable competitive advantage to the businesses. Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firms resources to actions that are irreversible. Expansion of business operations, acquisitions, modernization and replacement of long term assets and sale of a division or business can be identified as investment. Normally such investment will take more than one year period and it often include investments in plant and machinery, research and development, advertising and warehousing facilities. Against this backdrop, this study seeks to explore effective techniques of making business investments and it will analyse the Discounted Cash Flow (DCF) in detail. Background to the study Managers apply different criterion to evaluate investment decisions with the sole purpose of maximizing revenue generation. In current practice, managers use Discounted Cash flow (DCF) analysis to evaluate investment in financial terms. Also Payback method and Accounting Rate of Return (ARR) which make no adjustment for the time value of money are often considered. However, the DCF method considers the time value of money which is reduced progressively and it consists of Net Present Value (NPV) approach and Internal Rate of Return (IRR) methods. This could lead to more popularized investment appraisal techniques among the managers. In theory, it could be suggested that DCF method which encompasses NPV as well as IRR is superior over other methods. Consequently, NPV is also superior to IRR. Research has shown that the companies which do not practice especially the DCF method of investment in UK often lag behind. Whilst the DCF technique is widely regarded as superior, Koller (2006) has however identified some of the most frequent ten errors in application of DCF model. He also stated that if properly implemented, the DCF model should be economically sound and transparent. In this case, he suggests that application of DCF method needs to be adjusted and assumptions to be made accurately since the accuracy of such decisions relies on certain assumptions. Surveys of capital budgeting practices in the UK and USA reveal a trend towards increased use of more sophisticated investment appraisals requiring the application of DCF techniques. Several writers, however, have claimed that companies are under investing because they misapply or misinterpret DCF techniques. Such claims have been made on the basis of observations in only a few companies, or anecdotal evidence, without any supporting statistical evidence. Reports on survey conducted by the Drury C. & Tayles M. (1997) suggest that many UK firms are accountable for misapplying DCF techniques. In this survey, they have tested three areas where misapplication could have taken place. These are selection of investment appraisal techniques, treatment of Inflation and Uses of discount rate. In addition to that, they have tested the major reason that is cited to explain why the financial appraisal often fails to justify investment in Advanced Manufacturing Technology (AMT). It is because those benefits which are difficult to quantify are either understated, or frequently omitted from the financial appraisal. As a result of that, UK organizations may be failing to achieve profitable investment. On the other hand, when we are considering the appraisal of AMT project, different researchers have established diverse arguments. Kaplan (1986) argued that conventional DCF method should be used based on the financial data available to appraise the AMT projects. Meredith & Suresh (1986) also developed the new approach consisting of flexibility, high level of risk and the synergy of Flexible Manufacturing Systems (FMS) when linked together with other systems. These three levels were tested on different appraisal techniques and try to overcome the problems associated with Kaplan’s Model. But later, Browmich & Bhimami (1991) developed the model which quantifies all the benefits either in financial terms or score value terms. However, DCF approach is still a widely used investment appraisal technique. This can be proved according to the surveys carried out by Lawrence, Gary & Williams (1978) which show that 65% and 56% respondents of Large US firms applied IRR and NPV respectively and the survey carried out by the Pike (1996) reported 75% and 81% UK firms are applying NPV and IRR respectively. According to the study carried out by McIntosh (1993) among major valuation firms in Australia and by Sangster (1993) among largest 500 Scottish companies revealed that more than 75% firms are currently practicing the DCF method. Research Issue Research has shown that there is often conflict to a certain extent in choosing the appropriate method of capital investment evaluation process between using DCF analysis or any other method. However, many studies posit to the effect that DCF analysis is a more accurate and flexible decision making technique compared to other techniques which can be used (Kruschwitz and Loffler 2005). As far as practical application is concerned, DCF models have to be developed and to be adopted in line with the necessary adjustments to minimize errors that can occur in decision making process. The researcher therefore seeks to undertake research on following issue: To investigate the extent to which DCF analysis is validated by the Managers of the Oil industry as an Investment Decision making Tool in Libya. Objectives of the study 1- Identify the effectiveness of application of Capital Investment Appraisal methods in business the managers use. The major objective is to explore why Discounted Cash flow (DCF) analysis in particular is a preferred method to evaluate investment in financial terms in comparison to other methods such as Payback method and Accounting Rate of Return (ARR) which make no adjustment for the time value of money. 2- Understanding the extent to which DCF is helpful in prioritizing and making business decisions especially to the oil industry in Libya in general. 3- Identify the validity of decisions that have been made based on DCF approach. Aims of the study To identify whether DCF analysis is validated by the managers of Oil industry as an investment decision making tool in Libya. This research would explore the extent to which DCF is useful in making business decisions by managers. Therefore, focus is towards the link between DCF and validity of decisions that have been made by managers. Significance of the study Investment is the most critical aspect for the success of an organization. This is so because of its impact on the long term future of business, the amount of scarce resources utilized and degree of irreversibility. Misguided decisions can endanger the survival of business and cause difficulties in obtaining additional finance from more costly sources. Therefore, investment must be carefully analyzed in a systematic and logical way. Basically, all projects will be aimed at generating financial or non financial benefits to the organization. To evaluate the financial benefits, pre determined appraisal techniques are developed and exercised but in case of appraising non financial benefits, there is no specified method developed. Therefore, organizations evaluate non financial benefits on the basis of the judgments of the specialized persons and their experiences. When managers are evaluating the financial benefits of the generally accepted techniques such as Pay back, NPV or IRR, most of the calculations are based on assumptions therefore, validity and acceptability of such techniques is often in doubt. Considering the Oil industry which is more competitive and widely spread, their activities are all over the country therefore organizations which are currently running the oil industry often make frequent investments to keep their market by way of doing innovations. In addition to that, major organizations which acquired the majority of market share are foreign own companies. They often make frequent investments according to the changes in technology. Therefore it is significant to study the decision making process of the Oil industry in Libya if there is validity of the decision making techniques. Literature Review This section will deal with analyzing the literature that has already been published by other writers about the same subject on Capital Investment Appraisal. The study will also try to establish the gap which exists in the literature already published in relation to decision making by managers in the oil industry. Capital budgeting Capital budgeting decisions may be defined as “the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow benefits over a series of years” (Pandy, 2005) According to the above definitions of capital budgeting, following features can be identified, I. Exchange funds for future benefits II. Funds are invested in long term assets and III. Benefit will occur to the firm over a series of years. Therefore, the main objective of the capital budgeting decisions is to maximize the wealth of the shareholders by: Determining which specific investment projects to be undertaken Determining the total amount of capital expenditure which the firm should be obtained Determining how this portfolio of projects should be financed. In capital budgeting process, different investment appraisal techniques are used to evaluate the investments. But in DCF method, Net Present Value (NPV) and Internal Rate of Return (IRR) are included and they are adjusting the time value of money to the cash flows. These techniques give different benefits and limitations in investment evaluation process although the theoretical view DCF analysis may give more benefit to the organization. However, successful completion of a project mainly depends on the selection criteria adopted while choosing the project in the initial phases itself and the choice of a project must be based on a sound financial assessment and not based on impression. DCF techniques are being widely used in both public and private sector. This is the method recommended for evaluating investment proposals. In this method, the incremental cost and benefits of proposals are discounted by a required rate of return in order to obtain the net present value of the proposal. Discounted cash flow (DCF) DCF focuses on the time value of money, Rs.1 is worth more today than Rs.1 in the future.   The reason being that it could be invested and make returns even during the times of low interest as long as interest rates are positive. Basically, DCF has two methods namely Net Present Value (NPV) and Internal Rate of Return (IRR). Net Present Value (NPV) The annual cash flows are discounted and totaled and then the initial capital cost of the project is deducted.   The excess or deficit is the NPV of the project, it goes without saying that for the project to be worthwhile the NPV must be positive and the higher the NPV the more attractive is the investment in the project. Internal Rate of Return (IRR) The IRR or yield of a project is the rate of return at which the present value of the net cash inflows equals the initial cost, which is the same as the discount rate which produces an NPV of zero.   For an investment to be worthwhile, the IRR must be greater than the cost of capital. Advantages of DCF Due to the following reasons, DCF method is identified as a best method for investment appraisal processes; They give due weight to timing and size of cash flow. They take the whole life of the project into consideration. Irregular cash flows do not invalidate the result obtained. Estimation of risk and uncertainty can be incorporated. Use of discounting methods may lead to more accurate estimation. They rank projects correctly in order of profitability and give better criteria for acceptance or rejection of projects than other methods. DCF analysis is the best method to evaluate investment over other methods. A survey carried out by the Arnold & Hatzopolous (2000) and Graham & Harvey (2000) to identify the practical usage of investment appraisal techniques among the large manufacturing firms of UK have revealed that NPV and IRR are behind its rivals in practice. Therefore, they have commented that there is a gap between usages of appraisal techniques in practice and theoretically. Kaplan (1986) argued that conventional DCF method should be used to evaluate investments based on the financial data available. He also stated that if the net results of the cash flows results in a negative NPV, then it become necessary to estimate how much the annual cash flows must be increased before the investment gives a positive net present value. Kaplan goes on to argue that the management must then decide if the value of the intangible benefit will be greater than this figure. If the answer is yes, then he project would meet the criteria for acceptance. According to Koller (2006), there are errors which may occur frequently during the application of DCF techniques. He also concurs that DCF model should be economically sound and transparent to get the expected output. Economically sound means that the company’s return and growth are consistent with the company’s positioning and the ample empirical records. Transparent means you understand the economic implications of the method and assumptions you choose. As per his comment, most DCF models fail to meet the standards of economic soundness and transparency. Following are the frequent errors identified by Koller, Forecast horizon that is too short. One of the most criticisms is that any forecast beyond a couple of years is suspect. Uneconomic continuing value. The continuing value component of a DCF model captures the firm’s value for the time beyond the explicit forecast period which can theoretically extend in to perpetuity. Cost of capital. You will rarely see a grate equity investor point to an ability to judge the cost of capital better than others as the source of meaningful edge. But you do see many DCF models debilitated by non sensible cost of capital estimates. Mismatch between assumed investment and earnings growth. Companies invariably must invest in business in order to grow over an extended period. Return on investment (ROI) determines how efficiently a company translates its investments into earnings growth. So that investor must treat the relationship between investment and growth carefully. DCF models commonly underestimate the investment necessary to achieve an assumed growth rate. Improper reflection of other liabilities. Most liabilities, including debt and many pension programs are relatively straightforward to determine and reflect in the model. Some other liabilities like employee stock option are trickier to capture. Not surprisingly most analysts do a very poor job capturing these liabilities in an economically sound way. Discount to private market value. The discount to private market value model lacks sufficient transparency because it conflates the base and synergy cash flows. Double counting. Models should not count a rupee of value more than once. Unwittingly, DCF models often double count the same source of value. Scenarios. Probably the most often cited criticism of a DCF model is that small changes in assumptions can lead to large changes in the value. Because of such errors, they have commented that an investor must ensure that the models are economically sound and transparent to apply DCF models to the real world. Drury and Tayles (1997) argue the uses and limitations of DCF analysis in a different view. They have done a survey on application of DCF method based on 886 UK manufacturing organizations. In that survey, they identified that companies are under investing because of the misapplication and misinterpretation of DCF techniques. That survey showed that smaller organizations place less emphasis on formal appraisal techniques and the staff responsible for making capital investment decisions are likely to be involved in the invitation process. Hence they will have detailed “knowledge of the business” and intuitive managerial judgment. The survey findings also indicated that non-discounting methods continue to be used by both smaller and large organizations. Firms are accountable for rejecting worthwhile investment because of the improper treatment of inflation in the financial appraisal. Inflation affects both future cash flows and the cost of capital that is used to discount the cash flows. It must be noted also that inflation is likely to affect different components of cash flows in different ways. Inflation also affects the cost of capital because investors require higher monetary returns to compensate for inflation. Thus real cash flows should be discounted at a real discount rate or nominal rate. In order to ascertain how inflation was dealt with in financial appraisal they asked from the respondent to specify whether real or money discount rate used to discount the cash flows. In that case 49% of respondents were understating the IRR by using current or real cash flow estimates to compute the IRR and then comparing the resulting return with a normal discount rate. Results were almost similar to largest and smallest organizations. Therefore, it is important to ensure that inflation is dealt with correctly in financial appraisals. Another misapplication of DCF analysis is the use of excessive discount rate for investment appraisal. During that period, there was debate on UK companies for using high discount rates to appraise investment and as a result these companies were in danger of under investing. According to their survey, they have identified approximately 50% of respondents are using nominal and real discount rate more than 19%. It showed majority of respondents use rate significantly in excess of those calculated above for average risk projects. These findings show that many companies in UK were using excessively high discount rates. Advanced Manufacturing Technological In case of Advanced Manufacturing Technological (AMT) investments, different researchers have various ideas because AMT investments generate more benefits on financial and non financial terms as well. Benefits like quality improvement, manufacturing flexibility, higher level of customer service and delivery, shorter lead times and greater product innovations cannot be quantified but are distorted by the DFC analysis. It means that investment in AMT projects often fails because of non financial benefits which are difficult to quantify or either understated or frequently omitted. Meredith & Suresh (1986) argue that the financial appraisal methods used by industry to evaluate investments may be inappropriate on their own for today’s high technology business environment since they fail to capture many of the strategical benefits from important AMT projects. Therefore, he suggested three stages of appraisal techniques which can be identified as Flexibility, high level of risk and Synergy of Flexible Manufacturing Systems. Flexibility can be identified by way of conventional investment appraisal techniques and at the second stage company must pursue techniques such as value analysis, portfolio analysis and risk analysis. The final stage requires a more strategic justification. Bromwich & Bhimami (1991) had a different approach for the appraisal of AMT projects. In their approach, they attempted to quantify either financial terms or score values of benefits of investing in AMT. Still there is no specifically developed technique to appraise AMT projects. Different researchers have developed different models for appraising AMT projects. Even though there are different models and different arguments, managers still find it comfortable and are compelled to use DCF analysis for their investment decisions. According to the past survey carried out by Lawrence, Gary & Williams (1978) which inquired about the capital budgeting techniques employed by large US firms and computation of the discount rate and cash flows, the data gathered showed that 65% of the respondents were applied IRR and 56% uses NPV method. Over 86% of the respondents use either IRR or NPV or both. Another survey carried out by Pike (1996) on capital budgeting practices of large UK companies between 1975 and 1992 reported a substantial increase in the usage of discounted cash flow. According to the survey, it has identified 75% and 81% UK firms are applying NPV and IRR respectively. In a recent study carried out by the McIntosh (1993) to ascertain whether or not DCF technique is used by property investors as an investment decision making tool among the major property investors in Australia. It was reported that 75% of the respondents always use DCF and 25% usually use DCF analysis in the valuation of properties over $25 million. The survey carried out by the Sangster (1993) among the 500 largest Scottish companies to ascertain currently used techniques for capital investment appraisal. His findings indicated that companies are using several appraisal methods together, and application of discounted cash flow techniques is becoming more sophisticated. Although the survey does not directly indicate the use of DCF techniques for valuing property investments, it does suggest that the DCF technique of appraising investment is an accepted and widely used method by investment appraisers. Due to these research findings it can noted that there is an ongoing debate among managers for using DCF analysis for their investment decisions. And there is an unfilled gap for the uses of DCF analysis which is the reason which prompted the researcher to identify other theories that can be used to fill the gap in literature that exists. This literature needs much more careful planning. You need to divide it into distinct stages with accurate headings to guide the reader. This does nit read very well, because it is not clear what you are doing and where you are going. Read More