Investment Appraisal Techniques - Essay Example

Investment Аррrаisаl Tесhniquеs Name: Institution: Investment Аррrаisаl Tесhniquеs Introduction Manufacturing companies constitute a significant aspect of the business scene considering the role they play in availing goods as services in different supply chains. Although most people associate manufacturing with only delivery of goods and services to attain their objectives, they may accrue more from innovative investment. Investment forms a significant part of building the business brand therefore enabling constituent growth (Sangster, 1993). Through investment, manufacturing companies can focus on purchasing new materials such as machinery and incentives. In this case, such companies can ensure that it cuts costs on manufacture such as reducing the energy employed to accelerate productivity. Businesses often employ a range of techniques to identify with the most appropriate method of investment appraisal. Competition has become a significant issue that most manufacturing companies aim at countering. Attaining competitive advantage may be approached through investment appraisal. Investment appraisal is the planning process that is used to determine whether the long-term investments that include new machinery, replaced machinery and new plants are worth the funding and investment. Investment appraisal aims at increasing the value of the business to its consumers through allocating resources for major capital investment and expenditure. Discussion Accounting Rate of Return The accounting rate of return is among the common techniques used to calculate appraisal investment in manufacturing companies. It compares the profits made from an investment to the amount of investment that is needed. The ARR is usually calculated as the standard yearly profit of investment that is expected against the life of an investment compared to the average quantity of capital invested (Sangster, 1993). For instance, if a project requires an average investment of £100,000 and is expected to produce an average annual profit of £19,000, the ARR would be 19 per cent. Apple Inc. made a projection of 25% stock prices from $128 to $160. The company earnings in the near years is considered of higher quality with better cash flows in the future. It allows companies to examine the scope of viability and profitability that is accrued against the projected revenue less any invested amount. Within the lifespan of a project, companies often calculate the AAR quarterly, semi-yearly or yearly. In case the project may take an undetermined number of years, AAR is calculated through identifying the average in investment and revenue. Manufacturing companies can set a higher AAR that will translate positively to the nature of the investment. If the ARR is equivalent to or larger than the required rate of return, the project is deemed acceptable. However, if it is less than the desired rate, it should be rejected and an alternative identified. Advantages Businesses often use criterion rates available in the AAR model that highlights the standardized condition of return that any investment needs to meet. In this case, it allows manufacturers to value the need against the desirable rate to choose the most appropriate strategy of investment. A major advantage of the technique is the state of easiness of calculating the return on investment (Sangster, 1993). Considering that the profits are recorded in the accounting books, it is possible to calculate the accounting profits. It only considers the total profits and savings over the complete cycle and life of a project. Therefore, acquiring the values deepened on the estimated or identified costs of the investment such as modern machinery and the expected return. This technique also considers the theory of net earning. This concept ensures that earnings after tax and depreciation of purchasing and using the equipment or machinery are accounted in the returns. Calculating the earnings enables manufacturing companies to account for any investment through the return. It is an important aspect in the appraisal procedure. The concept of AAR also incorporates a comparison of the new product and project to the cost of a reducing project in a competitive aspect. This method enables manufacturing companies identify with the alternative direction of investment that will generate a competitive advantage and avoid any ventures that may cause the business to experience loss (Pike, 1996). For instance, investing in transport vehicles in manufacturing companies and investing in rail transport may create different returns. It offers a distinct argument of the future profitability of a project as well as the position of the company in a competitive market. Compared to other techniques, the method considers the profit concept in calculating the rate of return. Disadvantages Although the method has been applied in a variety of companies, making conscious decisions based on the return on investment and ARR may prove challenging. Different from additional methods of investment appraisal, ARR is based on profits other than cash flow. Therefore, it is affected by biased, non-monetary items such as the rate of decrease used to compute profits. The AAR technique ignores the importance of time particularly selecting the alternative uses of funds. The decision making process requires timely and concise decisions that will generate desirable returns (Pike, 1996). Similarly, the fair rate of return cannot be valued based on ARR considering that it is the discretion of the management. They do not account for the cash inflows that are considered more important than the accounting profits and the records. It also fails to consider the concentration of profits in connection with the time span of the project. For instance, a return on investment of 30% in five years may be considered better than a return of 10% in two years. Because of this, the average investment or initial investment may remain the same whether investment has a life period of five years or two years. Payback Period The payback period is a technique that assesses the investments based on the length of time that it would take to repay back. The payback period is calculated through identifying the initial investment cost against the annual cash flow from investment. Smaller businesses tend to employ this technique in calculating the worthiness of investments such as machinery and modern plants. The payback period of any investment or project is a relevant determiner of whether a manufacturing company may take up a certain investment (Pike, 1996). Investments that take a considerably longer payback period are often considered as poor investments. Similar to the activities carried out by manufacturing companies, corporate analysts need to evaluate the value of different investments before engaging in budgetary systems. In the payback period, the time value of money is taken into account considering the different economic changes that are experienced in different countries. Based on this value, the idea that monetary asset in the contemporary period is more valuable than in the future. In this case, the opportunity cost accrued during the time of implementation and the future needs to be accounted. Therefore, the payback period ensures that companies do not incur the opportunity cost. For instance, if a piece of machinery in the manufacturing plant requiring an investment of £100,000 is expected to offer an annual cash flow of £25,000, the payback period would be four years. Apple Inc. uses the payback period at a minimal rate as it approaches various transitions. The addition of Beats into the Apple market at a cost of $3.2 billion is likely to warrant a shorter payback period of less than three years. Advantages A shorter payback period translates to an elevated return on the capital investment. Most companies have a maximum satisfactory payback period and will only consider those projects whose payback period is less than the target number of years. The advantage of this technique is the easiness of calculation and understanding. Considering that the method focuses on projects that ascertain a quick and timely payback, it helps managers and companies avoid giving too much load to perilous and long-term projections. Manufacturing companies tend to employ workers with diverse skills in evaluating the capital requirements of projects. Therefore, through reducing the evaluation of a project or investment to a minimal number of years is an understandable and applicable process (Pike, 1996). Manufacturing companies require offsetting the increased balances and issues that often arise in the different plants and firms. Because of this, identifying projects that provide the fastest return on investment is important for such companies. Similarly, companies that deal with limited cash flow and a limited budgetary system need to recover before embarking on other investments. This method is rather favorable for projects that have smaller investments that do not require a vigorous economic analysis. Disadvantages The payback period technique has a number of distinct disadvantages. It fails to consider the tie value of money and adjust the corresponding cash flows as desired. For instance, under the payback system, projects and investments are considered equally attractive if they have similar payback despite the time it may take. For manufacturing companies, it ay become a liability if it purchased machinery at the same time and expected certain amount of return at different periods (Lefley, 1994). The rate of disintegration and usage ay imply that the machinery may not last long enough the complete the identified scope of return. Similarly, the machine may be more valuable in terms of efficiency and productivity therefore rendering the investment invalid. Payback technique also fails to consider the monetary inflows that occur after the payback period. This renders the manufacturing company unable to compare the rate of profitability of one project compared to another. For instance, two proposed investments on manufacturing machinery might have parallel payback periods but cash inflows from one machine might gradually drop subsequent to the end of the payback period. Cash inflows from the other machine may increase for several years following the end of the payback period. The analysis of the payback period seems diminutive in faulting to explain the density of cash flows that can happen with capital investments. Discounting Cash Flow Companies use the discounted cash flows (DCF) to measure the attractiveness of a business investment. This system employs a future free cash flow projection system that discounts the values to determine the present value estimate (Lefley, 1994). With the present value, a company is able to determine the viability of the return on investment. Considering that some investment projections may have extended periods, manufacturing companies need to present their cash flows in two forms. Their cash flows are presented in discounted form and non-discounted form. It proves effective while identifying the time value of money especially in longer terms. In the discounted cash flow, the present value is evaluated to be below the future value. However, this does not apply to investments and projects in the present (Lefley, 1994). Longer period preceding any cash flow event implies an increased present value of future cash. The net present cash flow of a cash flow system is calculated through identifying the total discounted value of a series of cash flow events into the future. DCF is considered vital when evaluating or comparing investments, action proposals or purchases by manufacturing companies. Apple Inc. employs the discounted cash flow within a two stage model to calculate its intrinsic values considering its higher predictability level above one-star. Advantages DCF analysis is extensively used in asset finance, real estate development, corporate financial management and copyright valuation. Companies prefer this technique owing to the intrinsic stock value that is provided during the valuation. This method uses multiples that compare stocks in the manufacturing sector. Alternatively, the technique also provides alternatives that are plausible while calculating the present and future stock value. Relative alternative measures that include price earnings and price to sales ratios are employed which prove easy to calculate and determine (Lefley, 1994). In this case, manufacturing company investments are redirected from rather expensive investments that may strain the performance of the company. The technique is simple to understand and apply and may be employed as a systematic check where the stock prices of the company are incorporated into the DCF model to identify how the company would develop its stock price to gain the stock price. Companies can determine the source of its value relating it to the share price. Disadvantages Considering that technique is a valuation tool, it depends on the company inputs that are employed in the valuation channel. Once the inputs are changed, the valuation of the company changes and offers an inappropriate value of investment. This may have an adverse const to the business, as it will need to offset the imbalance created with undesired investments. DCF models seem to fluctuate constantly with time therefore changing the operation and market strategy of the business (Lefley, 1994). Fair value is affected by the free cash flow forecasts, discount rates and the infinity growth rate. Predicting the future cash flows may also be a strenuous task that is determined by the ability of the manufacturing business to make conscious and concise decisions. For instance, if a company wants to purchase manufacturing equipment, it needs to be confident about its ability to ascertain positive future returns. Investment Risk and Sensitivity Analysis During investment, it is possible that companies identify potential threats that may affect performance and financial capabilities. In this case, it is important to develop a realistic risk assessment technique that will counter any undesired investment returns. The investment analysis and appraisal techniques involve making assumptions on the performance of a project or investment (Dayananda, 2002). Although this method of capital budgeting is common among many small businesses, the estimated calculations may be inaccurate causing the project to produce undesired results. For instance, purchasing manufacturing equipment may reflect profits in the initial years of operation dependent on the economic situation. Sensitivity examination helps a business approximate what will happen to the investment if the assumptions twist out to be undependable. It involves altering the postulations made in calculation to see the impact on the project's assets. As one of the fastest growing companies, Apple Inc. stock prices are approached through this method. This owes to the frequent 40% drops in stock prices experienced in 2013 and 2014. Advantages The advantage of sensitivity analysis includes its state of simplicity. The theories and calculations applied in determining the risks and threats includes a conscious and focused approach as well as a positive decision making team. Compared to other appraisal techniques, risk analysis and sensitivity does not require any appreciation of the theories before implementation. The technique directs the managerial efforts that will ensure tasks, funds and duties are distributed through identifying a hierarchy of needs (Dayananda, 2002). Similarly, the appraisal technique assist the business merge the investment with the missions and objectives of the investment. The technique is also a source of planning information by ensuring that the management has the appropriate data after assessment to ensure professional application of the investment technique. Quality checks may be done frequently using this technique while implementing quality control in investment. Disadvantages Investment risk and security analysis assumes that the variables within the system are independent of each other. For instance, the strategy assumes that prices of the materials will not affect the prices of other variables. It focuses on achieving a single component of the system that may render it inapplicable (Dayananda, 2002). The method is not considered relative considering that it accounts for the changes in variables only. It fails to account for the probability of change occurring. The technique may not be considered as an optimizing strategy considering that the information and calculations offered require extensive analysis. Recommendations Before engaging in any appraisal technique, it is important for manufacturing companies to consider a number of factors. The financial aspect of any technique dictates the scope of allowance that companies may engage in. Although investments in product development, research and development, expertise and new markets can open up exciting growth opportunities, it is important that companies avoid stretching limited company financial resources by restricting the pursuing of other factors such as institutional funding at the expense of the business (Dayananda, 2002). In this case, the managers and owners of any manufacturing company are tasked with the duty to ensure they make conscious decisions regarding the investment appraisal technique. Furthermore, while investing in projects such as development of diverse manufacturing plants and transport infrastructure to account for expansion, companies need to employ appraisal techniques when considering investments. For instance, while buying new machinery that is rather expensive, companies should ensure that they are more efficient and use cost effective supplies. Furthermore, the applicable technique needs to be flexible, account for a larger market share and ascertain quality assurance. Conclusion Investment appraisal is considered one of the most important aspects of any manufacturing company. Such companies often engage in investment owing to the increased level of changes that are associated with the delivery of manufactured goods and services. Machinery is one of the elements that require constant repair and replacement if the company is to yield more from its business activities. Therefore, employing the necessary investment appraisal techniques that include the accounting rate of return, the payback period, the discounting rate of cash flows and the investment risk and sensitivity analysis is an important part of any investment project or procedure. References Dayananda, D. (2002). Capital budgeting: financial appraisal of investment projects. Cambridge University Press. Lefley, F. (1994). Capital investment appraisal of advanced manufacturing technology. The International Journal Of Production Research, 32(12), 2751-2776. Pike, R. (1996). A longitudinal survey on capital budgeting practices. Journal of Business Finance and Accounting, 23, 79-92. Sangster, A. (1993). Capital investment appraisal techniques: a survey of current usage. Journal of Business Finance & Accounting, 20(3), 307-332. Read More