NATURE AND STAGES OF INVESTMENT APPRAISAL
- Replacement Investment
- Investment for Expansion
- Product Improvement/Cost Reduction
- New Ventures
- Strategic Investment – may satisfy overall objectives but might not satisfy normal financial criteria.
- Statutory Requirements/Employee or Community Welfare – may not produce a positive NPV but may be essential.
Ideas may generate from all levels of the organisation. Initial screening may reject those that are unsuitable – technically/too risky/cost/incompatible with company objectives etc. The remainder are investigated in greater depth – assumptions required regarding sales, costs etc./collect relevant data. Also consider alternative methods of completing projects.
Identification of expected incremental cash flows. Measure against some agreed criteria – Payback/Accounting Rate of Return/Net Present Value/Internal Rate of Return. Consider effect of different assumptions – Sensitivity Analysis or other techniques. Consultation with other interested parties (particularly if great organisational and/or technological change) – accountants/production staff/marketing staff/trade unions etc.
Submit to appropriate management level for approval/rejection/modification. The larger the expenditure, the higher the management level.. Reappraise investment – reassess assumptions and cash flows (e.g. check for any “bias” in estimates)/evaluate how investment fits within corporate strategy and capital constraints (if any). If budgetary or other constraints exist rank as to how essential (financial and non-financial considerations).
- Monitor & Control
Regularly review to ascertain if any major variations from cash flow estimates. If significant variations – consider continuation v abandonment. Post audits (one or two years after implementation!) useful – encourage more realistic estimates at evaluation stage/help to learn from past mistakes/basis for corrective action to existing investments.
INVESTMENT APPRAISAL TECHNIQUES
There are many techniques for evaluating investment proposals. These can be broadly classified as:
Accounting Rate of Return (ARR)
Discounted Cash Flow
Net Present Value (NPV)
Internal Rate of Return (IRR)
Definition: The time taken in years for the project to recover the initial investment.
The shorter the payback, the more valuable the investment.
Although of limited use it is the most popular technique.
It is often used in conjunction with other techniques.
It may be used as an initial screening device.
- Calculation is
- It is easily understood
- It gives an indication of
- It gives a measure of risk – later cash flows are more uncertain.
- It considers cash flow rather than profit – profit is more easily manipulated.
Cash flows after the Payback Period are ignored.
It ignores the timing of the cash flows (“Time Value of Money”).
• No clear decision is given in an accept/reject situation
- Calculation is simple.
- It is based upon profits, which is what the shareholders see reported in the annual accounts.
- It provides a % measure, which is more easily understood by some people.
- It looks at the entire life of the project.
- It is a crude averaging method.
- It does not take account of the timing of the profits.
- It is based on accounting profit which can be manipulated by creative accounting.
Shareholders’ wealth is determined ultimately by cash.
- Various definitions are used.
Discounted Cash Flow (DCF)
The main shortcomings of the non-discounting techniques of Investment Appraisal can be summarised as:
they do not allow for the timing of the cash flows/accounting profits
they do not evaluate cash flows after the payback period
Internal Rate of Return (IRR)
The NPV method produces an absolute value (RWF). A positive NPV indicates that the project earns more than the required rate of return and should be accepted; a negative NPV indicates a return less than the required rate and rejection of the proposal.
The IRR is another discounted cash flow technique. It produces a percentage return or yield, rather than an absolute value. It determines the discount rate at which the NPV would be zero -where the present value of the outflows = present value of the inflows. It can, therefore, be regarded as the expected earning rate of the investment.
If the IRR exceeds the company’s target rate of return it should be accepted. If less than the target rate of return it should be rejected.
The IRR can be estimated by a technique called ‘Linear Interpolation’. This requires the following steps:
- Calculate two NPV’s, using two different discount rates.
- Any two rates can be used but, ideally, one calculation will produce a positive NPV and the other a negative
- Choosing the discount rate is a ‘shot in the dark.’ However, if the first attempt produces a positive NPV, generally a higher discount rate will be required to produce a negative NPV and vice versa.Advantages
- Often gives the same decision rule as NPV.
- More easily understood than NPV.
- Doesn’t require an exact definition of r in advance.
- Considers the time value of money.
- Considers all relevant cash flows over a project’s life.
- Relative, not absolute return – ignores the relative size of investments.
- If a change in the sign of the cash flow pattern, one can have multiple IRR’s.
- NPV is much easier to use for benchmarking purposes in a post-audit situation then IRR.
- It looks at projects individually – the results cannot be aggregated.
- It cannot cope with interest rate changes.
DCF Techniques V Non-DCF Techniques DCF techniques have advantages over non-DCF techniques:
- They allow for the ‘time value of money.’
- They use cash flows, which result from an investment decision. The ARR technique is affected by accounting conventions (e.g. depreciation, deferred expenditure etc.) and can be susceptible to manipulation.
- They take account of all cash flows. The Payback Period disregards cash flows after the payback period.
- Risk can be easily incorporated by adjusting the discount rate (NPV) or cut-off rate (IRR).
Advantages of IRR Compared to NPV
It gives a percentage rate of return, which may be more easily understood by some.
To calculate the IRR it is not necessary to know in advance the required rate of return or discount rate, as it would be to calculate the NPV.
Advantages of NPV Compared to IRR
It gives an absolute measure of profitability (RWF) and hence, shows immediately the change in shareholders’ wealth, this is consistent with the objective of shareholder wealth maximisation. The IRR method, on the other hand, ignores the relative size of investments.
It always gives only one solution. The IRR can give multiple answers for projects with nonconventional cash flows (a number of outflows occur at different times).
It always gives the correct ranking for mutually exclusive projects, whereas the IRR technique may give conflicting rankings.
Changes in interest rates over time can easily be incorporated into NPV calculations but not IRR calculations.
- RELEVANT CASH FLOWS
In an examination question you will be given much information regarding the impact on the organisation of a new investment proposal etc. Some of the information may not be relevant to the decision and it is important that you are able to figure out which flows are relevant and should be included in an investment appraisal calculation.
The following pointers and simple examples should assist in coping with the various items which are presented to you in an examination:
- CASH FLOWS v PROFITS
Shareholders’ wealth is based upon the movement of cash. Accounting policies and conventions have no effect on the value of the firm and, thus, pure accounting or book entries should be excluded from calculations. The most common of these is depreciation, which should be excluded as it is a non-cash item.
- CASH FLOWS SHOULD BE INCREMENTAL
The effect of a decision on the company’s overall cash flows must be considered in order to determine correctly the changes in shareholders’ wealth.
- SUNK COSTS
Sunk costs (or past costs) are costs which have already been incurred. When making an investment decision sunk costs can be ignored and you need only consider future incremental cash flows.
- OPPORTUNITY COSTS
The use of resources for a new project may divert them from existing projects, thereby causing opportunity costs. These opportunity costs must be taken into account in evaluating any new project.
- INTEREST COSTS
In many examination questions you will be presented with all the costs of the proposed project. These may be presented in the form of a standard Profit & Loss Account. One of these costs may be ‘Interest.’ The figure for interest should not be included as a relevant cost because the cost of finance, no matter what its source, is encompassed within the discount rate. Therefore, to include the annual interest charge as a relevant cost and to also discount the cash flows would result in double counting.
- WORKING CAPITAL
Where the project requires an investment of, say RWF50,000, for working capital it should be remembered that working capital revolves around continuously in the project (e.g. purchase of raw materials, which are used to manufacture goods, sold and eventually generate cash to enable the purchase of more raw materials etc.. and continuously repeat the cycle). Thus, the RWF50,000 flows back into the organisation once the project ceases.