1. Investment Appraisal should add value to the business organization? Do you agree? Critically analyze the main discounted cash flow techniques available to management. Capital investment is one of the most important areas of company’s long term decision making. A firm invests huge amount of funds and resources in anticipation of increasing its profitability. To endure that only profitable projects are undertaken, there needs to be an assessment through investment appraisal.
This assessment will forecast the cash inflows and outflows resulting from the investment, cost of obtaining capital to finance the project and risks associated with the project.
Investment appraisal is a method for evaluating the financial and non-financial factors to find out the financial viability of a certain investment opportunity. As we know the shareholders, as owners of a company expect attractive return for their investment in the company’s shares.
Companies would only be able to give out attractive returns and add value to shareholder’s value only if they undertake profitable investment projects.
Therefore, investment appraisal process is extremely critical to ensure that companies undertake projects that are potentially profitable and have positive net present value (NPV). Hence investment appraisal does actually add value to a business organization as it helps determining the profitable investment opportunities.
Investment appraisal process uses various discounted cash flow techniques to evaluate investment opportunities(Vickerman,2007). These discounted flow techniques used by the management to appraise an investment project like; net present value (NPV), accounting rate of return (ARR), payback period and internal rate of return (IRR).
1. Net present value (NPV) The net present value of an investment project is calculated by the comparing the discounted cash flows which are expected from the project and the initial investment in the project.
The difference between the two is known as net present value of a project. The net present value is a traditional method for valuation of a project used in the discounted cash flow measurement process. It is considered as a technically superior investment appraisal method as it analyzes the project according to the real cash flows it delivers to the company. A project with a positive net present value is believed to be economically viable and generally given a go-ahead. A project with a zero or negative net present value is rejected as per this method.
The reason for net present value being preferred by the companies over other methods is because it evaluates the investment opportunities in the same manner as do the company’s shareholders. The NPV method analyzes projects based on its cash flows rather than the accounting profits and it also emphasizes the opportunity cost of money invested. This method is therefore, consistent with shareholder wealth maximization(Zanders, n. d). Net Present Value is used by many companies worldwide as an investment appraisal tool but it has too its limitations.
For instance, in an efficient market a positive NPV, in theory, should lead to a commensurate increase in the value of the company and share price. However, the use of the weighted average cost of capital (WACC) as a discount factor in NPV is only appropriate if there is no significant change in gearing as a result of the investment, the investment is marginal in size, and the operating risk of the company does not change(Zanders, n. d). 2. Accounting Rate of Return (ARR) ARR is based on accounting profit rather than project cash flows.
It allows depreciation to be deducted from total cash flows and than the remaining profit is divided by the project life to calculate the average rate of return(Siciliano, 2003). The Accounting Rate of Return (ARR) is defined as a ratio of profit before tax and interest to capital employed measured over a fixed period of time. Many analysts prefer accounting rate of return over other methods as it gives a basis of comparison of profitability and risk of potential investment projects. The ARR is often used by companies to analyze various competing projects according to their reward-to-risk ratio(Huthcinson, 1993).
While accounting rate of return is a useful investment appraisal tool but unlike NPV it does not consider the time value of money and fails to take into account the likely return on other traditional investment opportunities. This means that it renders a rather unrealistically high level of return for capital investment over other means of financial investments. ARR ignores the cash flows of the project and focuses only on the accounting figures. It does not take into account the timings of profits and is very subjective. ARR also ignores the life of the project and the size of investment.
3. Pay back period Payback period is an investment appraisal tool that determines that how long it will take for a certain project to cover pay back or cover its cost. While Payback period method an easy and simple method to use for appraising a project, it has its limitations which is why it’s not the commonly used tool for investment appraisal. Payback period method ignores the time value of money invested in the project as well as it does not measure profitability because it does not take into account the benefits occurring beyond the Payback period. 4. Internal Rate of Return (IRR)
This is the rate of interest that discounts the project cash flow to the net present value of zero. Internal rate of return is used where companies compare multiple investment opportunities against each other. Unlike NPV, which analyzes investments in terms of amounts of profits, internal rate of return seeks to determine the viability of a project in terms of its percentage of profit. Internal rate of return is the discount rate that brings the projects net present value to zero. The internal rate of return can then be compared with the company’s cost of capital (Narayanan & Nanda, 2004).
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