Traditional Investment Appraisal Techniques Essay
Traditional Investment Appraisal Techniques
“If you can’t measure it, you can’t manage it”. This basic principle of Peter Drucker is nowadays especially important when it comes to the valuation and management of strategic investments, which have the potential to bring sustainable change to the business processes of a company. When it comes to the process of assessing strategic investment proposals through investment appraisal techniques there might be doubts about the capability of traditional methods to recognize strategic intangible benefits which might be difficult to measure. Mainly it has been argued that the overconfidence on financial appraisal methods may lead to a predisposition against strategic investment projects, thus acting as a hurdle for business innovation (Phelan 1997, as discussed in Alkaraan and Northcott 2006, p. 150). Therefore this review aims to discuss this matter by analysing the scientific perspective on traditional techniques and new approaches. Furthermore it will analyse the development of the investment appraisal practise through recent studies about manufacturing companies in the UK, Sweden and Italy.
Shortcomings of traditional approaches
Many new investments in the manufacturing industry improve the production processes leading to higher flexibility, efficiency as well as reliability and consistent quality of products, shorter lead times, simplification of design changes and solve environmental issues (Nasarwanji et al. 2009, p. 2, Jonsson 2000, p. 1466). Other strategic benefits might be creating competitive advantage, improve organizational learning or the responding to customer needs (Kaplan 1991, p. 215). While some of these strategic benefits can be quantified and therefore be measured others may be difficult to value or estimate in financial terms. Therefore it might be possible that such strategic benefits are not included in the calculations of traditional models like the payback method, return on assets or investment, internal or annual rate of return or the present value. This circumstance could make it difficult to justifying necessary new manufacturing technologies (Alkaraan and Northcott 2006, p. 152; Dempsey 2003; Covin et al. 2001; Lefley 2000, p. 29; Adler 2000, p. 16; Carter 1992, p. 59).
Another flaw is the inherent and biased short-term focus of the traditional methods because manufacturing investments often require long lead times to become fully operational and thus realizing their benefits. The short-term bias of the DCF-methods is intensified by the failure of adjusting the discount factors to the changing inherent risk in each different project phase (Alkaraan and Northcott 2006, p. 152; Adler 2000, p. 16; Carter 1992). Although the DCF-method is considered as the most effective technique for the evaluation of investment opportunities (Boston 2000, p. 35), it is argued that one can rarely predict longterm cash-flows accurately. Furthermore hurdle-rates are often inappropriate because of the usage of extremely high discount factors, thus leading to a minimization of the long-term benefits and the rejection of strategic investment projects (Alkaraan and Northcott 2006, p. 152; Adler 2000, p. 16; Carter 1992).
Critics also argue that the common assumptions underlying the status quo alternative against which the investment is being compared are wrong. The status quo or the current competitive position will not remain unchanged if the investment is rejected because the cost, quality flexibility and innovation level of the competitors are unlikely to remain at the same level (Adler 2000, p. 17; Carter 1992).
Additionally Adler is criticizing the inconsistency with regard to the treatment of the inflation in the calculations because there are no allowances made for the increased cash flows based on the future increased sales prices (Adler 2000, p. 17). In order to solve the inherent flaws of the traditional investment appraisal techniques and to include an additional evaluation of advantages in enhancing the competitive strategy, it is possible to distinguish two basic approaches in the scientific literature which will be discussed in detail during the following chapters.
Modification of traditional approaches
The first approach basically intends to modify the implementation of the existing traditional approaches. Proponents of this approach simply believe that the traditional appraisal techniques are still the best to use and argue that all the criticized flaws are just consequences of their incorrect usage (Adler 2000, p. 8; Kaplan 1986).
Next to the suggestion of scholars to include the inflationary factor properly in the calculations of the cash flows (Boston 2002, p. 35), they complain about the use of excessively high discount rates. Pointon suggested that this error is due to the use of the arithmetic mean for calculating the equity risk premium (ERP) because the arithmetic mean rate of return could even be positive if the overall rate of return for a period is zero. Instead one should use the geometric mean which calculates a more conservative ERP for UK between 3 to 5 per cent (Pointon 2002, 29). This statement was supported by publications during the financial crises, suggesting the same range (Inkinen et al. 2010). However it should be mentioned that the ERP for UK increased after the overcoming of the crisis ranging recently between 6 and 7 per cent (Miles 2013, p. 5).
Ramasesh and Jayakumar (1993) proposed to divide the calculation into four consecutive stages, where commonly made mistakes are being corrected, strategic benefits which are soft or uncertain are getting measured by trying to attribute them values and learning curve benefits are recognized. If the NPV is still negative at this point they suggest to undertake a residual strategic benefits qualitative analysis on the last stage (Adler 2000, p. 19). The risk by applying this method in the practise might be the undesirable interpretation of these stages as a merely search for additional value in order to justify the investment proposal even if it leads to unrealistic assumptions.
The methods or models of the other main approach are differing significantly from the described suggestions because they rely on strategic analytical frameworks which are especially aiming at evaluating strategic benefits in the long-term run of a business. Introduction of new analytical approaches
In 1997 Lefley introduced the so called Financial Appraisal Profile (FAP) model which consists of three investment evaluations which are done by an appraisal management team. The financial appraisal aims at providing a financial perspective on the project through calculating the NPV and other financial key performance indicators (Lefley 2000, p. 28). The project risks are identified by calculating the Risk Index where its degree is influenced by the likelihood of occurrence and the degree of impact. The last evaluation part calculates the Strategic Index by examining the key strategic benefits through the corporate management before applying a corporate ranking to take the different levels of importance into account (Lefley 2000, p. 29). This approach could be helpful for the corporate management to monitor their investment strategies by comparing the risk commitment to each project in connection with the expected financial and strategic benefits.
The multiattribute decision model (MADM) develops a general measure of utility based on the important financial and non-financial factors in evaluating an investment (Adler 2000, p. 9; Carter 1992). The ratings assigned to the factors are based on the expectation if the alternative will decrease, increase or has no impact on the factors. Additionally the different level of importance of the factors to the organization are considered by applying a weight (Adler 2000, p. 9). Furthermore it is possible to multiply the score with the expected probability of achievement (Adler 2000, p. 10).
The value analysis and analytical hierarchy model (AHM) are differing from the MADM in the way of how they collect the necessary input information. The value analysis uses the Delphi method which implements an iterative process of collecting single group members’ opinion providing it as group-level information to gain a group consensus (Adler 2000, p. 20). The AHM asks managers for a pairwise comparison between the factors’ utilities and builds up a matrix with the responds. Afterwards the comparisons are analysed by mathematical models such as vector analysis (Lloyd 2001, p. 364). The AHM also allows to check the coherence of the given scoring (Adler 2000, p. 21).
With the strategic cost management approach Shank (1996) attempts to broaden the horizon of conventional financial appraisal methods by adding the analysis of the implications of adopting an investment proposal on the value chain, competitive advantage and cost drivers of the firm (Adler 2000, p. 19). Hence this tool enhances the coherence between the execution of an investment and the formulated strategies of the firm, their implementation and development of strategic controls.
As one can see the scientific community developed a wide range of new analytical frameworks, thus enabling to include the strategic aspects of an investment decision into the conventional financial appraisal or departing from it significantly by using new strategic analysis frameworks. Nevertheless the important question here is if these new models are adopted by the management and therefore having an impact on the business practise of investment appraisal.
Recent state of business practise
Alkaraan and Northcott conducted a study of practise about the strategic capital investment decision-making among large UK manufacturing companies. They revealed that when it comes to the financial analysis of investment projects the NPV is the most used technique. Besides that the findings suggested that the usage of the method is independent of the nature of project which is being evaluated. This confirms the view of Abdel-Kader and Dugdale in an earlier observation (Abdel-Kader and Dugdale 1998, p. 273). Despite of its inferiority the usage of payback method is still widely spread among companies, where 98 per cent of the respondents stated that they use it even in the case of evaluating strategic investment proposals (Alkaraan and Northcott 2006, p. 160).
The still prevailing role of the payback method in all industries is also supported by an older study among Sweden’s largest groups of companies. Besides that companies within the manufacturing industry tend to use DCF-methods more often (Sandahl and Sjögren 2003, p. 51).
Alkaraan and Northcott found empirical evidence that the risk analysis methods are still remaining intuitive and simple, suggesting that risk evaluation is being perceived as a question of professional judgement rather than a detailed formal analysis (Alkaraan and Northcott 2006, p. 164). Despite of the academic endorsement of more sophisticated strategic investment appraisal techniques the findings suggest that they are still not widely applied in the practise of investment decision-making because it is likely that managers judge their practical and conceptual application as too difficult (Alkaraan and Northcott 2006, p. 164). The authors described this prevailing attitude with regard to appraisal of capital as ‘simple is best’ (Alkaraan and Northcott 2006, p. 170).
The philosophy of ‘simple is best’ is also supported by an study of Italian manufacturing companies which rejected the common assumption that firms with advanced manufacturing technologies (AMT) and hence a higher need of strategic investment decisions are using more sophisticated financial appraisal and risk analysis techniques than non-AMT firms (Cescon 2010, p. 24).
Despite of the critics developed from the scientific community about traditional financial investment techniques the empirical evidence does not show a high level of integration between strategic and financial analysis approaches in the business practise. Partly adjusted traditional investment appraisal techniques are still dominating the evaluation of investment projects, while risk analysis approaches remain relatively unsophisticated. The emergent strategic investment analysis tools developed by scholars have very little impact on practice because they are often viewed as too complex and theoretical. The underlying maxim of nowadays appraisal of investment projects seems to be ‘efficient and simple practicability’. Intuition and judgement also play an important role in the evaluation and analysis of the connections between the strategic dimensions of capital investments and their financial impacts on the business performance.
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