Finance

Companies in todays world are always looking at ways to develop and change. This compels the senior management to be counter a variety of different proposals ranging from expansion decisions to assets acquisition decisions, not only this but certain contracts for services are also long term investments if they offer cash flows beyond one year. Choosing between investment appraisal decisions is of critical importance as the companies only have limited resources available with investors (shareholders and banks) only willing to offer limited amounts of finance.

The investment appraisal decisions are critical because such decisions impact availability of resources and shareholders wealth. This is also because such decisions involve an element of risk as the expected future cash flows associated with projects  investments are always uncertain.

Investment appraisal decisions effect on effectiveness and efficiency of the operations and profitability of the company in periods beyond current year, secondly one of the major concepts in modern financial managements associates the market value of a company as equal to the discounted value of the future cash flows it expects to yield from its investments in projects.

(Richard and Stewart 2007)The investors of a company prefer to get rich not poor, this is why they expect from the managers of the company to invest in every project that is expected to pay more than what it is actually going to cost. (Richard and Stewart 2007)

Drury (2000) stated,  The theory of capital budgeting reconciles the goals of survival and profitability by assuming that management takes as its goal the maximization of the market value of the shareholders wealth via the maximization of the market value of ordinary share.

This articles attempts to evaluate and assess the methods that should be used for the identification of the projects  investments that can add to the market value of the company and satisfy the corporate objectives of the managers.

PROBLEM
Managers often perceive the challenge as to which method should be used as an objective yardstick to evaluate their capital investment projects as investment appraisal refers to a process of identifying investments that result in maximizing the profits of a company from its investments, resulting in an increase to the wealth of shareholders and the companys objective of maximizing profits.

Once an investment opportunity has been identified and the funds have been committed it is difficult to abandon to the proposed investment without incurring significant losses. It is therefore of important that before making a final decision all the projects are critically evaluated.

ADDRESSING THE PROBLEM
Before we proceed to understand the different methods for investment appraisal we must understand various stages forming part of the decision making process for investment appraisal.
(KING 1975)

Triggering the search for an appropriate project.
Screening investment appraisal because it is not practical to appraise all possible investment opportunities.
Definition of the projects alternatives.
Evaluation of the alterative selected.
Transmission of project information.
Making the investment decision.

The appraisal decisions require forecasting for the expenditures required to undertake an investment (initial and over its total life), and the cash inflows a company expects to generate from such investments. Investment appraisal is generally defined as a trade off between current funds for future benefits.

The methods commonly used by the managers for making investment appraisal decisions can be categorized into two basic methods
Traditional Non-DCF methods
Payback method.
Accounting Rate of Return (ARR).
DCF methods
Net Present Value method.
Internal Rate of Return.
Discounted payback.

TRADITIONAL NON-DCF METHODS
A) Payback
It helps calculate the time required by the project to recover the initial investment. Hence it favors projects that offer a quick recovery of the invested capital. The method is a good indicator of measuring risk but not a good indicator of overall profitability and hence can only be used as a first screening method

B) Accounting Rate of Return
Accounting Rate of Return (ARR) attempts to calculate the rate of return offered by a proposed investment and tends to compare it with the companys targeted return for its investments. It is based on the same accounting principles as incorporated in Return on Capital Employed (ROCE) and return on Investment (ROI).
The method however is theoretically inaccurate as it calculated the return based on accounting profits that often include accruals and non-cash items. This violates the most objective manner of using Cash flows to quantify benefits from a project.

DCF METHODS
A) Net Present Value Method
Net present value differentiates between investment projects, recognizing the concept of time value of money. The method accumulated the all future cash inflows and outflows from a project and compares it with the initial investment. If the result gives a positive value then the investment  project is worth undertaking as it will increase the value of the business hence effecting the shareholders wealth.

It gives the answer in monetary values, which makes the comparison easy with other mutually exclusive projects by choosing a project with highest Net Present Value.

However the method is very sensitive to the discount rate used for calculating present values, which involves complex calculations involving WACC, CAPM and other risk adjustments.

B) Internal Rate of Return
Internal rate of return attempts to work out the rate that is earned by an investment over its total useful life. This rate causes the total cash inflows (receipts) from an investment to equal the total investment, hence giving a nil Net Present Value.

This method works on the implicit assumption that a company can reinvest total proceeds from an investment to earn a return equal to the IRR for that particular investment.
If the IRR is greater than the cost of capital for the company the investment  project is undertaken.

C) Discounted Payback
Discounted payback method takes in to consideration the time value of money and calculates the discounted time a project  investment would take to pay for its initial investment based. The method however, fails to estimate how profitable a project  investment would be.

CURRENT PRACTICES
Theory suggests that DCF method of investment appraisal is more superior to the traditional methods, and above that Net Present Value is preferred on Internal Rate of Return.

Managers prefer to use the traditional methods for appraising their investment projects (Payback method and Accounting Rate of Return) and Discounted Cash flow (DCF) analysis to evaluate the results only in financial terms. As seen through the discussion above that generally traditional methods fail to incorporate adjustment for the time value of money. However, DCF methods consider the same, that is they incorporate cash flows that are reduced with the passage of time and it consist with Net Present Value (NPV) approach and Internal Rate of Return (IRR) method.

Most survey authors express concern over the use of traditional methods by the respondents that do not incorporate the effect of time value of money. Dopuch et al. (1974) states it seems reasonable that a discounting approach to investment analysis is to be preferred over a non-discounting approach.
Further Bierman and Smidt (1993) argued that measures which, do not involve the use of discounted cash flow method can give rankings of investments that are obviously incorrect.

Similarly, they argue that among all the methods used by companies for evaluating their proposed projects  investments non-discounting methods are considered inappropriate and that As Brealey and Myers (1991) stated the net present value rule should be employed in preference to other techniques discounting cash flows.

John Graham and Campbell Harvey (2002) in their survey involving 4,400 companies reported that almost 74.9 and 75.5 of CFOs always or almost always used NPV or IRR respectively. In their survey they also highlighted that high leveraged firm were more likely to use NPV and IRR compared with low leveraged firms and that within the high leveraged companies, the companies that paid dividends were also significantly using NPV and IRR than compared with the firms that do not pay dividends. This is in conformity with the signaling effect of the dividend policy most companies peruse.

CONCLUSION
Based on the findings of this study discussing investment appraisal methods and surveys of current practices its evident that most of the organizations use DCF methods for evaluating the financial prospective of the proposed investments. This is because the DCF techniques make use of discounting arithmetic to the express future cash slows from an investment in today monetary value. This helps to determine whether the investment is expected to earn a satisfactory return for the company. In addition to this offer a number of benefits over the other appraisal methods.

They explicitly and systematically incorporate the time value of money concept.

They take in to account all relevant cash flows of the project.