Finance

Introduction
Project investment selection implies various choices between new investment and replacement investment or between make or buy or between buy or lease of equipment or even between widening of product line or diversification and deepening of product line or extension in same product line investments (Bierman, 1993). Such project investment selection involves analysis of the economic and financial feasibility aspects such as the return on investment and risk involved.  As was highlighted in CFO Executive Board (April, 2005), the main reason for an analysis of the project investment proposals is to ascertain where the future profits or cash flows will be the maximum and will redeem the initial investment outlays. Then only will the wealth of the stakeholders be increased and the organizational goals met. The selection of type of investment has to be made based on certain objective criteria known as techniques of capital budgeting.

Technique of Capital Budgeting  1
The Payback or Payout period is a very simple rule-of-thumb approach. As the term suggests the technique answers as to how long will it take to recover the invested capital outlay and hence is always concerned with number of years. With the advent of cash inflows from the project there will come a time when the original financial outlay will be recovered and that is the point when the payback occurs and the duration is the payback period for that investment. While accepting or rejecting a proposal some specific issues may have to be considered. For example, if the firm has a specific requirement that the invested outlay should be recovered in three years, then any project with a payback period less than three years would be preferred to those with longer payback periods. But for mutually exclusive projects which are alternative investments where if one project is taken on, the other must be dropped then the one with the shorter payback would be accepted (Morgan, 2001).

Some of the important features of the payback technique include that it is quite popular because it is very simple to calculate and easy to understand because it is a rule-of-thumb method. This technique places too much emphasis on short term returns and quick liquidity thus ignoring projects with long term sustainable gains. This method does not really show the extent of the profitability of the project because it does not consider the cash inflows after the payback period is attained. The major defect of this method is that it ignores the time value of money. If this gets incorporated than it will have some credibility particularly for high technology industry where the strategic focus is on avoiding obsolescence.

Technique of Capital Budgeting  2
The Accounting Rate of Return on investment or the ROI is just the reverse of the payback method. If we use AAnnual Cash flow IInvestment then Payback period  IA. but if we reverse this ratio and calculate the same in percentage terms, we get AI x 100  ROI. It can be easily seen that the decision rule for applying the payback method is shorter the payback period, more acceptable the project while he decision rule for ROI method is larger the ROI, more acceptable the project. Though the ROI is an established accounting method to compute financial profitability of a project, one may end up estimating different rates of return, depending upon the nature of measures used. For example, Annual Cash flow A for a number of years may be related to investment I such that one may compute the ROI for the project as

 QUOTE   separately, or one may compute  QUOTE  . In the second case, the computation is for the average ROI which may be different from a single year ROI like  QUOTE    the point remains the ROI method may be used by way of accounting convenience rather than accounting convention. More important, similar to the payback method, this ROI method also does not consider the time value of money.  

Technique of Capital Budgeting  3
Over the years the Net Present Value or the NPV method of judging the acceptance or otherwise of a project has gained popularity (Froot, et al. 1995). The basic reason is that the process of discounting of all the future cash flows, including outflows or costs and inflows or revenues, can be converted to their present value. The NPV method gives due cognizance to the fct of time value of money and calculates the result thereof (Michel, 2001). Since capital is being raised and invested to day it will naturally be convenient if there is knowledge of how the sum of all the future net cash flows would appear today and it would help tremendously to judge the profitability of the investment after taking into account the cost of capital instantaneously (Lin, et. al., 2000 pp. 36). This is exactly what the NPV and also the IRR seeks through the process of discounting the cash flows and bringing them down to a common denominator being their present values using a rate of interest which in this case would be the firms cost of capital (Khan, 1993). Even if the firm uses its own funds rather than tapping the market, the profitability or otherwise of the investment should be judged using the market rate of interest as the guide.

Thus the process to judge the profitability and acceptability of the investment involves knowledge about the various inputs like the initial investment, the cost of capital, the net cash inflows, and the life of the project in number of years. Then the next step is to convert the net cash inflows to their PV using the discounting factors given by the cost of capital and then summing up these PVs.  After deducting the initial investment outlay from this the resultant is the NPV of the investment. If the NPV is positive, the project is acceptable and the larger the NPV, the better the project. For mutually exclusive projects, the one with the higher NPV should be chosen (Ehrhardt, et al 2006). The project with the maximum positive NPV will always be the choice of the management as this will yield the maximum cash flows as well as future profits for the organization.

Technique of Capital Budgeting  4
Under the NPV method the initial investment was deducted from the sum total of PVs of all future net cash inflows after using r the discounting factor to arrive at the NPV of the project which would in most cases be positive. But the Internal Rate of Return or the IRR goes a step further and investigates at what r will the NPV  0, that is the sum of PVs at that r of all future cash inflows will equal the initial investment (Project, et. al., pp. 269).

What is that r which will make the NPV  0 Following the NPV analysis above it amounts to this that where the NPV is positive, the value of r will increase to reduce the value of NPV to eventually make it zero and where the NPV is negative, the value of r is too high and accordingly, the cash flows would have to be discounted using a lower r so that the value of the negative NPV would be reduced and the process continued until it reaches zero. The rationale of using IRR, as in the case of NPV, is the same, namely that if everything could be interpreted in todays terms taking a decision would be more easy. If the resultant r is greater than the cost of capital then the investment is worth undertaking. The IRR is defined as the discounted rate r which equates PV of the expected future cash flows to the initial cost of the project. It has to be noted that IRR is a percentage concept while the NPV is a sum, either positive or negative at a given r.

Both these Discounted Cash Flow (DCF) based methods, NPV and IRR have a similar feature that they take into account the time value of money which is their major virtue. It must be noted that of the two, the NPV is a simpler method and provides a logical acceptance criterion. In the case of IRR, the cash flows may not be able to attract a re-investment rate equal to r and yet it may be assumed in the IRR method that cash flows are to be re-invested at the IRR rate. This may be totally unattainable due to the magnitude of the r. Also, the r may not be the true r because if there are negative cash flows in between the years, then the possibility of multiple IRRs may emerge. As a rule-of-thumb the number of times the negative cash flows occur will determine the multiplicity of IRR and this leads to the advantage of using the NPV method. The NPV has its limitations, one of them being the selection of the discounting factor or calculating the cost of capital, because it is very likely that the firms cost of capital will change over a period of time though the pool of borrowed capital may look representative at a particular point of time. Thus because equity capital is much costlier than say debentures, raising the equity base during the course of the project might just change the overall cost of the project. To incorporate the flexibility in fixing the cost of capital in the NPV method, the cost of capital has to be used over a range rather than one fixed for the entire life of the project.

While normally both the NPV and IRR methods will show the same results, in some mutually acceptable investment proposals, there might be different results for the NPV and IRR methods, with the NPV method advocating one proposal and the IRR method advocating another (Graham, et al. 2001). Since these are alternative investment proposals wherein only one has to be accepted such alternative proposals are called mutually exclusive projects and are mostly of either technical or financial in nature (Pogue, 2004 pp. 565-570).

The technically mutually exclusive proposals deal with decisions regarding buy or make, purchase or lease sort of decisions and of the alternative outcomes only one outcome should be chosen and it will be that proposal which is the most profitable. In times of financial constraints when there are limited finances on hand for the organization, that project which will give the maximum profits will be chosen out of a bunch of proposals even though some other proposals are also showing a yield more than what is anticipated. This situation arises because the limited finances available have to be rationed or allocated very stringently and the organization may not find it prudent to invest in more than one available proposal.

The different results obtained by the NPV and IRR methods may also be the resultant of the size of the initial investment outlay or the differences in the time periods of the projects under evaluation or even because of the uncertainty of the project life. When the initial investment envisaged for mutually exclusive proposals is different with the investment being more in some cases, then the NPV and IRR calculations will give different readings. When all the NPVs calculated are positive for such mutually exclusive proposals than the one with the largest positive NPV value will be accepted and this will also be in line with the organizational goal of maximization of the wealth of their stakeholders since this acceptance will result in an increase in the share prices in the market (Madhumati).

Similarly when the IRR results for mutually exclusive proposals having varying initial investment outlays, are different but are also positive then also that proposal will be accepted which shows the maximum initial investment will be accepted. Though an exercise can be conducted to verify this acceptance by calculating the extra or marginal investment required and the cash flows envisaged for the mutually exclusive proposals, then calculate the IRRs for these marginal cash flows and after all calculations are done if the marginal cash flows indicate a positive IRR the proposal requiring more initial outlay will be accepted. This selection of the proposal is because the organization would get higher profits from proposals requiring more outlay than those requiring less because the yield will be more. This process is termed as the Modified IRR or the MIRR method (McCracken).

Conclusion
Also where the time period of the mutually exclusive projects vary, there may be a relatively irregular pattern of cash flows for these proposals (Daves, et. Al., 2000). This problem of time disparity may occur even though the initial investment for these projects is identical but the cash flows are varying. Here also the NPV method is superior to the IRR method for evaluating investment proposals. The bottom line is that the NPV method is very superior and more acceptable to the IRR method because it takes into consideration the organizational objective of maximizing its stakeholders profits which is not the case with the IRR method.

Project analysis is required because there is a limitation to the financial resources available and there are more than one investment proposal to be considered. Therefore these different projects have to be evaluated simultaneously and not as individual project. There may be a influence of non financial considerations like organizational policies, competitive advantages in the market and the policies of the competitors. What is essential is that the organizational goal of maximizing shareholders wealth has to be the main goal and the process of analysis of the investment proposals aimed at achieving this objective.