All financial theories agree that the interest of any business corporation is to make profit.Therefore this depends on taking the right financial decision. Like all other forms of decision it should involve careful planning, as well as considering and valuating the various options available. However, the nature of financial decisions is such that although the process may seem ordinary, the valuation base required for it has unique characteristics. Depending on the valuation process which will be employed by the financial manager, different results will arise. In order for a financial decision to be taken there are two conditions that need to be satisfied. The first is to have a decision situation with alternative options to compare and contrast the decision against and the second is a clear objective that would save the decision maker time and effort (Lumby/Jones).
Investment appraisal is the process of evaluating several options of capital expenditure schemes before a particular organization proceeds with the implementation of an investment of its resources, aiming at achieving optimal shareholder returns. The end result should be to get the most return from the project and fulfilling the interest of shareholders to the maximum(Brealey, Cooper and Habib, 1997). The steps of this process are to establish what the objectives are, identify all potential opportunities offered, evaluate the various options and alternative courses of action, make a final decision, implement this decision and in due time evaluate decisions of the past [Herts ppt].
Capital budgeting techniques are the ones that determine the whole process of asset investment. Yet, not all companies apply the same techniques mainly because differences in the size of the company or its market position require a different approach. Capital budgeting has received an increasing attention over the last few years and further believes that most studies have focused either on the relationships between investment decisions and financial theory or on behavioural aspects of Capital Budgeting (Maccarrone, 1996).
However, it is reasonable that given the importance of such a management decision and the risks and the uncertainty involved will make a business consider more than one method to appraise a potential investment. Additionally, there have been various researches suggesting that quite often the results obtained after applying capital budgeting techniques were not accurate and efficient. It has been claimed that in order to ensure the accuracy of investment appraisal results, risk-avoidance methods must be used to help overcome potential future problems regarding the investment decision that was taken (Ehrhardt and Daves, 1999).
Despite that there has been witnessed an increased use of the discounting methods, some of which are more popular than the others for reasons that would be analysed further down. The four methods of investment appraisal are the PP (Payback Period), the ARR (Average Return Rate), the NPV (Net Present Value) and the IRR (Internal Return Rate) (dr hazel johnson).
The correct use of the investment appraisal techniques in terms of timing can guarantee more accurate and more efficient results. Della Vigna and Pollet (2006) refer to the difficulties that capital budgeting involves in its theory and stress the need to look for investment opportunities. They also mention that market positions should also be seriously considered (i.e. age structure or income levels) before any investment decision is taken because companies mostly aim at the markets they already exist and operate in. In a related survey that they carried out they showed that companies with increasing demands for the future 5 years use more complex capital budgeting techniques aiming at an optimal market share, but companies with increasing demands for more than 10 years use targets that are more flexible and thus more easily attainable (Della Vigna and Pollet, 2006).
The first method of appraisal is the Payback Period (PP). This is “the amount of time required for the cash inflows from a capital investment project to equal the cash outflows” (Timeweb, 2006). In order to achieve that, a certain cut-off date is set as a target for the PP. Alternatively, we can agree on the project with the lowest PP. In several cases, the basic criterion behind decision making is the time period required in order to payback in the form of earnings (inflows) and the full amount of the initial investment (outflows).
The period of payback is determined by the number of years required for the unrealisable capital, with the expected cash inflows, to be fully repaid. The estimation of the required years for the payback of the investment capital is done with the use of the net annual cash inflows in current prices.
In the case when an investment requires an initial cash outflow, which in turn results in even cash inflows over the next years, then the period of payback is defined as the ratio of the initial investment to the net annual cash inflow.
PP decision rule:
For a project to be acceptable, it should have a short payback period, shorter than the maximum payback period set by the administration. If two (or more) competing projects have payback periods shorter than the maximum payback period, then the project with the shortest payback period should be selected. Actually, the shorter the payback period is, the better for the investment, the greater the liquidity of the company will be and the smallest the risk of losses and damages. (hazel and johnson)
The advantages of the PP method are: they are a simple to understand concept, it can be easily calculated -on condition though that future cash flows have also been calculated, it uses cash and not accounting profit, it offers valuable information regarding the risk involved and the liquidity potential of the investment. Alesii, G. (2006) Payback period and internal rate of return in real options analysis. The Engineering Economist, 51 (3), 237-257.
The disadvantages of the PP method are that it only considers cash flows within the payback period and not the risk involved, it does not refer to the project return as a whole, it ignores the size and timing of cash flows - leaving out net inflows which may be appealing for the rejected projects and that it does not take account of the time value of money, despite the option of using the discounted payback. Alesii, G. (2006) Payback period and internal rate of return in real options analysis. The Engineering Economist, 51 (3), 237-257.
Based on the fact that this is a simple-to-use method, it is commonly used to support other methods, mainly when the cash flows are expected to be constant over a long period of time. It helps to minimise risk by placing greater importance on earlier cash flows. On the other hand, it promotes the acceptance of short-term projects in a very effective way, offering information related to liquidity, but not increasing the firm value. It also ignores cash flows that occur after the Payback Period itself. This eliminates the possibility of future negative cash flows or the fact that the firm should expect greater profit over a longer period of time. This makes the overall profitability of the project an obsolete measure. After all, when an arbitrary cut-off date is set, there is nothing left to be used as a reliable measurement guide. (hazel and johnson)
When the cash inflow after the initial cash outflow varies then every annual cash inflow should be deduced from the invested capital until the whole sum has been repaid.
The selection of this particular type of investment is based on various factors that are related to: the type of the investor, the financial background of the investor and the technological advances.
The faster technology progresses, in relation to the small size of a firm or its limited credit background, the more imperative the need for this particular business to chose the method of PP. This investment appraisal method is mainly used as a supplement to the other methods especially in cases when they have difficulty in providing a full and clear answer to the issue of selecting the optimal investment project. According to PP the investor initially chooses in advance the time period he considers necessary in order for the invested capital to be paid back.
This is a method that is also called Average Return on Book Value. This is because it is an accounting measurement which can be easily calculated as the ratio or the average annual rate of return after taxes to its cost (Μ.Ε.Κ.Α.)/(Κ.Ε.).
It is a non-DCF method, because it does not take cash flows into account, but is mainly interested in the earnings.This particular method is also easy to understand and as a result, it is widely used. Net income is usually readily and conveniently available to be used in calculations. The famous concept “A dollar today is worth more than a dollar tomorrow” (Himmel, 1999) applies here. It uses net income instead of cash flows that can sometimes be misleading when appraising the potential outcomes of an investment, because it does not take into account the total expenditure of the project.
ARR decision Rule:
Evidently, income differs from year to year we calculate the average rate as the exponent of the ratio. After that and since the cost of the investment is known we calculate the ARR. On completion of that, we proceed with the appraisal of an investment project using the ARR and then it is compared and contrasted to the required return it would produce for the investor, before finally accepting or rejecting the proposal. For a project to be acceptable, it must achieve a target ARR as a minimum. Where two (or more) competing projects exceed the minimum rate, the one with the highest ARR should be selected. (hazel and johnson)
The advantages of ARR are that it produces a value in familiar percentage terms, it can be compared with primary accounting ratios i.e. the company's required rate of return or cost of capital, it is a relatively simple concept compared to other DCF methods, such as the Net Present Value and the Internal Rate of Return, it can be used to compare mutually exclusive projects and finally, it considers the whole benefits of the project, unlike the payback method. (hazel and johnson)
The disadvantages of ARR on the other hand are that although it is considered simple to be calculated by using the available operation results, it presents some difficulties. It uses accounting profit rather than cash. The profit is not directly linked to the primary financial objective –the maximisation of shareholder wealth and uses average profits, thus not taking account of the timing of profits. Finally, it does not take account of the time value of money and just because it is a relative measure, it ignores the size of the initial investment. (hazel and johnson)
As has already been stated the most important aspect behind the implementation of an investment project is to ensure that the investor will receive a high return on the capital invested. The issue of comparing the time value of money is dealt with the method of estimating the current value of the various future amounts. It is based on calculating the absolute size of net profits from an investment.
NPV takes into account of all the projected earnings and expenses of an investment and thus appraises its total effect on the business. In order for the accumulation and then the compare and contrast process of the money involved at different time periods to take place, the method of NPV takes into account the discount rate of future cash flows that may arise from the investment and adds algebraically their current values. (Pike Richard, Neale, B., 2003, Corporate Finance and Investment :decision and strategies, 4th edition, Prentice Hall)
The NPV rule also includes the cost of capital (or the discount rate). This way it takes risk into account and helps in the case that uncertain cash flows arise. It only includes the relevant costs but only when they occur. Since the main objective of any company is a maximum market value, a positive NPV achieves exactly that at the same time contributing towards the maximisation of shareholder wealth.
The NPV is given by the following formula:
C1 C2 C3 Cn
– I0 + ------ + ------ + ------- + . . . + -----
(1+r) (1+r)2 (1+r)3 (1+r)n
v I0 denotes the initial investment
v C1, C2, . ., Cn are the project cash flows occurring in years 1, 2, . ., n
v r is the cost of capital or the required rate of return
NPV decision Rule:
If the NPV of an investment is positive then the investment is also positively appraised. A positive NPV means that the discount earnings are higher than the discount expenses. If two (or more) potential investment projects have positive NPVs, the project with the highest NPV should be selected. The method of NPV integrates/takes account in one figure the net profits of all the time periods of the investment and compares them to the initial cost. If the NPV is positive then this means that the project will manage to repay all the investment cost including the initial cost and also yield some profit whose present value would be equal to the NPV (Ross et al, 2005).
The advantages of NPV are: it takes account of the time value of money thus eliminating the potential effects of inflation. It takes account of all the relevant cash flows and not accounting profits over the life of a project, it can easily adapt to changes in discount rate or price variations taking account of both conventional and non-conventional cash flows, during the life of the project. It also gives an absolute measure of project value and it is suitable for the combined selection among various investment projects at the same time. (Pike Richard, Neale, B., 2003, Corporate Finance and Investment :decision and strategies, 4th edition, Prentice Hall)
The disadvantages regarding NPV are: the cash flows of the project may be difficult to estimate, it is not realistic to accept all the projects with positive NPV since there is no perfect capital market and that the cost of capital may be difficult to determine and may change over the life of the investment project. Also, since the NPV is appraised in money figures the comparison between investments with different initial costs and a different project life is difficult. In addition, there is heavy reliance on the discount rate, which does not remain stable over the life of the project. This means that the NPV is underestimated when the discount rate is reduced and overestimated when it is increased. Lastly, only future costs are taken into the analysis. This means that past costs are ignored because they do not vary with future decisions (Irons, 2004).
The Internal Rate of Return is the discount rate, which, when applied to a project's future cash flows produces an NPV of precisely zero. It is the related return rate which summarizes and equals the cost with cash inflows from an investment and is expressed in a single percentage. Therefore the IRR of an investment is defined as the return rate which summarizes the initial capital and future earnings.( Hartman, J.C. and I.C. Schafrick. (2004) "The relevant internal rate of return." Engineering Economist, Vol. 49, pp. 139-158.)
IRR decision Rule:
The IRR is the most similar to the NPV rule, because it is also a DCF method. It does not depend on extrinsic factors such as interest rates; but focuses instead on the cash flows of the company itself. The most selective investments are those which offer a return rate higher than the alternative cost (r) of other available investments. According to the IRR criterion, in order for an investment project to be acceptable, it should meet a minimum IRR requirement. (This should be the opportunity cost of finance.) If two (or more) competing projects exceed the minimum IRR, the one with the highest IRR should be selected. If the return rate is higher than the capital cost then, the investment is of interest and should be accepted. By contrast, if the return rate is smaller than the capital cost, then the investment is of no interest and should be rejected. Watson Denzil ,Head, A. 2004, Corporate Finance : Principle & Practice, 3rd Edition, FT Prentice
IRR is the rate which if used as discount rate then the net present value of the investment will be zero. This rate in a way measures the true internal potential of an investment as well as its sustainability to high discount rates. It also ensures protection against the risks involved in investments with high internal return rate.
The advantages of using the IRR are that it is a popular method because it is easy to understand and it involves only one variable and not two, as is the case of the NPV. The IRR summarises an investment's potential in one simple percentage therefore making it easier to represent on cash flow analysis. It does take into account the time value of money, which is a more promising practise for decision-making in the future.
2.4.5 NPV vs IRR
As stated above every decision investment project is considered worth implementing if the NPV is positive. But again this is not a rule. Holmén (2005) believes that the risks involved should not affect investors with well-diversified portfolios since it is only the project's systematic risk that affects its value. The NPV is computed by forecasting the project's cash flow and discounting them at a discount rate that reflects the price charged by the capital markets for the risk of the cash flow.
Undoubtedly NPV is the most popular method applied, with the PP regarded as the one with the most drawbacks as it does not include the time value of money and cash flows beyond an arbitrary cut off date. However, it has been shown that 57% of the CFOs (Corporate Finance Organizations) in a survey carried out among US firms that always or almost always the payback method is used in capital budgeting decisions, compared to the 76% that use the NPV method (Graham and Harvey, 2001). The same was revealed with European companies where the PP method is mainly used as reported by Brounen, de Jong, and Koedjik (2004). They reported that the payback method is the most frequently used method among firms in UK, Germany, and France, and it is also very common in the Netherlands, where it is the second most popular method after the NPV (Brounen, de Jong, and Koedjik, 2004, pg 71-101).
Another survey carried out by Ryan and Ryan (2002) has indicated that the great majority of large companies with more capital investments prefer NPV over IRR techniques. The particular research involved the Fortune 1000 companies and showed that 49.8% of large firms use NPV and 44.6% use IRR with the probability of using each more frequently being 85.1% and 76.7% respectively (Ryan and Ryan, 2002). Drury and Talyes (1997) in a similar research stated that capital budgeting techniques are being used in the UK and USA for quite a long time and the vast majority of companies in UK and USA use all the four elements of capital budgeting (NPV, IRR, ARR and PP).
As stated earlier one problem related to applying IRR to projects with non-conventional cash flows is that multiple IRRs may be found. Again, the use of NPV can become the choice that offers the best selection guidance. NPV can accommodate changes in discount rate during a project's life, something that IRR fails to do. The NPV method assumes that cash flows can be reinvested at a rate equal to the cost of capital. Contrary to that, the IRR method assumes that cash flows can be reinvested at a rate equal to IRR. (Inselbag I., Kaufold H., 1997, Two DCF Approaches for Valuing Companies Under Alternative Financing Strategies : How to choose between them, Journal of Applied Corporate Finance)
The NPV rule mostly depends on two variables: the discount rate and the beta which is a measure of the volatility of the company in relation to the market as a whole. The IRR, on the other hand, relies solely upon the discount rate. This means that the NPV can become more easily influenced by changes in outside factors such as interest rates and inflation, potentially affecting the accuracy of the calculations the firm has made negatively.
Despite what was stated so far on a theoretical basis, the NPV rule is rather difficult to use, whereas the IRR is a lot simpler and easier to define. The point is though what IRR lacks reliability as a rule because the situations where the IRR can produce inconsistent and thus inaccurate results, are far too many, leaving the NPV as the only reliable method to be trusted in decision making.
The NPV rule has three key characteristics that are proved valuable when considering investment options. It uses cash flows instead of earnings. It also uses all the cash flows of a project, and discounts the cash flows with regards to the time value of money. The other types of investment appraisal lack at least one of these characteristics. So this fact renders the NPV rule the only form of investment appraisal which provides a clear answer to whether an investment project should be accepted or rejected.( Inselbag I., Kaufold H., 1997, Two DCF Approaches for Valuing Companies Under Alternative Financing Strategies : How to choose between them, Journal of Applied Corporate Finance)
In conclusion, the NPV rule has been widely regarded by managers and business analysts as the best and most reliable form of investment appraisal. Yet the issues of which method to use each time and what exactly the factors that determine the suitability of one method over the rest are, still remain. The dominance of the NPV rule has become more commonly adopted by firms over the years due to the undisputable theoretical background that it provides. It offers a more accurate and therefore more reliable profile of an investment's characteristics than the other three methods do. Yet this does not render the other three methods worthless. It only suggests that they are used either in combination with the NPV rule or on a separate basis, depending on the investment case which is under consideration.
Circumstances leading to adverse results
The circumstances under which the two investment appraisal types (i.e. the NPV and the IRR) may produce different results are the following: a. when the investment does not have an equal life value, b. when there is a difference in the investment cost and c. in the inflows disperse, regardless of whether the investments have the same initial cost and an equal life value. This happens in investments where the cash inflows in one increase in consecutive order, whereas the inflows of the other decrease. (hazel and johnson)
Basically the contradiction between the two methods is due to the fact that they use different means of measurement. So the method of IRR measures the efficiency of an investment made in a particular project and for this reason a small investment could have a high return rate. On the contrary, the NPV method expresses the absolute measurement because it takes account of the initial expenditure. Both of them however are better than other methods of appraisal. The validity and importance of the decision which is to be taken depends on the quality of the data used and the assumptions made.
Thus we assume that: a. the level of prices is stable, or if it does increase so will the costs and revenues, respectively, b. technology remains stable for the time period the investments are scheduled for, c. every new investment has the same productivity and d. there will be constant replacement of the investments once their life value expires, under the same circumstances and market conditions.
This way both methods are based on several assumptions, they appraise the same amount of investments and produce different results. This contradiction derives from the differences and diversity existing in the projected cash inflows and outflows. If the data required by the NPV method are given the administration of the firm would be in a position to recognize the size of inconsistency and develop or modify accordingly its future decision. Yet there is still the possibility that many financial directors may interpret the results of the IRR in a more effective way than the results of those of the NPV. (Watson Denzil ,Head, A. 2004, Corporate Finance : Principle & Practice, 3rd Edition, FT Prentice)