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In this assignment I will be identifying the main capital appraisal techniques and evaluate them by showing their strength and weaknesses. Then compare them with each other and show the main difference between them. At the end I will be showing some tables taken from different books ranking these methods and showing which methods are more used by most of the companies in the US and I-J.
Most of the competitive companies are looking for expansion and growth in order to control a bigger share of the market and eventually make more profits for the share holders and the stock owners, to do that the companies should always: * Identify attention investments * Review, analyze, and select from the proposals that have been generated * Implement and monitor the proposals that have been selected And since they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible; the managers aim to maximize shareholder ‘s wealth by maximizing long-term returns, taking account of risk and liquidity.
Capital investment decisions normally represent the most important decisions that the managers make to choose the best investments to take using the capital appraisal methods. Some of the capital appraisal methods ignore the time value of money like payback and Accounting Rate of Return (EAR) as they depend on the cash flow and the profit made by this investment, the other methods take into consideration the time value of money using a technique called Discounted Cash Flow like Net Present Value (NAP) and Internal Rate of Return (AIR).
The payback method is one of the simplest and most frequently used methods of capital investment appraisal. It is defined as the period in months or years that is required for a stream of cash earnings from an investment to recover the original ash outlay required by the investment but without taking in consideration the time value of money. Similarly to the payback method the Accounting Rate of Return also ignores the time value of money and is calculated by dividing the average annual profits from a project into the average investment cost.
On the other hand there are techniques that use the discounted cash flow and take in consideration the time value of money, The most straightforward way of determining whether a project is a total success or a huge fail is to calculate the net present value. This is the present alee of the net cash inflows less the project’s initial investment outlay. The internal rate of return (AIR) is an alternative technique for use in making capital investment decisions that also takes into account the time value of money.
The internal rate of return represents the true interest rate earned on an investment over the course of its economic life (Dry, 2008). Using the appraisal techniques is not an easy Job for the manager especially if it included the long term use of capital assets like land or expensive machinery, so if the manager is presented with few opportunities and he as to choose only one from them, he has to consider the use of all the techniques Ana teen cocoon ten one Walt n ten most stagnantly approach.
Using the payback method will tell the manager how long in months or years it will take each of the investments to bring in net cash inflows to match the initial cash outlay, so the manager can choose the project which has the fastest repay period. Now using (EAR) seeks to provide a measure of project profitability over the entire asset life, so the manager should choose the project with the highest percentage of profitability (Dry, 2008).
However by using NAP and AIR you will be getting more legalistic options to choose from as in NAP you will be getting the future values of the cash flows invested today, so the manager should choose the project with the highest NAP assuming that the amounts invested in all the projects are the same. Lastly using AIR you will have the average annual growth rate of your cash invested, therefore the manager can choose the project with the highest growth rate (Pike and Neal, 2008).
Each model has its strength and weaknesses, such attributes play an essential part for the managers helping them in choosing the best technique instead of the other. The strength in the payback method lies within that it’s by far the easiest model to use. This model answers the main questions that concern most of the companies these days “How soon will I recover my initial investment? ” (Brooks, 2013). Accounting Rate of Return is the 2nd model according to the ease of use and since it can be attributed to the wide use of the return on investment measure in financial statement analysis. Ritter say that EAR is better than payback when it comes to ranking projects as it ranks them based on their profitability. On the other hand, NAP ND AIR are little harder to calculate but they give a much more appealing answers as they consider the time value of money rather than ignoring it, they consider the risk and they focus on the cash flow rather than profits. Both methods will most likely result in the same decision (Dry, 2008).
After discussing and comparing the methods strongest features, now we have to take in consideration their main weaknesses. Payback and EAR have in common that they both ignore the time value of money, this makes the calculation of them simpler but less trustworthy. Payback has a major flow that it ignores all the cash flows after the tofu date(Brooks, 2013). However EAR differs from payback that it uses the profit rather than the cash flows, and the profits can vary much more than the cash flows.
Thus, the EAR tends to be less reliable than Payback (Dry, 2008). In contrast come the NAP and AIR which both respect the time value of money but in NAP The biggest disadvantage to the calculation of NAP is its sensitivity to discount rates. Another major disadvantage to using NAP as an investment criterion is that it wholly excludes the value of any real options that may exist within the investment. The AIR formula in fact can be very complex depending on the timing and variances in cash flow amounts.
Without a computer or financial calculator, AIR can only be computed by trial and error. One of the disadvantages of using AIR is that all cash mows are assumed to De relates at ten same Locknut rate, although In ten real world these rates will fluctuate, particularly with longer term projects (http:// www. Investigated. Com/articles/internal_rate_return. Asp). Not to forget that AIR has the potential for errors in ranking projects especially when there are mutually exclusive projects because multiple AIR could be generated(Brooks, 2013).
Table 1. 1 Summary of the 4 decision models(Brooks, 2013) looking at the comparison table(Brooks, 2013) we can see that AIR is the hardest and the most time consuming to calculate without a spreadsheet or a calculator, NAP takes the second place in difficulty while Payback and EAR sets to be easy to apply. Regarding the risk consideration it’s obvious that NAP and AIR are the models which effectively consider it through the whole project while payback ignores everything after the cutoff and EAR seems to not take it into account.
Most of the writers gave the superiority for NAP over AIR as there are scenarios where AIR tend to become confusing and the use of NAP would be better: * Mutually exclusive projects: this occurs when there are many projects and the acceptance of one of them meaner the rejection of the others in this case it would be better to use the NAP as the AIR method can incorrectly rank projects, because of its reinvestment assumptions. * Percentage return: NAP return monetary terms while on the other hand AIR returns a percentage and comparing percentage returns can be misleading if the mounts invested are not equal in the projects. Reinvestment assumption: NAP method assume that the cash flows generated from an investment will be reinvested immediately at the cost of capital whereas AIR assumes that all the proceeds from a project can be reinvested immediately to earn a return equal to the AIR of the original project, This assumption is likely to be unrealistic. * Unconventional cash flows: NAP is not sensitive to multiple sign changes in cash flows. It is a method that presents the expected cash amount that shareholder wealth would increase or decrease upon the acceptance of a project.
Whereas AIR has a technical shortcoming as most projects have conventional cash flows that consist of an initial negative cash flow followed by positive cash inflows in later years (Dry, 2008). Also most of the writers gave the superiority to Payback over EAR except in one case where EAR is preferable as it allows for differences in the useful lives of the assets being compared because of taking the whole term of the project rather than the cutoff period. Surveys of capital budgeting practices in the UK and USA between the years 1975 and 1992 showed the following results: Method (Percent) I EAR I AIR I
NAP I I Ole 1 2 Extent AT use AT Investment appraisal techniques (Dry Ana lay sees I Never/Rarely (Per Cent) I Sometimes (per cent) Payback method | 23 1 141 63 | 39 | 20 | 41 | 321 Ill 571 411 161 431 Often/Always We can see that payback is the most desirable technique by these companies as mentioned before because of its easiness of use, on the contrast comes EAR as the least desirable technique because it doesn’t consider the time value of money and that it takes the profit rather than cash flow (Dry and Tallest, 1997). A much later study has shown that NAP became most of the companies choice of the appraisal techniques.
While EAR stayed the least preferable technique among them lastly, there are some other factors that might affect the manager’s decision and he might end up making a wrong decision. Performance measurement for example as most of the companies evaluate their managers on an annual or more frequent basis. Therefore, the manager will tend to choose projects that have a favorable impact on short-term financial performance and ignore projects that might be more profitable but on the long term. In conclusion, the manager’s main goal of applying these techniques is to help him make the best decision.