Part B Key concept, In formulating your Key Concept Exercise, consider the follo
ID: 2383893 • Letter: P
Question
Part B Key concept, In formulating your Key Concept Exercise, consider the following question: * What are some of the alternative methods of investment appraisal? In an approximately 500-word response, address the following issues/questions: Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management. Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organisations? To complete this Key Concept Exercise: Collaboration Forum. * Be sure to read over your Key Concept Exercise before submitting it to your Instructor. Make sure the spelling and grammar are correct and the language, citing and referencing you use when providing your opinion are appropriate for academic writing. Part B Key concept, In formulating your Key Concept Exercise, consider the following question: * What are some of the alternative methods of investment appraisal? In an approximately 500-word response, address the following issues/questions: Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management. Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organisations? To complete this Key Concept Exercise: Collaboration Forum. * Be sure to read over your Key Concept Exercise before submitting it to your Instructor. Make sure the spelling and grammar are correct and the language, citing and referencing you use when providing your opinion are appropriate for academic writing. Part B Key concept, In formulating your Key Concept Exercise, consider the following question: * What are some of the alternative methods of investment appraisal? In an approximately 500-word response, address the following issues/questions: Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management. Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organisations? To complete this Key Concept Exercise: Collaboration Forum. * Be sure to read over your Key Concept Exercise before submitting it to your Instructor. Make sure the spelling and grammar are correct and the language, citing and referencing you use when providing your opinion are appropriate for academic writing.Explanation / Answer
Answer: Capital investment decisions, widely referred to as ‘capital budgeting’ or ‘investment appraisal’, consist in making decisions that should have significant future benefits for the organization and its shareholders. Management’s responsibility in making the right decisions on investments in long term assets therefore should pursue the main objective of creating additional wealth to the owners and shareholders, as mistakes
may result in disastrous outcome and huge losses. According to Atrill & McLaney (2011), making sound investment decisions is crucial because typically ‘large amounts of resources are often involved’ and ‘it is often difficult and/or expensive to bail out of an investment once it has been undertaken’ (Atrill & McLaney, 2011 –
p.370). A development in new facilities, plant, equipment, products or new technologies requires the deployment of funds and thus some sort of planning is necessary to assure success and to minimize the risk of failure. Unfortunately however, many businesses around the world fail because their capital investments are based upon intuitive decision making, incorrect factors or wrong calculations. This is somewhat understandable, since ‘…more than 99% of the world’s businesses are Small and Medium Enterprises’ producing 50% of the world’s GDP and employing 85% of the world’s population. And although they (the SMEs) ‘…form the foundation of the global economy’ (D&B report, 2008 – p.3), most of them lack the financial sophistication of larger businesses and thus commit serious errors in their investment decisions that often enough lead to disastrous results.
There are various formal methods and techniques utilized, more or less effectively, by organizations and managers in their capital budgeting approaches.
We will discuss the four most common methods of investment appraisal and will describe their particularities, advantages and limitations.
Accounting Rate of Return (ARR): The ARR (also called the ‘average rate of return’) is a financial ratio expressed in percentage and computed by dividing the average profit by the average investment made over the life of a project. It calculates the expected return from the net income, and expresses it in percentage to the initial investment made. For instance if the expected rate of return is 10%, a project achieving an ARR of 10% or higher is considered acceptable, and when comparing several options, the project with the highest ARR shall be prioritized over others, as it will generate higher profits on the investment made.
However, while the ARR method is generally accepted and utilized, its major limitation is that it takes almost no account of the timing factor, and therefore a comparison between various projects may show them all as equally attractive, while some may generate a faster return on the investment, but may not be highlighted as being better investment options. Another problem is that the ARR uses the accounting profit as a calculation basis, which is suitable for short-term performance measurement, while cash flow is the better measure for measuring performance over the project’s life span.
Payback Period (PP): The PP method measures the time required for the return on investment to be made from the actual cash flow generated by a project. Thus, projects that will recover the initial investment faster are considered more attractive, and therefore the emphasis on liquidity is given priority over profitability in the PP
approach. The time factor plays an important role here, for which reason, PP is considered a better option than the ARR method. However, PP features its own drawbacks, as it emphasizes on the payback period only and is not considered with the actual profitability of a project. This may result in valuable profitability information being omitted, which indicates that PP will not promote the increase in wealth to the shareholders, but will favor projects that have the shortest payback period.
Net Present Value (NPV): The NPV method is considered to be a ‘better solution’ of investment appraisal, as it covers the cost and benefits of a project as well as the timing factor in the computation. The NPV discounts the future expected cash inflow from an investment project reflecting the interest lost to the investors, the related risk
and the expected inflation. According to Kierulff (2008) ‘…If the sum of the discounted future cash inflows exceeds the initial cash requirement for funding, NPV is positive and the project is financially attractive’ (Kierulff, 2008 – p.321), thus adding value to the investors. In fact, NPV considers the ‘timing of cash flows’, the ‘whole of the relevant cash flows’ and ‘the objectives of the business’ in its computation, which is why NPV is considered to be the preferred choice for decision makers. Further, the NPV ‘…uses all the differences between every possible IRR for a project and its cost of capital; therefore NPV is a richer concept’.
However, no one particular method is perfect. Even the NPV approach has its flaws.For instance, the NPV considers the cash flows to be fixed and that managerial flexibility is non-existent, whereby in reality we see that projects get postponed, expanded in size or partially/totally abandoned.
Internal Rate of Return (IRR): Like the NPV method described above, the IRR also utilizes the discounting of future cash flows in the calculation of a particular investment, and represents the yield of an investment opportunity. IRR is the discount rate, expressed as a percentage that will produce a zero value on the NPV when applied to future cash flows of a project. Thus, if IRR is higher than the required rate of return, the investment project is considered profitable, and should therefore be realized. Both methods the NPV and the IRR, show clear dominance over other
appraisal methods, however the IRR seems to be additionally favored, because of its ‘intuitive appeal’ (Kierulff, 2008 – p.322), and executives’ preference in dealing with percentages. We will see however, that also the IRR does not provide the ultimate solution to investment appraisal, as it assumes that the generated cash flow, will be
reinvested under the same conditions (rate of return) of the initial investment, which is not a realistic scenario, and more importantly, the IRR method may result in confusion due to alternating positive/negative cash flows of a project.
In response to the ambiguities of NPV and IRR, Kierulff (2008) proposes the use of the ‘Modified Internal Rate of Return’ (MIRR), which should get rid of the problems envisaged in the IRR approach, to provide ‘…a more accurate percentage measure of financial attractiveness’ (Kierulff, 2008 – p.322). In any type of organization, investment appraisal and capital budgeting should be based on calculations, that provide a ‘clearer picture’ of what is to be expected in terms of returns on investments made. Here we would suggest the implementation of a step-by-step phased approach to any project envisaged. The phased approach should consist in five steps, as follows:
1. Defining an existing opportunity (identifying a potential project/investment, that is expected to generate good return on investment).
2. Outlining a conceptual study (describing how the opportunity may be achieved).
3. Pre-feasibility Study (studying various options or projects and selecting the most favorable/profitable one).
4. Feasibility Study (studying the most favorable/profitable project, and confirming its suitability.
5. Investment Decision (deploying the necessary funds to finance the new investment).
Following a phased approach, would help in improving the cost effective deployment of fund, and will result in more disciplined decisions. Most importantly, if a particular investment would not show signs of viability, the project can be stopped at a minimum loss to the investors.