Investment Appraisal: Methods and Considerations - capital structure
CiteLegal
 
HOME RISE NEW ABOUT LOGIN
Home > Finance Sectors > Accounting

Investment Appraisal: Methods and Considerations

deepak_ds_sharma Started The Discussion:

Investment Appraisal: Methods and Considerations

INVESTMENT APPRAISAL METHODS
Investment appraisal methods can be divided into two basic areas. One in which no time value of money is taken into consideration and one in which it is. Using time value of money while evaluating projects is known as discounting.

A. Non-Discounting Methods
 Urgency
 Payback Period
 Accounting Rate of Return
 Debt Service Coverage Ratio

B. Discounting Methods
 Net Present Value
 Profitability Index
 Internal Rate of Return
C. Economic Value Added (EVA) charm as a Performance Measure


NON-DISCOUNTING METHODS
Urgency
According to this critera, projects which are deemed to be more urgent get priority over projects which are regarded as less urgent.

The problem with this criterion is: How can the degree of urgency be determined? In certain situations, of course, it may not be difficult to identify highly urgent investments. For example, some minor equipment may have to be replaced immediately due to failure, to ensure continuity of production. Non-replacement of such equipment may mean considerable losses arising from stoppage in production. It may be futile in such a case to go into detailed analysis and delay decision.

In view of these limitations of the urgency criterion, we suggest that in general it should not be used for investment decision making. In exceptional cases, where genuine urgency exists, it may be used provided investment outlays are not significant.

Payback Period
Payback period is the most widely used technique and can be defined as the number of years required to recover the cost of the investment. This is easy to calculate, but is often calculated before tax, and always after accounting depreciation. By definition, the payback period ignores income beyond this period, and it can thus be seen to be more as a measure of liquidity than of profitability.

The payback period is the length of time required to recover the initial cash outlay on the project. For example, if a project involves a cash outlay of Rs 6,00,000 and generates cash inflows of Rs 1,00,000, Rs 1,50,000, Rs 1,50,000 and Rs 2,00,000 in the first, second, third and fourth years respectively, it payback period is four years because the sum of cash inflows during four years is equal to the initial outlay. When the annual cash inflow is a constant sum, the payback period is simply the initial outlay divided by the annual cash inflow. For example, a project which has an initial cash outlay of Rs 10,00,000 and constant annual cash inflow of Rs 3,00,000 has a payback period of Rs. 10,00,000/Rs 3,00,000 = 3.1/3 years.

According the payback criteria, the shorter the payback period, the more desirable the project. Firms using this criterian, generally specify the maximum acceptable payback period. If this is n years, projects with a payback period of n years or less are deemed worthwhile, and projects with a payback period exceeding n years are considered unworthy.

Projects with long payback periods are characteristically those involved in long range planning, and which determine a firm's future. However, they may not yield their highest returns for a number of years and the result is that the payback method is biased against the very investments that are most important to long term success.

Evaluation
A widely used investment criterion, the payback period seems to offer the following advantages.

• It is simple, both in concept and application. It does not use comlex concepts and tedious calculations and has few hidden assumptions.

• It is a rough and ready method for dealing with risk. It favours projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years but not in earlier years. Now, if risk tends to increase with futurity - in general, this may be true – the payback criterion may be helpful in weeding out risky projects.

• Since it emphasises earlier cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.

The limitations of the payback criteria, however, are very serious:

• It fails to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting. This violates the most basic principle of financial analysis which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding / discounting.

• It ignores cash flows beyond the payback period. This leads to discrimination against projects which generate substantial cash inflows in later years. To illustrate, consider the cash flows of two projects, A and B:

Year Cash flow of A Cash flow of B
0 -1,00,000 -1,00,000
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 60,000

The payback criteria prefers A, which has a payback period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantial cash inflows in years 5 and 6.

• Since the payback period is a measure of a projects' capital recovery, it may divert attention from profitability. Payback has harshly, but not unfairly, been described as the "fish bait test since effectively it concentrates on the recovery of the bait (the capital outlay) paying not attention to the size of the fish (the ultimate profitability), if any."

• Though it measures a project's liquidity, it does not indicates the liquidity position of the firm as a whole, which is more important.

Accounting Rate Of Return
The accounting rate of return, also referred to as the average rate of return or the simple rate, is a measure of profitability which relates income to investment, both measured in accounting terms. Since income and investment can be measured variously, there can be a very large number of measures for accounting rate of return.

The measures that are employed commonly in practice are:

Average income after tax
A : -------------------------------
Initial investment

Average income after tax
B : -------------------------
Average investment

Average income after tax but before interest
C : ------------------------------------------------------
Initial investment

Average income after tax but before interest
D : ------------------------------------------------------
Average investment

Average income before income and taxes
E : ---------------------------------------------------
Initial investment

Average income before income and taxes
F : ---------------------------------------------------
Average investment

Total income after tax but before depreciation - Initial investment
G : -------------------------------------------------------------------------------
Initial investment
---------------------- x Years
2

This method is superior to the payback period, but is fundamentally unsound. While it does take account of the earnings over the entire economic life of a project, it fails to take account of the time value of money. This weakness is made worse by the failure to specify adequately the relative attractiveness of alternative proposals. It is biased against short term projects in the same way that payback is biased against longer term ones.

Evaluation
Traditionally as a popular investment appraisal criterion, the accounting rate of return has the following virtues:

• It is simple to calculate.

• It is based on accounting information which is readily available and familiar to businessmen.

• It considers benefits over the entire life of the project.

• Since it is based on accounting measures, which can be readily obtained from the financial accounting system of the firm, it facilitates post-auditing of capital expenditures.

• While income data for the entire life of the project is normally required for calculating the accounting rate of return one can make do even if complete income date is not available. For example, when due to indeterminacy of project life a complete forecast of income cannot be obtained, the accounting rate of return can be calculated on the basis of income for some typical year or income for the first three to five years.

The shortcomings of the accounting rate of return criterion seem to be considerable:

• It is based upon accounting profit, not cash flow.
• It does not take into account the time value of money. To illustrate this point, consider two investment proposals X and Y, each requiring an outlay of Rs 1,00,000. Both the proposals have an expected life of four years after which their value would be nil. Relevant details of these proposals are given below:


-------------------------------------------------------------------
PROPOSAL X
-------------------------------------------------------------------
Year Book Value Depreciation Profit Cash
after tax
-----------------------------------------------------------------
0 1,00,000 0 0 1,00,000
1 75,000 25,000 40,000 65,000
2 52,000 25,000 30,000 55,000
3 50,000 25,000 20,000 45,000
4 0 25,000 10,000 35,000
-------------------------------------------------------------------
PROPOSAL Y
-------------------------------------------------------------------
Year Book Value Depreciation Profit Cash
after tax
------------------------------------------------------------------
0 (1,00,000) 0 0 (1,00,000)
1 70,000 25,000 10,000 35,000
2 50,000 25,000 20,000 45,000
3 25,000 25,000 30,000 55,000
4 0 25,000 40,000 65,000

Both the proposals, with an accounting rate of return (measure A) of 50% look alike from the accounting rate of return point of view, though project X, because it provides benefits earlier, is much more desirable. While the payback period criterion gives no weight to more distant benefits, the accounting rate of return criteria seems to give them too much weight.

• There are, as we have seen, numerous measures of accounting rate of return. This can create controversy, confusion and more confusion, and problems in interpretation.

• Accounting income (whatever particular measure of income we choose) is not uniquely defined because it is influenced by the methods of depreciation, inventory valuation, and allocation of certain costs. Working with the same basic accounting data, different accountants are likely to produce different income figures. A similar problem, though less severe, exists with respect to investment.

• The argument that the accounting rate of return measure facilitates post-auditing of capital expenditure is not very valid. The financial accounting system of a firm is designed to report events with respect to accounting periods and for profit centres but not for individual investment.

Debt Service Coverage Ratio
Financial institutions, which provide the bulk of long-term finance for industrial projects, evaluate the financial viability of a project primarily in terms of the internal rate of return and the debt service coverage ratio.

Debt service coverage ratio (DSCR) is defined as


where PATi = Profit after tax for year i
Di = depreciation for year i
Ii = interest on long-term loans of financial
institutions for year i
LRIi = loan repayment instalment for year i.
n = period over which the loan has be repaid.

Looking at the debt service coverage ratio we find the numerator consists of a mixture of post-tax and pre-tax figures (profit after tax is a post tax figure and interest is a pre-tax figure). Likewise, the denominator consists of mixture of post-tax and pre-tax figures (loan repayment installation is a post-tax figure and interest is a pre-tax figure). It is difficult to interpret a ratio which is based on a mixture of post-tax and pre-tax figures. In view of this difficulty, we suggest two alternatives :

Alternative 1:

Earnings before depreciation interest and taxes
DSCR = ----------------------------------------------------------
Interest + Loan repayment instalment
--------------------------------
1 - Tax rate

Alternative 2:
Profit after tax + Depreciation
DSCR = -------------------------------------
Loan repayment instalment

While alternative 1 is based on pre-tax figures, alternative 2 is based on post-tax figures. There is one more difference. Alternative 1, assumes that the interest and loan repayment obligations are of the same order and focuses on the ability of the firm to meet these obligations jointly. Alternative 2 assumes that the interest burden is of a higher priority, and focuses on the ability of the firm to meet the principal repayment obligation, once the interest obligation is fully met.

These traditional methods of investment appraisal are misleading to a dangerous extent. A means of measuring cash that allows for the importance of time is needed. This is provided by the discounting methods of appraisal, of which there are basically two methods, both of which meet the objections to the payback period and the average rate of return methods.


DISCOUNTING METHODS OF APPRAISAL

Net Present Value
The net present value of a project is equal to the sum of the present value of all the cash flows associated with the project. One of the most important concepts originating from the time value of money, NPV is calculated by subtracting the present value of the cash outflows (investment) from the present value of the cash inflows (income).

Suppose you are making an investment of Rs 1 lac today and are expecting that you will get Rs 1.1 lacs one year from now. You will only invest if the present value of Rs 1.1 lac that you are getting one year hence is more than Rs 1 lac you have invested today. Using the table for present value of Rs 1, the multiplying factor for one year at 10% is 0.909. If we multiply Rs 1.1 lac with .909 we get approx. Rs 1 lac. This means that we are getting a return of 10% from the project.

If you again look at the same table, the value gets lowered as the interest rate increases, which means that for an interest rate of more than 10% we will be getting a present value which will be lower than the investment we are making. So if we are expecting a return of 15% for one year, we will not invest as the present value of Rs 1.1 lac at 15% discount rate is lower than the investment of Rs 1 lac we are making today.

The formula for calculating the NPV is:


where NPV = net present value
CFt = cash flow occurring at the end of year
C0 = Initial cash out flow or investment
t = (t = 0 ......n), A cash inflow has a positive sign,
whereas a cash outflow has a negative sign
n = life of the project
k = cost of capital used as the discount rate

Here C0 is the initial investment we are making into the project and the rest is the present value of the cash flows we are expecting in the future. So NPV is the difference between the two at the expected rate of return.

With NPV the acceptance rule is
NPV > 0 Accept
= 0 Indifferent
< 0 Reject

If the NPV is greater than zero we accept the project because we are getting a rate of return which exceeds our desired rate of return, if it is equal to zero we may or may not accept the project as we are getting a return which is exactly equal to our desired rate of return, and if it is less than zero we reject the project proposal because the rate of return we are getting is less than our desired rate of return.

Features of Net Present Value
Two features of the net present value method to be emphasised :

1. The NPV method is based on the assumption that the intermediate cash inflow of the project is reinvested at a rate of return equal to the firm's cost of capital.
2. The NPV of a simple project monotonically decreases as the discount rate increases; the decrease in NPV, however, is at a decreasing rate.

Evaluation
Conceptually sound, the net present value criterion has considerable merits:

• It takes into account the time value of money.

• It considers the cash flow stream in its entirety.

• It squares neatly with the financial objective of maximisation of the wealth of stockholder. The net present value represents the contribution to the wealth of stockholders.

• The net present value of various projects, measured as they are in today's rupees, can be added. For example, the present value of package consisting of two projects A and B, will simply be the sum of the net present value of these projects individually :

NPV (A+B) = NPV (A) + NPV (B)

The additivity property of net present value ensures that a poor project (one which has a negative net present value) will not be accepted just because it is combined with a good project (which has a positive net present value ).

The limitations of the net present value criteria are:
• The ranking of projects on the net present value dimension is influenced by the discount rate. To illustrate, consider two mutually exclusive projects – A and B which have the following cash flow streams :

Year A B
0 -3,00,000 -3,00,000
1 60,000 1,30,000
2 1,00,000 1,00,000
3 1,20,000 80,000
4 1,50,000 60,000

The net present value of A and B for various rate of discounts is given below.

Discount rate NPV (A) NPV (B)
10% 36,622 29,180
12 20,390 17,658
14 5,318 6,828
15 -1,826 1,654
16 -8,702 -3,350

Looking at the behaviour of net present value, we find that : (i)when the discount rate is 12 per cent , the net present value of A is greater than the net present value of B; and (ii) when the discount rate is 14 per cent the net present value of B is greater than the net present value of A.

• The net present value measure, an absolute measure, does not appear very meaningful to businessmen who want to think in term of rate of return measures.

Profitability Index (PI)
Profitability Index relates the present value of benefits to the initial investment. It is also known as Benefit-Cost Ratio (BCR)


PVCF
PI = -------
I

where , PI = Profitability Index
PVB = present value of cash flows
I = initial investment


To illustrate the calculation of these measures, let us consider a project which is being evaluated by a firm that has a cost of capital of 12 per cent.

Initial investment : Rs. 1,00,000
Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000

The profitability index for this project is:

25,000 40,000 40,000 50,000
---------- + --------- + --------- + ---------
(1.12)1 (1.12)2 (1.12)3 (1.12)4
PI = ---------------------------------------------------------- = 1.145
1,00,000

With PI the acceptance rule is
PI > 1 Accept
= 1 Indifferent
< 1 Reject

If PI is greater than one we accept the project because we are getting a rate of return which exceeds our desired rate of return. If it is equal to one we may or may not accept the project as we are getting a return which is exactly equal to our desired rate of return. If it is less than one we reject the project proposal because the rate of return we are getting is less than our desired rate of return.

Putting it simply PI is an adaptation of the NPV rule because through it uses the same figures it only helps in ranking of the project.

Evaluation
The proponents of profitability index argue that since this criterion measures net present value per rupee of outlay it can discriminate better between large and small investments and hence is preferable to the net present value criterion. How valid is this argument ? Theoretically, it can be very easily verified that:

(i) Under unconstrained conditions, the PI criteria will accept and reject the same projects as the net present value criteria.

(ii) When the capital budget is limited in the current period, the benefit cost ratio criteria may rank projects correctly in the order of decreasingly efficient use of capital. However, its use is not recommended because it provides no means for aggregating several smaller projects into a package that can be compared with a large project.

(iii) When cash outflows occur beyond the current period, PI criteria is unsuitable as a selection criteria.

Internal Rate Of Return
When the present value of cash inflows are exactly equal to the present value of cash outflows we are getting a rate of return which is equal to our discounting rate. In this case the rate of return we are getting is the actual return on the project. This rate is called the IRR.



Using the same formula as given in the NPV above, IRR will be the return when the NPV is equal to zero as only then the present value of cash inflows will be equal to the present value of the cash outflows.


here CFt = cash flow at the end of year t
r = discount rate
n = life of the project

In the net present value calculation we assume that the discount rate (cost of capital) is known and determine the net present value of the project. In the internal rate of return calculation, we set the net present value equal to zero and determine the discount rate (internal rate of return) which satisfies this condition.

Both the discounting methods NPV and IRR relate the estimates of the annual cash outlays on the investment to the annual net of tax cash receipt generated by the investment. As a general rule, the net of tax cash flow will be composed of revenue less taxes, plus depreciation. Since discounting techniques automatically allow for the recovery of the capital outlay in computing time-adjusted rates of return, it follows that depreciation provisions implicitly form part of the cash inflow.

Internal rate of return method consists of finding that rate of discount that reduces the present value of cash flows (both inflows and outflows attributable to an investment project to zero. In other words, this true rate is that which exactly equalises the net cash proceeds over a project's life with the initial investment outlay.

If the IRR exceeds the financial standard (i.e. cost of capital), then the project is prima facie acceptable. Instead of being computed on the basis of the average or initial investment, the IRR is based on the funds in use from period to period.

The actual calculation of the rate is a hit-and-miss exercise because the rate is unknown at the outset, but tables of present values are available to aid the analyst. These tables show the present value of future sums at various rates of discount and are prepared for both single sums and recurring annual payments.

What Does IRR Mean?
There are two possible economic interpretations of internal rate of return: (i) Internal rate of return represents the rate of return on the unrecovered investment balance in the project. (ii) Internal rate of return is the rate of return earned on the initial investment made in the project.

Evaluation
A popular discounted cash flow method, the internal rate of return criteria has several virtues :

• It takes into account the time value of money.

• It considers the cash flow stream in its entirety.

• It makes sense to businessmen who want to think in terms of rate of return and find an absolute quantity, like net present value, somewhat difficult to work with.

The internal rate of return criteria, however, has its own limitations.

• It may not be uniquely defined. If the cash flow stream of a project has more than one change in sign, there is a possibility that there are multiple rates of return.

• The internal rate of return figure cannot distinguish between lending and borrowing and hence a high internal rate of return need not necessarily be a desirable feature.

The internal rate of return criterion can be misleading when choosing between mutually exclusive projects that have substantially different outlays. Consider projects P and Q .

-----------------------------------------------------------------
Cash Flows Internal rate Net present value
-------------- of return (%) (assuming k = 12%)
Period 0 1
----------------------------------------------------------------
P - 10,000 + 20,000 100 7,857
Q - 50,000 + 75,000 50 16,964

Both the projects are good, but Q, with its higher net present value, contributes more to the wealth of the stockholders. Yet from an internal rate of return point of view P looks better than Q. Hence, the internal rate of return criterion seems unsuitable for ranking projects of different scale.


Comparison of Discounting Methods
In ordinary circumstances, the two discounting approaches will result in identical investment decisions. However, there are differences between them that can result in conflicting answers in terms of ranking projects according to their profitability.

In formal accept/reject decisions, both methods lead to the same decision, since all projects having a yield in excess of the cost of capital will also have a positive net present value.


Example

Project A and B both require an outlay of Rs 1000 now to obtain a return of Rs 1150 as the end of year 1 in the case of A, and 1405 at the end of year 3 in the case of B. The cost of capital is 8%.

Internal rate of return A = 15%
B = 12%

Net present value A = (1150 x 0.926) - 1000 = Rs.65
B = (1405 x 0.794) - 1000 = Rs.115

Both project have rates of return in excess of 8% and positive net present value; but on the basis of the internal rate of return method, project A is superior, while on the basis of the net present value method, project B is superior.

Confusion arises because the projects have different lengths of the life, and if only one of the projects is to be undertaken, the internal rate of return can be seen to be unable to discriminate satisfactorily between them. As with any rate of return, there is no indication of either the amount of capital involved or the duration of the investment. The choice must be made either on the basis of net present values, or on the return on the incremental investment between projects.

The two methods make different implicit assumptions about the reinvesting of funds received from projects–particularly during the "gaps" between the end of one and the end of another.

The net present value approach assumes that cash receipts can be reinvested at the company's cost of capital, thereby giving a bias in favour of long-lived projects. In contrast, the internal rate of return approach assumes that cash receipts are reinvested at the same rate, giving a bias in favour of short-lived projects.

It follows that the comparison of alternatives by either method must be made over a common time period, with explicit assumptions being made about what happens to funds between their receipt and the common terminal date.

EVA'S CHARM AS A PERFORMANCE MEASURE
The central idea in most organisations is to tie managerial compensation to measures of financial performance that are linked closely to changes in shareholder wealth. In theory, this should motivate managers to maximise shareholder value.

The most direct financial performance measurement is the business's stock price. However, stock prices can be limited in their usefulness. The litmus test for any performance measure is whether it accurately reflects the decisions taken by management.

Economic Value Added (EVA), like other performance measures, attempts to resolve the tension between the need for a performance measure that is both highly correlated with shareholder wealth and responsive to the actions of a company's managers.

Investment distortions typically arise because a manager is not "charged" for the capital he or she uses or even rewarded for the shareholder value created. This is the fundamental contribution of EVA. It rewards managers for the earnings they generate but is also conditional on the amount of capital employed to reap these earnings. In this vein, EVA is defined as

EVA = NOPAT - (Kw x Net Assets)

Where NOPAT = Net operating profit after-tax,

Kw = Weighted average cost of capital and

Net Assets = adjusted book value of net capital

If managerial compensation is tied to EVA, then the managers inclination to consume capital is now tempered by the fact that he or she must pay a capital charge evaluated at the weighted average cost of capital on the net capital he or she used.

Earnings-based compensation schemes can cause over-investment of capital, whereas return on net assets (RONA-based compensation) can result in under investment of capital. Therefore, EVA has evolved as the focal point in many organisations as a means of marrying their project selection and managerial compensation schemes.

Why does EVA offer the correct incentives in the example above? The answer is simply that EVA is fundamentally related to shareholder value. At a company level, the present value of EVA's equals a business "market value added" (MVA), which is defined as the difference between the market value of the organisation and the (adjusted) book value of its assets. Moreover, at a project level, the present value of the future EVA's equals the NPV derived from the usual free cash flow forecasts.

If EVA and free cash flow analyses give identical NPV estimates, why is it that EVA is useful for compensation and NPV is not? The reason is that one needs flow measures of performance for periodic compensation since compensation is designed to provide a flow of rewards. EVA is a flow measure, whereas NPV is a stock measure.

Moreover, of the available flow measures, EVA is the only one that explicitly takes into account the cost of the capital and the amount of capital invested in the company. In this respect, EVA is superior to another flow measure, cash flow.

The goal of a good financial performance measure is to ask how well a company has performed in terms of generating operating profits over a period, given the amount of capital tied up to generate those profits. EVA is novel in that it provides as answer to this question. The idea is that the business financiers could have liquidated their investment in the company and put the liberated capital to some other use. Thus, the financiers could have liquidated their investment in the company and put the liberated capital to some other use. Thus, the financiers opportunity cost of capital must be subtracted from operating profits to gauge the organisations' financial performance. In this spirit, EVA views NOPAT as a representation of operating profit and subtracts a capital charge that views the economic book value of assets in place as a measure of the capital provided to the company by its financiers.

Estimating this capital base is the most cumbersome (yet necessary) aspect of the calculating EVA. How do we arrive at this number? A company's balance sheet contains one measure of the value of the organisations' assets in place. Unfortunately, due to a plethora of accounting distortions, the total asset value on this balance sheet is not an accurate representation of either the liquidation value or the replacement-cost value of the business assets. It is, therefore, of limited use for asset valuation and must be adjusted.

Stern Stewart is careful to adjust this accounting balance sheet before arriving at an estimate of the value of a company's assets in place. In fact, Stern Stewart considers more than 250 accounting adjustments in moving to EVA.

In practice, however, most organisations find that no more than 15 adjustments are truly significant. The adjustments include netting the non-interest bearing current liabilities against the current assets, adding back to equity the gross goodwill, restructuring and other write-offs, capitalised value of R&D (and possibly advertising), LIFO reserve and so on. (These accounting adjustments are referred to as "Equity Equivalents").

The debt balance is also increased by the capitalised value of operating lease payments. The goal of these adjustments is to produce a balance sheet that reflects the economic values of the organisations assets more accurately than the accounting balance sheet.

Limitations And The Future
EVA is, therefore, a powerful concept. However, before all businesses rush to adopt it, they should note that EVA is not the holy grail since it has its limitations. A frequently-asked questions is: What does EVA add to conventional valuation analysis? The answer is nothing. EVA based financial analysis will not (and should not) change the conclusions reached on the basis of cash flow-base valuation analysis.

However, this equivalence is to EVA's credit. In fact, one limitation of EVA is that it is often touted as a new valuation tool, which is simply incorrect. EVA should be viewed primarily as a behavioural tool that alters the distortions prevalent in many companies. The most severe limitation of EVA is what it(as well as most other financial measures) fails to capture on an ex post basis.
Total company value can be derived as the sum of two fundamental components as shown in Figure 14.1. The most basic component is represented by its physical assets in place. If we assume that this is an economic value, then we can equate this part to EVA's estimated capital component. In addition to this component, however, is the present value of the business growth opportunities. The components value is certainly less tangible and can be large for many businesses. One can view this part of company value as being driven by what the market expects to happen.

Unfortunately, EVA is unable to capture changes in this value. In fact, attempts to capture this value bring us back to simply looking at changes in an organisations' stock price. However, the limitations of stock price in judging corporate performance is what motivated our investigation of EVA in the first place.


Figure 14.1 The Components of firm Value

Example
Suppose that a manager at Super Company must choose one of three mutually exclusive projects. The company can invest Rs 50m in project A, or Rs 110m in project B or Rs 240m in project C.

PROJECT A generates incremental net operating profits after-tax (NOPAT) of Rs 50m one year from now and Rs 20m two years from now, after which the project is terminated.

PROJECT B generates incremental NOPATs of Rs 45m the first year, Rs 70m the second year and Rs 70m the third year and then the project is terminated.

PROJECT C is expected to generate incremental NOPATs of Rs 55m the first year, Rs 75m the second year, Rs 80m the third year and again the project is terminated.

Which project will the manger select if: (i) his compensation is tied to the rate of return of the project, (ii) his compensation is tied to project earnings (NOPAT) and (iii) his compensation is tied to EVA? Assume a cost of capital of 10% and that capital levels are maintained at their original levels throughout the life of each project. That is, new capital investment in any year equals depreciation in that year. Moreover, assume the capital is sold at its book value in the last year of each project's life. As a consequence, free cash flow will be equal to NOPAT in each year except for the last year, when the capital is recovered.

The internal rates of returns (IRRs), product earnings (NOPATs), free cash flows and NPVs are as follows:

----------------------------------------------------------------------------------
PROJECT NOPAT Free cash flows IRR NPV = PV of FCFs
(yearly) (million)
---------------------------------------------------------------------------------
A Rs 50, Rs 40 Rs 50,Rs 90 93% Rs 69.83

B Rs 45,Rs 70,Rs 70 Rs 45,Rs 70,Rs 180 53% Rs 124

C Rs 55,Rs 75,Rs 80 Rs 55,Rs 75,Rs 320 28% Rs 112.4
----------------------------------------------------------------------------------

Clearly, project B is the best for Super's shareholders. However, a managerial compensation or capital allocation scheme based or IRR will lead the manager propose project A. And if the manager is compensated based on product earnings, he will prefer introducing project C.

But if EVA is used to compensate managers, the correct project will be chosen, as can be seen from the following table, where we define EVA = NOPAT - (Capital Employed at Beginning of Period multiplied by cost of capital) :

PROJECT EVA NPV = PV of EVAs
----------------------------------------------------------
A Rs 45,Rs 35 Rs 69.83
B Rs 34,Rs 59,Rs 59 Rs 124
C Rs 31,Rs 51,Rs 56 Rs 112.4
-----------------------------------------------------------
EVA is a measure that is useful for every enterprise, but do not forget its limitations when you apply this measure to your company. We would suggest a detailed study of this before you apply it.
EVALUATING ALTERNATIVE PROPOSALS
The selection of a particular proposal should follow a careful appraisal of both alternative uses of funds and alternative means of performing a particular project. For instance, a company may wish to double the capacity of its production line, and determine three means of accomplishing this, namely;

• introduce double-shift working;

• install a second production line; or

• scrap the existing production line and build a new line with double the initial capacity.

The choice of a particular alternative will depend on how it accords with the firm's established investment objectives, and the choice of projects will depend on both corporate objectives and the availability of funds. But the fact remains that if the most advantageous alternative has been overlooked, no amount of technical evaluation and appraisal can overcome this basic ommission.

CAPITAL RATIONING

In terms of financing investment projects, three essential questions must be asked:

1. How much money is needed for capital expenditure in the forthcoming planning period?

2. How much money is available for investment?

3. How are funds to be assigned when the acceptable proposals require more money than is available?

The first and third questions are resolved by reference to the discounted return on the various proposals, since it will be known which are acceptable, and in which order of preference. The second question is answered by a reference to the capital budget. The level of this budget will tend to depend on the quality of the investment proposals submitted to top management. In addition, it will also tend to depend on:

• top management's philosophy towards capital spending (e.g., is it growth - minded or cautious:)?

• the outlook for future investment opportunities that may be unavailable if extensive current commitments are undertaken;

• the funds provided by current operations; and

• the feasibility of acquiring additional capital through borrowing or equity issues.

It is not always necessary, of course, to limit the spending on projects to internally generated funds. Theoretically, projects should be undertaken to the point where the return is just equal to the cost of financing these projects. If safety and the maintaining of, say, family control are considered to be more important than additional profits, there may be a marked unwillingness to engage in external financing and hence a limit will be placed on the amounts available for investment.

Even though the firm may wish to raise external finance for its investment programme, there are many reasons why it may be unable to do this. Examples include:

a) The firm's past record and its present capital structure may make it impossible or extremely costly to raise additional debt capital.

b) The firm's record may make it impossible to raise new equity capital because of low yields or even no yield.

c) Covenants in existing loan agreements may restrict future borrowing.

Furthermore, in the typical company, one would expect capital rationing to be largely self-imposed.

Each major project should be followed up to ensure that it conforms to the conditions on which it was accepted, as well as being subject to cost control procedures.
VENTURE MANAGEMENT AND RISK ANALYSIS
Venture management
Venture management is an approach to new product development and marketing that is based on the systems approach to corporate planning. Essentially, it requires that the management should view new product programmes as 'ventures'. In other words, from conception to commercialisation each new product is treated as one product, and handled by a small team which is responsible for the creation, evaluation, and marketing aspects of new product development and testing.

Venturing is an attempt to make innovation more predictable and less random than it otherwise might be by managing the new product development as a continuing commitment, rather than as a sporadic or periodic crash programme.
To be most effective, venture management requires that projects be subjected to a rigorous, multistage evaluation procedure. At each stage in this procedure the project is subjected to a go/no go decision to determine its eligibility to proceed to the next stage. The criteria on which these decisions are made should be clearly defined corporate objectives. The stages may be:
• concept testing;

• qualitative screening;

• economic analysis;

• product testing;

• test marketing; and

• phased launch/national launch.

Each particular new product venture will be unique, and will require its own specific combination and sequence of evaluation steps. It is the role of venture management to provide a framework within which the results of these various tests may be interpreted.

The usefulness of the venture analysis approach is in the viewing of project activities in relation to all other inter-related activities, rather than in total isolation. It enables management to compare alternative courses of action in a systematic way, with such results as:

• The impact of possible current decisions on the freedom of the firm in the future may be revealed.

• A clarification of the significance of current assumptions about the future, or the corporate objectives, may occur.

• A clearly defined and acceptable set of assumptions can be formulated.

• An internal consistency in the product plan may be achieved.

• Sensitivity analysed may be applied to each stage of the plan to illustrate the impact of changed assumptions and changes in policy on the end result.

By adopting a systems perspective that allows for interrelationships, it is obvious that present decisions will affect future outcomes. But by making explicit all possible alternatives or strategies, present and future analysis reduces the level of uncertainty, and thus reduces the likelihood of error in making the wrong decision.

Each strategy is a route to an objective, and the problem becomes that of choosing among alternative strategies to ensure that the best one is followed in terms of goal-attainment.

For projects to be effectively evaluated, venture analysis requires that some finite time horizon be specified. Such a planning horizon permits the building-in of the time-related effects of competing strategies, and the life of the project itself is best described in terms of the product life-cycle.

Given the length of the project, and the annual costs and revenues over that life, it is possible to evaluate the project in accordance with the discounted cash flow (DCF) procedure. Decision rules should be devised to facilitate simple evaluation of each stage, in relation to the expected financial outcome. The form of these decision rules may be:

For launch decision, the likelihood (i.e. possibility) of obtaining at least the ROI that can be obtained from other ventures must be greater than, say, 0.8 (i.e. 80% certain). For a scrap decision, the probability of obtaining this ROI must be less than, say, 0.4. If the probability of obtaining this ROI is between 0.4 and 0.8, the decision must be taken to test the product further.

At all stages, due consideration must be given to risk and uncertainty. These matters are discussed below.
RISK AND UNCERTAINTY
Risk is used to describe the type of situation in which there are a number of possible states of nature, hence outcomes, but in which the decision maker can reasonably assess the probability of occurrence of each. Thus risk can be expressed in quantitative terms.

Under conditions of uncertainty, in contrast, it is recognised that several out-comes are possible, but the decision-maker is unable to attach probabilities to the various states of nature.

The liability is usually due to a lack of data on which to base a probability estimate. For instance, in launching a new product, the marketing manager may have an idea of what the sales in year 1 are likely to be, but he must accept that the actual level will be one of many possible levels. However, the marketing manager may be unable to specify the probability of each level being achieved, making it an uncertainty situation.

There is also, of course, the situation of complete certainty. This relates to a decision over which the decision-maker has complete control, and is thus likely to be confined to the production sphere. This is so because the existence of external agents in marketing and distribution means that knowledge is incomplete, and the creative aspect of R & D means that outcomes are unknown in advance.

In relation to decision-making under conditions of risk and uncertainty, the purpose expressing an opinion about the likelihood of an event occurring is to facilitate the development of decision-making procedures that are explicit and consistent with the decision-maker's beliefs.

By convention, probabilities follow certain rules, such as:

• The probability assigned to each possible future event must be a positive number between zero and unity, where zero represents an impossible event and unity represents a certain one.

• If a set of events is mutually exclusive and exhaustive, then the total of the probabilities of the events must add to one.

Although analytical methods can be applied to evaluation of risk and uncertainty, management may prefer to take other courses of action to reduce risk and uncertainty. Perhaps the best method is to increase the information available to the decision-maker prior to his making a decision. For instance, marketing research can supply further information prior to new product launches via product testing or trial marketing.

Alternatively, the scale of operations may be increased, or product diversification pursued. Product A having a seasonal demand pattern that is the opposite of the pattern of product B. But in combination they only produce profits. Whereas either product in isolation would result in a loss during part of its demand cycle.

Allowing for Risk
In investment decision-making, risk generally derives from five sources:
• risk from undertaking insufficient numbers of similar investments;

• risk from misinterpretation of data;

• risk from bias in the data in their assessment;

• risk from a changing external economic environment, invalidating much of the usefulness of past experience; and

• risk from errors of analysis.

The pre-requisite to allowing for risks such as these is the establishment of a risk policy. The amount of risk a firm is willing to accept to obtain a given financial return is a general question of values that cannot be rationally determined. A firm may, for instance, opt for a policy of conservatism and require a very high return for risk, or alternatively for a policy of taking greater risks. The major problem is, perhaps, that in pursuing a conservative policy as regards investment, the firm places itself in a risk situation because of its unwillingness to accept risky investments.

Once a policy has been determined, it must be translated into specific rate of return requirements for different types of projects. The categories of project may be:

a) cost saving investments;

b) replacement investments;

c) market expansion investments;

d) investments required by regulations; and

e) welfare amenity investments.

Each category will involve different types of risk, and the aim of classifying the various investment proposals by type is to ensure that they all receive equal consideration once due allowance has been made for the differential risk involved.

For practical business decisions, agreement on the exact method of incorporating risk into analysis is less important than agreement that varying the discount rate used in evaluating a project is not a good way of accomplishing the objective of taking risk into consideration. (The discount rate is the rate that is used to reduce future income streams to their present value and is the converse of an interest rate).

The application of simple risk analysis is best illustrated by means of an example. Let it be assumed that RS Limited has two new products A and B, but only sufficient resources to launch one of these. The relevant states of nature relate to competitive activity; no matter which product is launched, it may be assumed that the competition will:

l do nothing; or

l introduce a comparable product; or

l introduce a superior product.

On the basis of past experience and current knowledge, the management of RS Limited attach probabilities of 0.25, 0.5, and 0.25 respectively to these states of nature. In the light of these alternative conditions, the profit of each strategy can be shown in law pay-off matrix.

Allowing for Uncertainty
Uncertainty arises from a lack of previous experience and knowledge. In a new venture, it is possible for uncertainty to be attached to the following factors:

• date of completion;

• level of capital outlay required;

• level of sales prices;

• level of revenue;

• level of sales volume;

• level of operating costs; and

• taxation rules.

Inevitably, decision-making under conditions of uncertainty is more complicated than is the case under risk conditions. In fact there is no single best criterion that should be used in selecting a strategy. Of the various available techniques, company policy or the decision-marker's attitude will determine that which is selected.
ANALYSIS OF NON FINANCIAL ASPECTS

Investment decisions are based on appraisal and evaluation techniques. Apart from technical and financial viability the project's economic and socio-political costs also matter.

Economic Aspects
Institutions and banks consider various economic factors before deciding to invest in a project. Various analytical tools exist to assist the decision maker in dealing with this situation. Among these tools are: cost-benefit analysis, risk-benefit analysis, risk-cost benefit analysis, project economic viability, opportunity cost and insurability limits. It is not suggested that these methods give exact results, but only that they reveal something of the nature of the underlying valuation.

For a completely satisfactory assessment of the cost and benefit aspects of the acceptability of risk, the assessment has to include evaluation of the following:

1. The total costs associated with each option.

2. The benefits in money terms associated with each option. It must be recognised that, at least initially, all the benefits may not be expressed directly in quantitative terms and there may be problems in converting qualitative statements about benefits into quantitative statements.

3. The costs in quantitative terms associated with the direct and indirect risks inherent in each option.

4. The errors and uncertainties associated with the estimates of costs and benefits.

5. The overall economic implications of the options considered.

Given the doubts about the feasibility of finding universal criteria for assessing the ranking that economic factors justify, it is suggested that for many cases ranking of acceptability of the economic factors could be made on the basis of the life cost and benefits, the calculation taking into account all direct and indirect costs and benefits. It also has to be accepted that the calculation has to include a factor to allow for the risk of the project not being completed. Such a factor may be a compound factor, which includes allowance for all the features of the economic environment that may cause a project to fail.

It should be recognised that simply postulating a ranking criteria does not resolve the moral question of how the costs of benefits should be distributed, answer questions about the macro-economic significance of the proposal, or explain how the calculation should be made. The moral question is partly answered by assessing public reaction to a proposal and this point is discussed next under the heading of socio-political factors.

Socio-Political Aspects
When these decisions are considered from the point of view of society, they go beyond finding out cash inflows and outflows, the benefits to society are also worked out. For example, whenever a new capital intensive project is undertaken, its impact on the health of the society is seen in terms of environmental pollution, noise pollution, employment generation, etc.

Because of the nature of socio-political factors the problems involved in assessing their significance in decision making are quite different to the problems of assessing technical and economic factors. Socio-political aspects of a decision are concerned with what ought to be, and such decisions are quite different from technical judgements which are concerned with what can be done.

There are four methods for assessing acceptability of socio-political factors:
Method Strengths Limitation Comment
Epidemiological studies Relates what has already been accepted to environment of decision being considered Past experience may not be relevant to the future. Does not represent a commitment by public involved such studies identify past areas of concern, but do not predict present or future concerns or reaction to novel proposals
Consultation Quick, provided appropriate machinery for consultation already exists. Can give a permanent form of contact between the public and the project and the decision makers Those consulted may not represent the views of the whole community affected by the proposal in question. May be difficult to organise when national boundaries have to be crossed. Does not represent a commitment by the public involved The success of this method depends upon those consulted being fully aware of the views of the community concerned and understanding the issues involved. Sometimes it can take two or three years to arrive at a view
Sampling A sample survey can provide structured evidence about views on acceptability Does not give every-one a chance to express their views about what is acceptable. Does not represent a commitment by the public involved The sample surveyed must be taken directly from the population affected by the decision and for the results of the sampling process to really help the decision maker the population sampled must understand the issue involved
Voting It is the most comprehensive way of establishing the views and wishes of a particular population Not appropriate for all projects particularly small ones. Expensive and slow to arrange. Unless some form of compulsion is used not everyone will vote. Not necessarily binding on either party involved If the result is clear it gives the decision maker positive guidance on the action the population consider should be taken. If the verdict is marginal the issue is not efficiently resolved for the decision maker



There are four methods for assessing acceptability of socio-political factors:

The conclusions that can be made about the problems of assessing socio-political factors are:

1. The socio-political factors related to complex decisions can be evaluated by carefully designed surveys.

2. Changes in opinion that take place over a period as short as two years can be detected by conventional survey methods.

3. Variations in views can be detected over a relatively small geographical area.

4. For an effective survey to be made the nature of the risk must be explained to the population being surveyed.

5. A sample opinion survey does not represent any kind of commitment by the people being surveyed, whereas voting procedures may be binding.

6. For the decision maker considering a major public project there may be considerable uncertainty about the viability of the assessment of public acceptability unless it is based on the results of a voting procedure.

7. For small non-conventional projects' surveys of the public's view of the acceptability of a proposal may not be justified.

SUMMARY
There are two broad categories of appraisal criteria : non-discounting criteria and discounting criteria. The important non-discounting criteria are : urgency, payback period, accounting rate of return, and debt service coverage ratio. The important discounting criteria are : net present value, benefit cost ratio, internal rate of return, and annual capital charge.
According to the urgency criterion, projects which are deemed to be more urgent get priority over projects which are regarded as less urgent. The problem with this criterion is : How can the degree of urgency be determined ?
The payback period is the length of time required to recover the initial cash outlay on the project. According to this criterion, a project is acceptable if its payback period is less than a certain specified payback period. Though the payback period has serious shortcomings, it is widely used because it seems to serve as a proxy for certain types of information which are useful in investment decision-making.
The accounting rate of return, also referred to as the average rate of return, is a measure of profitability which relates income to investment, both measured in accounting terms. Since income and investment can be measured variously, there can be very large number of measures for accounting rate of return. A project is deemed acceptable if its accounting rate of return exceeds a certain cut off rate of return.
Financial institutions, which provide the bulk of long-term finance for industrial projects, consider debt service coverage ratio (DSCR) as an important index of financial viability. DSCR is calculated for each year of the currency of the loan an for the entire period of the loan. A DSCR of 1.5 to 2.0 is considered satisfactory.
The net present value of a project is equal to the sum of the present value of all the cash flows (outflows and inflows) associated with the project. A project is acceptable if its net present value exceeds zero.
The net present value method assumes that the intermediate cash inflows of the project are reinvested at a rate of return equal to the firm's cost of capital.
The net present value criterion has a sound rationale underlying it: When the net present value is maximised, you reach the highest consumption frontier.
A project is acceptable if the profitability index, as per the first measure, exceeds 1. (An equivalent decision rule is: Accept a project if its benefit cost ratio, as per the second measure, exceeds 0.)
The internal rate of return of a project is the discount rate which makes net present value equal to zero. A project is acceptable if its internal rate of return exceeds the cost of capital.
There are two possible economic interpretations of internal rate of return: (i) Internal rate of return represents the rate of return on unrecovered investment balance in the project. (ii) Internal rate of return is the rate of return earned on the initial investment made in the project.
If the cash flow stream of a project has multiple changes of sign there may be more than one internal rate of return.
The annual capital charge of an investment is the cost on an annual basis of the initial outlay and operating costs associated with that investment. This method is helpful in choosing between alter natives which provide similar service but have differing patterns of costs associated with them.
Economic Value Added (EVA), like other performance measures, attempts to resolve the tension between the need for a performance measure that is both highly correlated with shareholder wealth and responsive to the actions of a company's managers.
The number of companies that have adopted EVA (or one of its many close cousins, such as McKinsey's Economic Profit) is startling. Stern Stewart Management Services (the founder of EVA) claims that more than 200 companies globally have been in discussions with it about adopting EVA.
A wide variety of measures are used in practice for appraising investments. These include measures suggested by capital budgeting literature and several non-standard measures.
The most commonly used method for evaluating small-sized investment is the payback method. For larger investments, accounting rate of return, and, in more recent years, discounted cash flow methods, are commonly employed.

KEY CONCEPTS AND TERMS
Accounting Rate of Return (ARR)

If you have any insight on this, or if you are looking for information on the same topic, please engage with this member to help add value to this discussion.
Disclaimer: This network and the advice provided in good faith by our members only facilitates as a direction towards the actions necessary. The advice should be validated by proper consultation with a certified professional. The network or the members providing advice cannot be held liable for any consequences, under any circumstances.
Explore Topical Knowledge Areas

Interesting Relevant Discussions

DISCUSSSION STATISTICS


2872
VIEWS

PLEASE KEEP YOUR CONDUCT PROFESSIONAL AND POLITE


3M Users, 100K+ Documents & 450K+ Discussions

Share »

Community Support & Professional Insights. Login or Register.
Email/Username     Password  

About Us - Advertise - Contact Us - RSS   On Google+  
All trademarks and copyrights held by respective owners. Member comments are owned by the poster.
Privacy Policy | Disclaimer | Terms Of Service
Facebook Page | Follow Us On Twitter | Linkedin Network