Professional Documents
Culture Documents
1227429
Date Sent:
15th April
Module Title:
Module Code:
IB91Z0
Date/Year of Module:
Submission Deadline:
Word Count:
2802
Number of Pages:
15
Question:
This is to certify that the work I am submitting is my own. All external references and
sources are clearly acknowledged and identified within the contents. I am aware of the
University of Warwick regulation concerning plagiarism and collusion.
No substantial part(s) of the work submitted here has also been submitted by me in other
assessments for accredited courses of study, and I acknowledge that if this has been done
an appropriate reduction in the mark I might otherwise have received will be made.
Contents
[I] Introduction .................................................................................................................................................... 3
[II] Project Appraisal Methods ...................................................................................................................... 3
[II]A. Net Present Value (NPV): ................................................................................................................ 3
[II]B. Internal Rate of Return (IRR):....................................................................................................... 4
[II]C. Accounting Rate of Return (ARR): ............................................................................................... 4
[II]D. Payback and Discounted Payback:.............................................................................................. 4
[II]E. Sensitivity Analysis:........................................................................................................................... 5
[II] F. Scenario Analysis:.............................................................................................................................. 5
[III] APPRAISAL METHODS IN PRACTICE ................................................................................................ 5
[III] A. Empirical Evidence ......................................................................................................................... 6
[III] B. Factors Influencing Use of Appraisal Techniques: ............................................................. 7
[IV] Adjustment in Traditional Approaches and New Possible Approaches ............................. 9
[IV] A. Real Options Method ...................................................................................................................... 9
Option to Defer/wait option ................................................................................................................. 9
Option to Follow-on/Growth option................................................................................................. 9
Option to Expand..................................................................................................................................... 10
Option to Abandon ................................................................................................................................. 10
Option to Switch/Flexibility Option ................................................................................................ 10
Option to Contract/Scale down ......................................................................................................... 10
Option to Stop/Shut Down Temporarily ....................................................................................... 10
[IV] B. Strategic Cost Management (SCM) ......................................................................................... 10
[IV] C. Multi-attribute decision model MADM ................................................................................. 11
[IV] D. Value analysis and analytical hierarchy method .............................................................. 11
[IV] E. R&D method ..................................................................................................................................... 12
[IV] F. Uncertainty method ...................................................................................................................... 12
[V] Conclusion .................................................................................................................................................... 12
[VI] Executive Summary ................................................................................................................................ 13
[VI] References .................................................................................................................................................. 14
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Table of Figures
I.
II.
III.
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[I] INTRODUCTION
Project appraisal technique is an engagement of fundamental knowledge and
preliminary information to derive the correct decision before investing capital in a
project. Projects need to be analyzed quantitatively as well as qualitatively to establish
the hidden potential of the project and then decide upon the investment. Envisioning
the outcome becomes important before making a capital investment and hence methods
or techniques need to be used to provide consent to a project (Anuar, 2005). The
following report critically examines the main technique for project appraisal and
attempts to explore its utility and efficiency and benefits to the industry. It considers
the advantage and disadvantage of these factors and provides empirical evidence to
support it. These methods are in use since countless years and technology has had its
impact on these appraisal methods, eroding a few, thereby requiring necessary changes
and adjustment to suit the current industry projects. In the mean while new appraisal
methods have been proposed for better flexibility and accuracy of decision-making.
The author has tried to do an assessment of the collected empirical evidence with
discussion over the report to provide an effective conclusion.
For NPV, first find out about the present value of the cash inflow discounting it by
opportunity cost of capital. Assume cost of capital is 10 percent,
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Principally, it is the rate of return, internal, as it does not consider the external inflation
or rate of interest. As we saw for NPV, if the result is positive, project could be
accepted. For IRR if IRR greater than cost of capital, Project can be accepted. (Brealey
et al., 2011)
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our investment. Hence, essentially, it is the length of time taken to recover our initial
investment. Whereas, Discounted Payback considers the net positive discount values
the project is predicted to generate at its different stages.
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and more rewarding in result (Anuar, 2005). The argument put forward is that
companies look for maximizing profit and to achieve the desired profit, an effective
evaluation of the investment is required, which is best done using an appraisal
technique (Milis et al., 2009).
Indian, both medium and large sized, firms tend to use payback method. Second most
common among such firms is IRR. The common trend observed was to recover the
investment as early as possible. The prominent reason for non-popularity of DCF is
lack of experienced professionals and difficulty in using it. Similarly, even the
managerial class was reluctant to use it. (Pandey, 1989 as cited in Njiru, B. M., 2008)
In 1993, Payback method was used by 86% of the 260 UK manufacturing businesses
that were surveyed by Drury et al., (as cited in Njiru, B. M., 2008). Surprisingly; IRR,
ARR and NPV were also used at a high scale. The appraisal techniques conveyed
usage of more than 70% for the manufacturing firms. The results illustrate that 100 of
the largest 300 UK firms use more than one appraisal technique. Almost all (94%) the
companies applied payback with some or the other technique. It was observed that
NPV and IRR recorded high popularity with 74% and 81% respectively (Pike, 1996).
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Arnold and Hatzopoulos (as cited in Njiru, B. M., 2008) survey in 2000 gave us
attractive figures.100 firms were surveyed from UK. Firms seen to be using NPV or
IRR or both. 81% use at least one of the two. Survey gave us results showing 34%
using all four techniques (NPV, ARR, IRR and Payback), 42% using three of the four
and 17% using two of them.
In juxtapose, there are surveys where capital budgeting doesnt play a major role in
decision-making for companies. The disparity between theories with respect to
practical investment decisions was evident when model companies from Netherlands
UK and professionals linked with APM or PMI-NL from UK were considered.
Complementary to our previous results it was found that 65.8% of the surveyed firms
did not use any appraisal method. Popular appraisal methods among the remainder of
the firms were NPV (13.7) followed by IRR (10.3%). Analysis of the surveys
conveyed that combinations of methods were used as the firms felt that individually
these techniques were not sufficiently efficient. (Mehari, 2002)
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Figure 1: Tabular representation of the factors influencing the choice of the capital investment
appraisal techniques (Njiru, 2008, p. 29)
Interestingly, size of the firm is a very important factor in determining the project
appraisal method, as bigger firms prefer computer-based analysis, which involves
discounted cash flows. Skilled and trained managers are required to understand and
analyze the project appraisal methods and hence it is now included in management
studies as a key element and hence now more complex methods are preferred as
compared to simple methods that were preferred initially. (Pike, 1996)
Survey analysis provided us with a relation between market risk and project appraisal
technique, which is a relation of inverse proportions. It also considered the size of the
firm as a criterion for evaluation. Results found that the complexity of the method used
depends on the size of the company. As the firm size increases, the complexity of the
methods increases. (Schall, 1978)
While considering these factors for a small firm where debt, retained market earnings
and equity conditions played a very insignificant role in decision making we find that a
small firm would focus on reduction of tax and take a calculated risk and would look
for period of return and not on the rate of return and hence payback was the most
preferred method amongst such firms. (Runyon, 1983)
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A modified NPV will potentially be more accurate hence will have more usage. Now,
this includes considerations of inflation and variation of the discount factor. Put forth
values of risk of projects that seemed out of reach. Qualitative analysis of the project is
required as compared to its NPV to give us a real idea of the situation (Adler, 2000).
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3. Option to Expand
Providing flexibility to an option depending upon market conditions is what is made
available to an investor in expanding options.
4. Option to Abandon
The choice offered to an investor to make investments based on information and also
allow the investor to stop or continue at different points of the project is what is mean t
by option to abandon (Huchzermeier and Loch, 2001 as cited in Anuar, M. A., 2005).
5. Option to Switch/Flexibility Option
Operations altered after initial investment depending upon pricing of the stock.
Operations of the firm switched depending upon the need of the investor so as to
appropriate the returns are what define options to switch/ flexibility option.
(Huchzermeier and Loch, 2001 as cited in Anuar, M. A., 2005)
6. Option to Contract/Scale down
If the investor is making losses in his initial investment and feels his project approval is
not appropriate then he can scale down his losses by appropriate scaling down the total
required investment. This usually happens when the market is uncomplimentary.
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Figure 2: Tabular representation of Strategic Investment Decision Making Using MADM (Adler, 2000,
p. 20)
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Figure 3: Graphical Representation of Strategic Investment Decision Making Using the Uncertainty
Method (Adler, 2000, p. 21)
[V] CONCLUSION
As shown by the empirical evidence traditional investment appraisal techniques are by
far the most used methods for decision-making. However, trained and skilled managers
raise doubts about the accuracy in the present era. So it is important to adjust and
revise the methods currently in practice. Evidently, this report is in favor of MI, as I,
too, believe that theoretical methods are needed before decisions regarding capital
budgeting are made, as experience is not enough. Personal instinct or experience does
help but qualitative and quantitative analysis has no substitute. A capital investment
decision requires analytical tools to help them with numbers values and grades to
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decide better. Investment appraisal techniques do the same. Hence, I strongly agree
with MI.
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[VI] REFERENCES
Adler, R. W. (2000). Strategic Investment Decision Appraisal Techniques: The
Old and the New. Business Horizons, Vol 43(6), pp. 15-22.
Anuar,M.A. (2005). Appraisal techniques used in evaluating capital
investments: conventional capital budgeting and the real options approach
(Doctoral dissertation, Loughborough University).
Brealey et al. (2011) PRINCIPLES OF CORPORATE FINANCE. 10th ed. New
York: McGraw Hill Irwin.
Hermes, N., P. Smid and L. Yao., (2005): Capital Budgeting Practices: A
Comparative Study of the Netherlands and China, Research paper, University of
Groningen.
Mehari, M.A., (2002): Evaluating the Capacity of Standard Investment Appraisal
Methods Tinbergen Institute Discussion Paper, Erasmu University, Rotterdam.
Milis, K., Snoeck, M., & Haesen, R. (2009). Evaluation of the applicability of
investment appraisal techniques for assessing the business value of IS services.
FBE Research Report KBI_0910, 1-19.
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