Investment Appraisal Techniques
Meaning of Capital Budgeting – Capital budgeting can be defined as the process of planning an organisation’s expenditures on any proposed assets where returns are expected to exceed a period of one year. The term capital refers to fixed assets used in production whereas budget is a plan which details projected inflows and outflows during some future periods. Thus, capital budget outlines the planned expenditures on fixed assets.
Research has it that effective capital budgeting improves when the timing of asset acquisitions is put into consideration, it also affect the quality of the assets that is been purchased. The firm, which foresees its needs and purchases capital assets early, will have the opportunity to install the assets before its sales are at capacity. Wrong forecast of assets requirement can have serious consequences. For instance, if a firm had invested too much in assets, it will incur unnecessary heavy expenses.
If the capital assets are not enough, the firm may not produce competitively, it may lose some portions of its share of the market to rival firms and regaining lost customers requires heavy selling expenses, price reductions, and product improvements, which are costly. Assets expansion involves large expenditures, which need to be arranged several years in advance, hence the need for effective capital budgeting. Each firm will have its own procedures to follow in capital budgeting.
These typically will include establishing selection criteria, investigating proposals to determine their value and feasibility, comparing alternative projects, determining financial needs, costs, and resources, deciding on the projects to be implemented, allocating funds to their development, controlling and reviewing results.
The project cash inflows and outflows must be determined. Included in these flows will be the actual outlays, projected returns, delivery and installation charges, salvage values on both old and new assets, additional working capital needs and certain annual expenses.
The risk elements in the proposed outlays must be estimated in one way or another. Risk in any particular project will be determined, at least in part, by the relative size of the proposal, the flexibility of the assets involved, the duration of the expected return period, and the degree of control (if any) that the investor has over its markets, sources of supply, labor pool, etc. The various risk elements must be quantified, and the use of probabilities is one of the more commonly accepted methods of doing this. The proposals must be formally appraised using all these data.
Basic Capital Budgeting Techniques Under Certainty
The capital budgeting process starts with the establishment of objective(s) and criteria for investing financial resources of an entity in long term projects. This is followed by creative search for feasible investment opportunities. Investment opportunities could be new capital projects or replacement of existing ones as they turn out to be unprofitable with passage of time. It could be mutually exclusive investment opportunities like in the case of building commercial residential accommodation or factory building on the same plot of land. It could be independent investment opportunities where all the identified investment alternatives can be undertaken at the same time provided there is no capital constraint. For instance an investor can invest in money market and capital market instruments at the same time once the wherewithal is there. The fourth stage is the estimation of cashflows from the various investment opportunities on assumption that we can estimate in advance and with certainty too, the monetary values of costs and benefits from any investment proposal. Cash flow. is simply cash received less cash paid out.
The timing of the cash flows is very important in evaluation of any investment proposal. The impact or effect of inflation should be factored into the estimation of cash flow. The fifth stage can be described as the project/investment evaluation period where you get to determine if as an investor you should commit your scarce resources to the project or go with the alternatives or you should adopt using the appraisal techniques to be discussed from now onward.
The Capital Investment Appraisal Techniques
The techniques can be classified into two categories namely the traditional or conventional or non-discounted cash flow methods and the discounted cash flow (DCF) methods. The traditional methods include the following;
- Accounting Rate of Return (ARR)
- Non-discounted payback period (NDPBP)
The discounted cash flow (DCF) methods are as follows:
- Discounted payback period (DPBP)
- Net present value (NPV)
- Internal rate of return (IRR)
- Profitability index (PI)
- Cost benefit analysis (CBA)
Investment Appraisal Techniques – Accounting Rate Of Return (ARR)
The ARR can equally be referred to in this regard as the return on investment (ROI) or the return on capital employed (ROCE) by the investor. It is computed based on the accountant concept of profit calculation. Simply put, ARR is the ratio of profit after depreciation charges to the project cost. It could be computed using the following four methods.
Advantages of Accounting Rate of Return (ARR)
(1) It is not completed, hence easy to calculate and widely understood.
(2) It can be obtained from readily available accounting data.
(3) It make use of data generated throughout the project life.
(4) The rates are presented in form of the familiar percentage figure that can be easily understood.
Disadvantages of Accounting Rate of Return (ARR)
(1) It Doesn’t recognize the concept of time value of money.
(2) There is no rule for setting the minimum acceptable ARR by the management.
(3) It suffers definition problem in that it can be calculated in four different ways.
(4) It uses accounting profit instead of cash profit.
Investment Appraisal Techniques – Non-Discounted Payback Period (NDPBP)
The payback period method measures the length to time it takes a project cash inflow to repay its initial capital outlay. Management usually establishes the firm’s maximum payback period target for planned investment projects and then provides operational guidelines such that only investments resulting in payback periods which are either less or equal to the policy in place. It then becomes easier to review the proposed payback period that will be rejected or accepted as the case maybe. For instance, if the policy – determined expected payback period is 5 years, then any project with payback period greater than 5 years is deemed to be too risky and hence rejected. It is assumed that the shorter the payback period the lower the chance of making for a risky project.
The payback period can be calculated in two different ways depending on the type of the investment cashflow.
Investment Appraisal Techniques – Annual Constant Cash Flow (ACCF)
(i) Annual Constant Cashflow (ACCF): If the project annual cash inflow is constant, the PBP is calculated using the formula method. That is: PBP = Initial Capital Outlet (ICO)
(ii) Annual Irregular Cash Flow (AICF): If the project annual cash inflow is irregular, the PBP is calculated using the recouping or sequential check-off method. The process of AICF will be sustained, it will be stopped when the ICO is written off entirely. The year in which it is written off represents the payback period.
(iii) Independent Projects: Accept if the project has a PBP that is equal to or less than that set by the management. Reject if the project has a PBP that is higher than that set by the management.
(iv) Mutually exclusive projects: Select the project with the least PBP but ensure that the project selected has a PBP that is equal to or less than that set by management.
Advantages of Payback Period (PBP) Methods:
(1) It is simple to calculate and understand.
(2) It makes use of cash profit which is considered as a superior to accounting method for profit.
(3) It serves as a simple initial screening process for new project.
(4) Emphasis is on liquidity because the lower the PBP the more liquid the company becomes.
(5) It is useful in risk analysis.