financial analysis

Masters Programmes

Assignment Cover Sheet Submitted by: 1227429 Date Sent: 15th April Module Title: Financial Analysis for Management Module Code: IB91Z0 Date/Year of Module: Jan 7th to March 12th 2013 Submission Deadline: 12 noon, Monday 15th April 2013 Word Count: 2802 Number of Pages: 15 Question: Projecting or Rejecting Project Appraisal: Are Academics Wrong? 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.

WARWICK BUSINESS SCHOOL STUDENT ID:1227429

1 Analytical Study of the Applicability of Project Appraisal Methods

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



Table of Figures

I. Figure 1: Tabular representation of the factors influencing the choice of the capital investment appraisal techniques (Njiru, 2008, p. 29) ............................ 8

II. Figure 2: Tabular representation of Strategic Investment Decision Making

Using MADM (Adler, 2000, p. 20) ................................................................................11

III. Figure 3: Graphical Representation of Strategic Investment Decision Making Using the Uncertainty Method (Adler, 2000, p. 21) .............................12



[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.

[II] PROJECT APPRAISAL METHODS

[II] A. NET PRESENT VALUE (NPV):

NPV is a comparison of the present values of the return, discounting it at the

opportunity cost of capital with the initial investment. We will try to explain this using

an example. Consider you are buying a house for $1 million and your broker predicts

that you will be able to sell it off, next year, at $1.2 million. To decide for project

appraisal, we use the technique of Net Present Value, We go ahead with the project if

NPV is positive.

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,

PV = $1.2 million/1.1 = $1,090,909.09



NPV = PV initial investment = $1,090,909.09 $1 million = $ 90,909.09

Net Present Value is positive, if we are using this project appraisal technique we would

go ahead with the project.

[II] B. INTERNAL RATE OF RETURN (IRR):

IRR deals with measuring the return on a capital investment. The discounting factor is

the initial investment itself.

Rate of Return = (Payoff / Investment) 1

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)

[II] C. ACCOUNTING RATE OF RETURN (ARR):

Decision based on accounting profit of the project or firm and the impact the project

will have on the profit is the core of ARR. ARR roots its decision on profit and not on

cash flows. Therefore, where cash flows are involved you need to consider the

depreciation to evaluate the profit. ARR, fundamentally, is the percentage of the

average accounting profit after its depreciation to initial capital investment.

Average Annual Income = Average Annual Cash flow Depreciation

Average Annual Investment

[II] D. PAYBACK AND DISCOUNTED PAYBACK:

The time taken to recover the initial investment without considering other useful

information like earnings or time value of money is called payback method. In this, we

decide to accept or reject a project depending upon how soon are we able to recover



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.

[II] E. SENSITIVITY ANALYSIS:

Sensitivity analysis allows us to predict outcomes of a particular variable which is

sensitive to other variables in the market environment. Herein, we provide probability

values to variables in order to evaluate the optimal option. It requires consideration of

the most sensitive variables that have the probability of being endangered by

fluctuation after investment. Cost benefit analysis should include sensitivity analysis

for larger projects.

[II] F. SCENARIO ANALYSIS: External factors, creating a scenario, do affect the project in hand and thereby needs to

be analyzed and evaluated. Creating appropriate scenarios and grading them with a

range of values within a stable framework is scenario analysis. Scenario analysis

followed by NPV provides a much efficient result. (Department of Public Expenditure

and Reform, n.d.).

[III] APPRAISAL METHODS IN PRACTICE

Academicians rightly argue that appraisal techniques augment the financial analysis

and evaluation of an investment. The efficacy of decision-making increases with these

techniques. The quantitative analysis required altering future aspects of strategy and

financial investment can be attained easily using these techniques. The project

appraisal techniques increase the compatibility of evaluation and analysis of the

investments. When considering projects with high market risk or high technology, we

need to make the techniques sufficiently compatible to work out a decision.

Academicians feel that appropriate, precise and trustworthy information suitable for

decision-making is used by appraisal techniques. The experience of academicians, with

decision making provided by appraisal techniques seem to be favorable, practically,



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).

[III] A. EMPIRICAL EVIDENCE

In 1978, 86% of the US firms used IRR or NPV with payback for their investment

appraisal. Ironically, without payback only 16% firms use IRR and NPV. Discounted

cash flow methods coalesced with payback was the most widespread method used in

the US (Schall et al., 1978). Similarly Moore and Reichert in 1983 (as cited in Njiru, B.

M., 2008) concluded that ARR was the least common method used while agreeing on

payback being the most popular with 80.3% US firms adopting it. In 1984, surveys

revealed that 65.3% US MNCs used IRR and 16.5% used NPV as their core project

appraisal technique whereas 37.6% used payback and 30% used NPV as their

subordinate skill to evaluate the projects. (Stanley and block, 1984 as cited in Njiru, B.

M., 2008)

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).



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)

A survey of a comparative manner, in two different countries China (Developing) and

Netherlands (Developed), was conducted to base their decision about project appraisal

techniques in relevance with economy of the country. CFOs of 250 companies of

Netherland stated NPV as the most popular approach at 79%. Whereas, China in

comparison highly preferred IRR and Payback and NPV was not so popular within this

country. Survey concluded that developed economies prefer more complex methods

for investment appraisal than a developing economy (Hermes et al., 2005).

[III] B. FACTORS INFLUENCING USE OF APPRAISAL TECHNIQUES:

Developing financial markets, requirement of more accurate results, better skilled and

trained CFOs who understand appraisal techniques better so they can be exposed to

more complex techniques (Hermes et al., 2005). The Performance and the industry

sector also play an important role in decision of appraisal techniques. High performing

companies do experiment with market measures and complex techniques whereas low

performing companies use traditional approach. A retail sector firm would use a more



simple or a regular method of investment appraisal technique whereas one in banking

or finance would prefer combined method with complex techniques. (Mehari, 2002)

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)



[IV] ADJUSTMENT IN TRADITIONAL APPROACHES AND FUTURE APPROACHES

The existing investment appraisal techniques need modifications to survive in the

present state. The shortcomings need to be eliminated by modifying the method

appropriately and consideration of options like combining or effective usage at

appropriately places. If looking for potential of new appraisal methods then we will

have to take a completely different path.

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).

[IV] A. REAL OPTIONS METHOD

Real options allow deferring, upgrading and stopping of projects, thereby capturing

opportunities that are missed out by traditional approach model. The core of real

options model is Option Pricing Theory, which is based on flexibility of investment.

The Types of Real Options

1. Option to Defer/wait option

Deferring the investment or keeping it on hold, till solid information becomes available

for the investment project is the main crux of this option.

2. Option to Follow-on/Growth option

Growth opportunity after initial investment, on similar lines to the initial investment or

option available after initial investment for growth of the previous investment is the

core concept of follow-on/growth option.



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.

7. Option to Stop/Shut Down Temporarily

Its a wise decision to shut down operations temporarily sometime, if the fluctuation of

the market in having adverse effects on your project. Projects with high price

fluctuation usually consider this option. (Anuar, 2005)

[IV] B. STRATEGIC COST MANAGEMENT (SCM)

The value chain analysis that allows a competitive advantage making sure of

appropriate costing is SCM. It allows appropriate control over strategies. The decision-

making is done on basis of its effect on the value chain, the advantage over competitors

and increment it will show on the cost drivers.



[IV] C. MULTI-ATTRIBUTE DECISION MODEL (MADM)

Using NPV or payback to perform the financial analysis and taking into consideration

the satisfaction of the individual, then modeling the project according to the

individuals preferences, allowing an advantage to get the required return is MADM.

Attributes are awarded values on their importance they hold and the effect they hold on

the performance of the company. It was said that MADM helps us analysis the risk/

uncertainty the project has if approved.

Figure 2: Tabular representation of Strategic Investment Decision Making Using MADM (Adler, 2000, p. 20)

[IV] D. VALUE ANALYSIS AND ANALYTICAL HIERARCHY METHOD

This, at times, is considered a subset of MADM as it differs only in terms of data

collection. Herein, an expert panel discusses the project in consideration. Then it lists

the advantages and disadvantages in terms of finances, personal regards and other

norms. After the above qualitative analysis we require a quantitative analysis to get the

required answer for decision-making.



[IV] E. R&D METHOD

A project should be considered as a project on which research and testing needs to be

done rather than capital budgeting, this allows data gathering and data analysis to put it

further for testing. R&D projects allow you to consider real data and future scope of

the project while investing.

[IV] F. UNCERTAINTY METHOD

Projects with uncertain probabilities are dealt well with such kind of method where we

deal with the investment in the project and the capital that is affected by the project.

Considering positive and negative outcomes and then deciding on the investment is the

second step of the method (Adler, 2000).

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



decide better. Investment appraisal techniques do the same. Hence, I strongly agree

with MI.

[VI] EXECUTIVE SUMMARY

This is a brief report about project appraisal methods. It highlights the practical

applicability in industries and provides evidence of the popularity of the traditional

methods. It also brings under focus the loopholes which the traditional approaches

have and attempt to explore ways as to how to improvise on the same. It also discusses

the new approaches that are trending for project and investment appraisal and shows

the importance of academic guidance before practical applicability of the methods.



[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.

Njiru, B. M. (2008). A survey of capital investment appraisal techniques used by

commercial parastatals based in Nairobi (Doctoral dissertation, University of

Nairobi).

Pike, R., (1996): A Longitudinal Survey on Capital Budgeting Practices, Journal of

Publicspendingcode.per.gov.ie (2006) THE PUBLIC SPENDING CODE. [online]

Runyon, L.R., (1983): Capital Expenditure Decision Making in Small Firms, Journal

of Business Research, September, pp.389-397.



Schall, L.D., G.L. Sundem and W.R. Geijsbeak, (1978): Survey and Analysis of

Capital Budgeting Methods, Journal of Finance, No.1, March, pp.281-287.

Publicspendingcode.per.gov.ie (2006) THE PUBLIC SPENDING CODE. [online]

Available at: http://publicspendingcode.per.gov.ie/overview-of-appraisalmethods-

and-techniques/ [Accessed: 14 Apr 2013].

financial analysis

Documents

Transcript of financial analysis