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Capital Budgeting

Capital Budgeting

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Published by: theshahzad on Apr 28, 2009
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05/11/2014

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A CRITIQUE OF A CAPITAL PROJECTAPPRAISAL TECHNIQUES
Simon M Keane
CONTENTS3.1 Introduction3.2Underinvestment bias in conventional capital budgeting techniques3.3 Wealth creation versus wealth accretion3.4 Nonrationing versus Rationing3.5 Does the NPV method need support?
3.5.1 Payback 3.5.2
 
Internal Rate of Return3.5.3 The significance of Scale
3.6 Investment fallacies
3.6.1 The positive-NPV fallacy3.6.2 The reinvestment fallacy3.6.3 Investment efficiency fallacy.
3.7 Does IRR have any role?
3.7.1 Can IRR ever serve as an alternative to NPV in ranking projects?3.7.2 Can IRR serve as a supplement to NPV?3.7.3 Is IRR equal to NPV as an accept-or- reject criterion
?
3.7.4 Is IRR 
 
useful in rationing conditions?3.7.5 Is IRR a useful aid to nonfinancial managers?3.7.6 Can IRR serve even as a preliminary screening method?3.7.7 Is IRR not a better link to the rate of return in subsequent financial reporting?
3.8Why is the yield approach acceptable in the securities market but not in theproduct market?3.9 Conclusion3.10 SummaryTutorial questionsProblemsSuggested further reading
 
3.1 INTRODUCTION
Most Finance text books agree that the Net Present Value (NPV)method is the optimal investment selection criterion, but they also tend tosuggest that the Internal Rate of Return (IRR) has a significant role to play,and to a lesser extent the Profitability Index (PI) and even Payback (PB).The argument is often made that investment decisions are too important to be left to a single method of appraisal. Decision-makers need to see the problem from more than one, and possibly several, perspectives. This multi-criteria approach to capital budgeting is widely reflected in practice, in thatmost large companies use several methods to make investment decisions,except that IRR tends often to be preferred over NPV as the appropriateDiscounted Cash Flow method. The purpose of this chapter is to reviewthis multi-criteria approach and to show that:
A)The IRR method is fundamentally flawed as an investmentappraisal method and, like Payback and PI, has no defensible rolein capital budgeting decisions,B)The use of the above measures, together with the popularinterpretation of the Positive NPV rule, have a propensity toencourage underinvestment,C)The widespread practice of using two or more methods forinvestment appraisal purposes is more likely to confound ratherthan enrich the decision process. The NPV method should be usedas the sole criterion under all conditions, being the only methodconsistent with the primary financial objective of the firm.3.2 UNDERINVESTMENT BIAS IN CONVENTIONAL CAPITALBUDGETING TECHNIQUES
 
The chapter adopts the corporate objectives developed in Chapter 2where it was shown that the appropriate goal is “to maximise the value of the firm subject to maximising the share price” (
MAX V
t
MAX P
t
).
Thistranslates to a capital budgeting context as “to maximise the present value of the firm’s investments subject to maximising their net present value” (
MAXPV
t
MAX NPV
t
).
 
To develop the argument we first need to show why there is anunderinvestment bias in standard investment selection criteria, in particular a propensity for conventional capital budgeting decision rules to beinfluenced by the logic of capital rationing even when nonrationingconditions are explicitly assumed to hold.Symptomatic of this bias are three widely held misconceptions thatwill be later discussed in some detail. These are the assumption i) that, for a project to be acceptable, it must in practice have a positive, asdistinct from a nonnegative, net present value (the "
positive-NPVfallacy
") ii) that the reinvestment opportunities for a project'sintermediate and terminal cash flows are relevant to the project's degree of acceptability, (the "
reinvestment fallacy
") and iii) that a project ismore desirable the more efficient its use of capital, in the sense that,
 for a given NPV 
, a quick payback is preferred to a slow payback, and ahigh IRR or Profitability Index preferred to a low one (the "
investmentefficiency fallacy"
).To illustrate these fallacies consider the two mutually exclusive projects, A1 and A2, in Table 1 available to a company operating innormal, nonrationing conditions. It is assumed that neither project will bereplaced on completion. The projects have identical positive NPVs and both are obviously acceptable. Conventional theory would suggest thatthey are equally attractive or, possibly, that the project with the lower outlay and shorter life should be favoured. To test the intuitive appeal of this interpretation, the above problem was presented to a group of studentswho had successfully completed a standard introductory course inBusiness Finance. 92% of the students indicated either that A1 is lessattractive than A2 or that, at best, the two are equally desirable. The mainreasons given for favouring A2 were that the investment capital "saved"might be better employed in other projects, and that A2 is more desirable because it employs less capital to generate the same amount of NPV.

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