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Masters Programmes

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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.

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

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Analytical Study of the Applicability of Project Appraisal Methods

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

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STUDENT ID:1227429

Analytical Study of the Applicability of Project Appraisal Methods

[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


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STUDENT ID:1227429

Analytical Study of the Applicability of Project Appraisal Methods

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
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Analytical Study of the Applicability of Project Appraisal Methods

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,
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STUDENT ID:1227429

Analytical Study of the Applicability of Project Appraisal Methods

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).

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Analytical Study of the Applicability of Project Appraisal Methods

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

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Analytical Study of the Applicability of Project Appraisal Methods

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)

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Analytical Study of the Applicability of Project Appraisal Methods

[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.

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Analytical Study of the Applicability of Project Appraisal Methods

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 decisionmaking is done on basis of its effect on the value chain, the advantage over competitors
and increment it will show on the cost drivers.
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Analytical Study of the Applicability of Project Appraisal Methods

[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.

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Analytical Study of the Applicability of Project Appraisal Methods

[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

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Analytical Study of the Applicability of Project Appraisal Methods

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.

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Analytical Study of the Applicability of Project Appraisal 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.

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Analytical Study of the Applicability of Project Appraisal Methods


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

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