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Methodology :Methodology may be a description of process, or may be expanded to include a philosophically coherent collection of theories, concepts or ideas as they relate to a particular discipline or field of inquiry Methodology may refer to nothing more than a simple set of methods or procedures, or it may refer to the rationale and the philosophical assumptions that underlie a particular study relative to the scientific method. For example, scholarly literature often includes a section on the methodology of the researchers. RESEARCH: Research is defined as human activity based on the intellectual application in the investigation of matter. The primary purpose for applied research is discovering, interpreting, and the development of the methods and systems for the advancement of human knowledge on a wide variety of scientific matters of our world and the universe. Research can use the scientific method, but need not do so. SCOPE OF RESEARCH: Research needs valuable resources such as money, time, materials, manpower and machines to get the work done effectively to minimize input value for a unit value of output and the return-on-investment.
Aim of the research: The assigned task was to conduct a survey for a well reputed company. Research is concerned with the systematic and objective collection, analysis and evaluation of information about specific aspects in order to help management make effective decisions. Once the aspect is identified and defined it is the responsibility of the researcher to chalk out a comprehensive plan explaining each step required to conduct the research in a successful manner.
OBJECTIVES OF RESEARCH: The principal objective of research it to find solutions to problems in a systematic way. In general, the objectives of research can be specified as:
• To acquire familiarity with a phenomenon. • To study the frequency of connection or independence of any activity or occurrence. • To determine the characteristics of an individual or a group of activities and the frequency of the occurrence of these activities. • To test a hypothesis about a causal relationship that exists between variables.
The first step in research is setting the objectives for which their study is to be undertaken. It is essential that objectives are set before hand. The objectives must be hierarchical, quantifiable, realistic and verifiable. The main objective of this study is to study how the employees value for rewards
and recognition (non-monetary rewards) in Tata Consultancy Services Ltd. Period of study: The time period was three months for the study, starting from January to March _ _ _ _. Data Used: The type of data collected comprises of Primary data and Secondary data. Primary data is the first hand data collected from the employees. It was collected through questionnaire. Secondary data for the study has been compiled from the reports and official publication of the organization, which have been helped in getting an insight of the present scenario existing in the operation of the company. Research Instrument: The method used for data collection was “questionnaire method”. The questionnaire is a structured one. It was a mixture of open ended, close ended and multiple choice. The words used were simple and helps in avoiding confusion and misunderstanding among the respondents. Research Design: The Research design is purely and simply the framework of plan for a study that guides the collection and analysis of data. Descriptive Research design was used for this research. Research Approach: Questionnaire survey method was adopted for completing the data collection in this research. Sample Design: In designing the sample the researcher must specify three things. 1) Sampling Unit 2) Sample Size 3) Sampling Technique Sampling Unit: The unit comprises of all employees cadre from Level 1 to 5. Sample Size: The size of the sample is 100. Sampling Technique: The technique adopted here is the probability sampling, simple random sampling was adopted. The Statistical tools applied 1. Percentage 2. Chi-Square Test Percentage:
The earliest method used in analysis is percentage methods. No. of respondents for each response Percentage = ------------------------------------------------------ * 100 Total Number of respondents Chi-Square Test ( X2 ) : The X2 test is one of the simplest and most widely used non-parametric test in statistical work. The formula used to find out the X2 value is 2 X2 = ------------------E Where O stands for Observed Frequency. E Stands for expected frequency In general the expected frequency for any cell can be calculated from the following equation. RTXCT E= -----------------------N Where RT = the row total for the row containing the cell CT = the column total for the column containing the cell N = the total number of observation Degree of Freedom (d.f) = (r-1) (c-1) Where R = number of rows C = number of columns Charts: Charts are the graphical representation of data. It is mainly to give a clear picture of the collected data. Charts helps to communicate the data easily to the viewer without comsuming much time. It is done with more care and well planned before representing the data in a pictorial form. Report Presentation: Analysis and evaluation of data transform the raw data collected during the field survey into management information. This has communicated in an attractive and effective information. Report is planned and also relevant to the information needed. It is clearly represented, effectively illustrated with tables, diagrams etc. Printing and binding is done with special care.
Method and Research Design
PURPOSE The method section answers these two main questions: 1. How was the data collected or generated? 2. How was it analyzed? In other words, it shows your reader how you obtained your results. But why do you need to explain how you obtained your results? We need to know how the data was obtained because the method affects the results. For instance, if you are investigating users' perceptions of the efficiency of public transport in Bangkok, you will obtain different results if you use a multiple choice questionnaire than if you conduct interviews. Knowing how the data was collected helps the reader evaluate the validity and reliability of your results, and the conclusions you draw from them. Often there are different methods that we can use to investigate a research problem. Your methodology should make clear the reasons why you chose a particular method or procedure. The reader wants to know that the data was collected or generated in a way that is consistent with accepted practice in the field of study. For example, if you are using a questionnaire, readers need to know that it offered your respondents a reasonable range of answers to choose from (asking if the efficiency of public transport in Bangkok is "a. excellent, b. very good or c. good" would obviously not be acceptable as it does not allow respondents to give negative answers). The research methods must be appropriate to the objectives of the study. If you perform a case study of one commuter in order to investigate users' perceptions of the efficiency of public transport in Bangkok, your method is obviously unsuited to your objectives. The methodology should also discuss the problems that were anticipated and explain the steps taken to prevent them from occurring, and the problems that did occur and the ways their impact was minimized. In some cases, it is useful for other researchers to adapt or replicate your methodology, so often sufficient information is given to allow others to use the work. This is particularly the case when a new method had been developed, or an innovative adaptation used.
COMMON PROBLEMS irrelevant detail unnecessary explanation of basic procedures Remember that you are not writing a how-to guide for beginners. Your readers will be people who have a level of expertise in your field and you can assume that they are familiar with basic assessments, laboratory procedures etc, so do not explain these in detail. For example: "Total chlorophyll content (microgram/gram vegetable tissue) was determined spectrophotometrically by the Anderson and Boardman method (1964), as adapted by Barth et al., (1992)" (Barth et al., 1993). Notice that the authors
do not explain the Anderson and Boardman method (we can assume it is known in their field of study) nor their own previous adaptation of it (because the adaptation has already been recorded in the work they published in 1992). However they do record in detail their own procedures that have not been previously recorded: "At each time interval, three replicates/treatment were taken, ground (stem and florets) with a Kitchen-Aid grinder Model K5-A and used for determination of reduced ascorbic acid" (Barth et al., 1993). Notice that they specify the equipment used because it could affect the results. problem blindness Most of us encounter some problems when collecting or generating our data. Do not ignore significant problems or pretend they did not occur. Often, recording how you overcame obstacles can form an interesting part of the methodology, and means you can also give a rationale for certain decisions, plus a realistic view of using the methods you chose.
OVERVIEW This is how method fits into your thesis: Introduction: introduction of research problem introduction of objectives introduction of how objectives will be achieved (methodology), optional introduction of main findings and conclusions, optional Literature review: review of previous work relating to research problem (to define, explain, justify) review of previous work relating to methodology (to define, explain, justify) review of previous work relating to results (particularly reliability, etc.) Method (how the results were achieved): explanation of how data was collected/generated · explanation of how data was analyzed explanation of methodological problems and their solutions or effects Results and discussion: presentation of results interpretation of results discussion of results (e.g. comparison with results in previous research, effects of methods used on the data obtained) Conclusions: has the research problem been “solved”? to what extent have the objectives been achieved? what has been learnt from the results? how can this knowledge be used? what are the shortcomings of the research, or the research methodology? etc.
SOME EXAMPLES OF DIFFERENT TYPES OF RESEARCH analysis: classes of data are collected and studies conducted to discern patterns and formulate principles that might guide future action case study: the background, development, current conditions and environmental interactions of one or more individuals, groups, communities, businesses or institutions is observed, recorded and analyzed for stages of patterns in relation to internal and external influences. comparison: two or more existing situations are studied to determine their similarities and differences.
correlation-prediction: statistically significant correlation coefficients between and among a number of factors are sought and interpreted. evaluation: research to determine whether a program or project followed the prescribed procedures and achieved the stated outcomes. design-demonstration: new systems or programs are constructed, tested and evaluated experiment: one or more variables are manipulated and the results analyzed. survey-questionnaire: behaviors, beliefs and observations of specific groups are identified, reported and interpreted. status: a representative or selected sample of one or more phenomena is examined to determine its special characteristics. theory construction: an attempt to find or describe principles that explain how things work the way they do. trend analysis: predicting or forecasting the future direction of events.
METHOD SECTION: AN EXAMPLE The following example is abridged (the introduction has been removed, as well as the results, discussion and conclusions). Task: Look for the purpose of each part of the methodology. Examine each sentence and see if you can decide its function. Here is a range of possibilities to help you: rationale (reasons for doing something), description (e.g. of equipment), purpose (e.g. of the model), application (how something is used), structure of the research (the order in which information will be given), assumptions (for a model), parameters (these may be variables that are measured).
Click on the highlighted sentences for suggested answers, then return here using the designed for you to jump and forth rather than to read as a complete text.
. The answers are
Production and Storage of Ice for Cooling Buildings Wubben, E.A., Shapiro, H.N. and Nelson, R.M. Transactions of the ASME, Vol. 111, pp. 338 - , 1989. Abstract A strategy that may provide economic benefits in buildings is to use and ice production system to provide cool storage for later use when cooling is needed. Understanding the fundamental dynamics of the storage tank is critical in determining the feasibility of such strategies. For this purpose, a lumped parameter model of ice growth on a heat exchanger is developed. Results of an experimental study of an ice storage system installed in a residential research facility are also presented. The results of the parametric study are also presented that show some of the effects of geometric and operation variables on system performance. Trends exhibited in the results suggest ways to optimize ice production for the particular exchanger studied.
Introduction [removed] Lumped Parameter Model of Ice Growth In this section, governing equations are developed to model ice growth on the heat exchanger plates. The model is intended to characterize the dynamics of the ice growth without the [added problem] of the detailed ice profiles. The presentation begins with mass and energy balances and concludes with the development of a model for the heat transfer between the water and the coolant. Energy and Mass Balances An analytical model of a storage tank and heat exchanger was constructed to predict the amount of ice that could be produced on the heat exchanger. The model predicts the energy flows into and out of the storage tank by considering energy and mass balances for a suitable control volume. The rates of energy removal from the tank are related to parameters that depend on the properties of the storage medium, the physical characteristics of the system, and the environmental conditions. After this model was verified by experiments, it was used to predict the effects of these parameters on the system performance. The heat exchanger, illustrated in Figs. 1 and 2, consists of two plates with attached tubes placed in parallel between supply and return headers. This type of heat exchanger was chosen because of its thermal characteristics, large surface area, ready availability, and because the ice remains attached to the heat exchanger. To simplify the model, no stratification of the water is allowed in the storage tank. A submerged pump is placed in the tank to keep the water well mixed.
Social research refers to research conducted by social scientists (primarily within sociology and social psychology), but also within other disciplines such as social policy, human geography, political science, social anthropology and education. Sociologists and other social scientists study diverse things: from census data on hundreds of thousands of human beings, through the in-depth analysis of the life of a single important person to monitoring what is happening on a street today - or what was happening a few hundred years ago. Social scientists use many different methods in order to describe, explore and understand social life. Social methods can generally be subdivided into two broad categories. Quantitative methods are concerned with attempts to quantify social phenomena and collect and analyse numerical data, and focus on the links among a smaller number of attributes across many cases. Qualitative methods, on the other hand, emphasise personal experiences and interpretation over quantification, are more concerned with understanding the meaning of social phenomena and focus on links among a larger number of attributes across relatively few
cases. While very different in many aspects, both qualitative and quantitative approaches involve a systematic interaction between theories and data. Common tools of quantitative researchers include surveys, questionnaires, and secondary analysis of statistical data that has been gathered for other purposes (for example, censuses or the results of social attitudes surveys). Commonly used qualitative methods include focus groups, participant observation, and other techniques. Scientific method refers to techniques for investigating phenomena, acquiring new knowledge, or correcting and integrating previous knowledge. To be termed scientific, a method of inquiry must be based on gathering observable, empirical and measurable evidence subject to specific principles of reasoning. A scientific method consists of the collection of data through observation and experimentation, and the formulation and testing of hypotheses. Although procedures vary from one field of inquiry to another, identifiable features distinguish scientific inquiry from other methodologies of knowledge. Scientific researchers propose hypotheses as explanations of phenomena, and design experimentalstudies to test these hypotheses. These steps must be repeatable in order to dependably predict any future results. Theories that encompass wider domains of inquiry may bind many hypotheses together in a coherent structure. This in turn may help form new hypotheses or place groups of hypotheses into context. Among other facets shared by the various fields of inquiry is the conviction that the process be objective to reduce a biased interpretation of the results. Another basic expectation is to document, archive and share all data and methodology so they
are available for careful scrutiny by other scientists, thereby allowing other researchers the opportunity to verify results by attempting to reproduce them. This practice, called full disclosure, also allows statistical measures of the reliability of these data to be established.
iii-CAPITAL BUDGETING Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency. During the capital budgeting process answers to the following questions are sought: • What projects are good investment opportunities to the firm? • From this group which assets are the most desirable to acquire? • How much should the firm invest in each of these assets
1 -WHAT IS CAPITAL BUDGETING?
Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting. Capital budgeting is investment decision-making as to whether a project is worth undertaking. Capital budgeting is basically concerned with the justification of capital expenditures. Current expenditures are short-term and are completely written off in the same year that expenses occur. Capital expenditures are
long-term and are amortized over a period of years are required by the IRS.
CAPITAL IS A LIMITED RESOURCE
In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing. In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital.
Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.
3-Nature and Introduction of Investment Decisions
An efficient allocation of capital is the most important finance function in the modern items. It involves decisions to commit the firm’s funds to the long term assets. Capital budgeting or investment decisions are of considerable importance to the firm since they tend to determine its value by influencing its growth, profitability and risk. The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be define as the firm’s decisions to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firm’s operations beyond the one year period. The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long term asset. Sale of division or business is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programmed have long term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions. It is important to note that investment in the long term assets invariably requires large funds to be tied up in the current assets such as inventories and receivables. As such, investment in fixed and current assets is one single activity. The following are the features of investment decisions, • The exchange of current funds for future benefits. • The funds are invested in long term assets. • The future benefits will occur to the firm over a series of years.
Importance of Investment Decisions
Investment decisions require special attention because of the following reasons: • They influence the firm’s growth in the long run • They affect the risk of the firm • They involve commitment of large amount of funds • They are irreversible, or reversible at substantial loss • They are among the most difficult decisions to make Growth The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. A firm’s decision to invest in long term assets has decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share. Risk A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm. Funding Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmers
very carefully and make an advance arrangement for procuring finances internally or externally. Irreversibility Most Investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Complexity Investment decisions are among the firm’s most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flows of an investment. Economic, political, social and technological forces cause the uncertainty in cash flow estimation.
4-PROJECT APPRAISAL – INTRODUCTION
Project appraisal is typically performed by financial institutions, government departments and others, prior to making loans, equity finance or grants to project implementing entities. There are many wellknown approaches to project appraisal. For example, the US Federal Government from time to time establishes procedures for the examination of potential projects for the purpose of making federal grants for investment projects to be implemented by state and local governments. An example of such an approach, in the USA, is that of the Major Investment Study (MIS), dealing with major metropolitan transport investments. A very well-known international example is the intensive appraisal work performed by the World Bank. A principal role of project appraisal is to protect the interests of investors. In an integrated system of governance, it is also concerned with the overall economy, efficiency and effectiveness of projects, in serving the common good.
Although project appraisal might be carried out by investors, lenders and grantors, the institution bearing the major risk is usually the implementing entity itself. If a project is inadequately or incompetently designed, implemented or operated, the entity risks financial loss, waste of economic resources, failure to provide intended services and potential political embarrassment.
Thus, even though project appraisal can be seen as an independent assessment, by outside observers, it must also be regarded as an activity to be performed by internal specialists, to protect the interests of the entity. Internal project appraisal is also implicit in the preparation of applications for grants, loans or other capital funding, because the questions posed by project financiers are also those which the project entity should be putting to itself.
Project appraisal, as described in this and other literature, may appear to be a rigid and specific process, whereby feasibility studies are performed and then designs are prepared, before an appraisal takes place. Indeed, this is often part of the formal process, because one cannot efficiently appraise something that is not prepared to a reasonably advanced stage.
There is, however, something of a dilemma here. Project preparation, analysis and appraisals consume time, money, and resources, before anything begins to be built. Sometimes, for this reason, as well as because of political and other pressures, appraisal is seen as a delaying or limiting function, possibly leading to the curtailment or abandonment of popular schemes. At the same time, failure to appreciate the full financial, economic and other factors involved is not very sensible, useful or economically efficient. There is at least one other dilemma. Accountants and financial analysts, however professionally competent, do not usually build projects. These are usually derived from political, administrative or commercial vision, coupled with the leadership and dedication of a few key people. Furthermore, however well a project is appraised, nobody really knows for certain how it will eventually turn out. Indeed, even if a project bankrupts the initial investors, it might sometimes be a contribution to posterity, useful and successful over the very long term. Examples might include some of the US railroads and the "Channel Tunnel." There is a consequence of all this for project designers and implementers. Firstly, although they will not necessarily understand the detailed techniques of project appraisal, they must learn to open and to sustain meaningful conversations with those who do. Secondly, their design work must be carried out within a mental background of concern as to potential costs and financing. They should bear in mind that the higher the cost, or the more uncertain the financing, the less likely is the project ever to be implemented. Their designs will, therefore, be largely wasted, except for the learning process that can be assumed to be implicit in all meaningful work. With these concerns understood, the project appraisal process will be described as if performed by an independent team of professionals, either within the project implementing entity or from outside.
Appraisal Concerns and Purposes
Far too often, project financial appraisal is limited mainly to revenue generation, with a narrow focus upon pricing and taxation policies. Setting tariffs and taxes is frequently directed only at covering 14
immediate and short–term cash requirements, elicited from simplistic budgetary procedures. These, in turn, are based upon an uncritical and unconstrained view of current public service operations, together with immediate budgetary impacts of projects coming into operation.
Political considerations are often paramount – usually directed at keeping prices down and postponing, for as long as possible, the time at which they should be increased. Of course, the setting of prices and local taxes at the lowest possible levels is typically perceived of as being in the best interests of consumers, at least in the short term. However, this benevolence is sometimes achieved only by the use of large subsidies from general public funds, creating a misallocation of resources. Frequently, also, low prices and charges are associated with poor service delivery, with little or no prospect of upgrading or expansion, because of a shortage of funds.
There is, in principle, no objection to the use of general public revenues to finance project implementation and operation. Indeed, these are necessary for services that do not generate (or cannot reasonably be financed from) individual user charges. These include categories of services which economists refer to as "public," "merit" or "collective" goods. In particular, such projects deal with economic "externalities" and other circumstances where users of services are not, necessarily, the sole or principal beneficiaries 1. An important thing is to determine, as far as possible, that general public revenues, of the extent proposed, are the most economically efficient use of funds and resources. It is an often overlooked principle that it is usually more economically efficient to subsidize deserving people than deserving activities. For example, the lowering (or holding down) of transit fares might attract more people away from cars and onto public transport, producing (actual or claimed) economic benefits.
1 These questions are dealt with at length in the many texts on public sector economics and finance. One example of such a text is
"Economics of the Public Sector" by Nobel Laureate Joseph E. Stiglitz. (Formerly: VP & Chief Economist, World Bank) Third Edition, February 2000.
However, much of any "subsidy" used to keep down the fares will benefit those who might ride the public transit system anyhow and would be prepared to do so at higher fares 2. Some of these passengers might be of higher incomes, thus undeserving of subsidy3. Unfortunately, there is no practical way4 in which they can be identified and charged, so the lower fares will be charged to all.
Consumers and citizens are almost always resistant to price and tax increases. However, this resistance can be greatly mitigated by perceptions of better service, based on improved productivity. These improvements, in turn, will keep down costs and limit the extent of price and tax increases. Much more attention should, therefore, be given to review of the financial performance and management of project operating entities. In addition, there should be a complete appraisal of new development projects, with full regard to technical, operational, financial, economic and other implications. Pricing and cost recovery policies can then be related to more efficient service delivery institutions, as well as to well-designed and feasible protects.
The first activity, therefore, is to establish a process for appraising the management capability of service delivery institutions. Then, there will be a need for appraisal of actual development projects. The underlying premise is that pricing and cost recovery practices should be examined within the much broader context of these overall assessments. Financial policy decisions can then be related to longer– term economic and financial requirements and implications.
2 More rigorously, this is the concept of "consumers' surplus." 3 This is not, strictly correct. If the purpose is to get car-users off the roads, the subsidy should, more strictly, be directed at those who
would need the most financial incentive to garage their cars. They might well be the more affluent, thus giving an appearance of social unfairness, despite an inherent economic efficiency. In any case, it would be more economically efficient, were it always possible, to charge car-users the full economic cost of using the roads.
4 In principle, this might be done by the use of classes (first and standard). However, for commuter transit this has not usually proven
practical or efficient. Most commuter systems are one class, even if there are separate classes for longer, inter-city, transport journeys.
APPRAISAL OF PROJECT ENTITY MANAGEMENT CAPABILITY
The appraisal of the financial management capability of a public utility or governmental institution often comes about as a result of a request for, or a perceived need for, a substantial change in its manner and level of operations. One example of such a change would be the possible expansion of operations through an externally financed development project.
Such an appraisal is concerned with financial administration and with financial performance. Emphasis on financial administration is concerned with budgetary management, financial control and reporting capability, together with audit, both internal and external. Financial performance is concerned with financial viability, both of present operations and of potential future operations, including those of the intended development project. This type of review is often concerned with pricing policies and with other revenue–generating activity.
A sound system of accounting is a necessary pre–condition for the effective monitoring of performance. It is also a central feature in any well-developed system of financial control. The US Federal Government will normally insist that state and local governments follow the recommendations of the Governmental Accounting Standards Board, together with appropriate auditing practices. In the international context, financing organizations, such as the World Bank, will often expect to see the implementation of appropriate systems of accounting and auditing as a part of project preparation or implementation5. This requirement will typically be included, as what is called conditionality, in the project loan agreements.
Although a proposed project investment may provide the incentive for the appraisal of financial management capability, such an appraisal is not directed towards the viability of the project itself. Instead it focuses upon the overall viability of the project entity. Thus, it is attempting to determine whether, and to what extent, the enterprise operates optimally at present and whether, with the added burden of the proposed project, it will be able to adapt itself to its new situation without undue financial and management stress. Normal operations can usually be handled, financially, in a "steady state" mode. Projects, by contrast, are often disruptive, as they often seriously affect: cash flow; profitability; and, capital structure.
5 Outside of the USA, the most likely accounting standards to be followed, for a private entity, would be based on those of the
International Accounting Standards Board (IASB). For a public sector entity, the appropriate standards would be the International Public Sector Accounting Standards, promulgated by the International Federation of Accountants (IFAC). This body has also promulgated International Auditing Standards.
The Administrative Environment
A perquisite to the review of financial management is an examination of the administrative environment within which the entity operates. This necessitates a review of the organization of the sector and the role of various levels of government (federal or national, state or regional, and local) in the affairs of the entity or enterprise. A crucial question is the extent to which the entity has the autonomy to operate free of higher levels of governmental controls. While some controls over public enterprises are necessary and almost inevitable, excessive controls can often be stifling of any management initiative.
It will be necessary to examine the legal basis under which the enterprise operates. Laws or regulations may prescribe its organization and management structure, the scope and limitations of its operations and its financial policies and controls. Among the key financial practices to be considered are the status and role of the chief financial officer, financial performance expectations, financial reporting requirements, financial management policies, internal controls and audit.
These legal requirements must be regarded as minimum. They are also bounds, within which the entity must operate. An early judgment must be made as to whether the legal requirements allow sufficient flexibility, whilst imposing adequate controls, within which the entity may carry out its intended expanded role or scale of operations. If not, steps should be taken, promptly, to initiate the necessary legal changes to permit such operations. However, any proposed legal changes may be out of the hands of those most directly interested in the entity's operations. Whilst the need may be obvious, central or state government legislators may find it lacking in urgency and even in conflict with what they consider as more important concerns. An intended project might, for these reasons alone, need to be postponed, modified or abandoned.
The next matter to consider is the general management of the entity. This will include a review of the powers and duties of the council or management board, together with those of the general manager and the top management team. The management structure will be reviewed, with particular reference to the power, duties and influence of the chief financial officer6.
6 In UK local government, for example, there is a legal requirement that a professionally qualified person be so designated. 19
Many organizations in the public sector become a source of domination by a powerful politician (such as an elected mayor), an all–powerful general administrator, or a strong technical or engineering specialist. Thus, one sometimes finds, in the case of the political or administrative manager, a set of detailed and irksome financial procedures, intended to substitute for good, high–level, well–trained and experienced financial management, which is often missing altogether.
Alternatively, where a technical specialist dominates, he sometimes perceives his role only as to build things quickly or to run services effectively – but without regard to cost, funds availability or economic efficiency. He or she perceives the financial specialist only as a source of funds, not really as part of the management. Indeed, he or she is sometimes considered as a nuisance. None of this should detract from the fact that project implementation, as well as the running of services, requires vision and leadership. Moreover, one does not, typically, look for this among financial managers, because that is not their principal responsibility, nor often in their nature.
Key concerns, in the selection of top managers, are often salary administration and personnel management policies generally –– leading to yet another stage in the investigative process. Sometimes, an impediment to efficient operation of public sector entities is over–staffing, coupled with low pay. Yet often the opportunity to dismiss staff, or even to discipline them, is constrained by bureaucracy, trade union power or even nepotism. As well as looking at management and staffing structures, it is also important to underline the efficiency and effectiveness of individual staff, particularly managers. If key staff cannot perform, consideration should be given to their removal, training or transfer. Otherwise, or in addition, new and more competent staff must be recruited.
One more important item must be examined before narrowing down to the financial matters. That is the physical operation of the entity and the provision and marketing of its products. What goods or services does it provide? To whom are they provided? How are they produced? What is the pattern and growth of demand? How are costs recovered? What opportunities exist for more efficient cost recovery? What new services or products are proposed or are in demand? And, what are the important aspects and constraints with regard to construction, operation, maintenance, repair and replacement of physical facilities and equipment? How are operating decisions made?
Although many of these matters are not under the control of the financial management, they are so closely related to it as to be essential features of any financial investigation. Sometimes, indeed, there is considerable merit in the financial investigator asking questions about technical or operational matters. The technical specialist, who might resent such interrogation from professional peers, will sometimes seek to humor the financial specialist – and even to show off – by answering seemingly “stupid” questions. In doing so, he may reveal matters which might otherwise never have been questioned, leading to further investigations, perhaps by a technical colleague of the financial investigator.
There is another matter that is often overlooked, concerning personnel matters, in dealing with operations. Senior professionals of an entity may too easily be narrowly categorized by appraisers within specialist 21
disciplines. However, typically, these professionals will only have reached their positions because they have developed broader, commonsense, skills. They usually will have a good working knowledge of other specializations than their own, facilitating more useful and effective conversations with colleagues in other activities.
Examination of the structures and operations of the enterprise will lead, naturally, to inquiry about how its properties are managed. Such an investigation can include rent–or–buy assessments; record keeping; hazard insurance; land management policies; and, economic utilization of properties. Along the same lines should be a review of the management of stores and equipment, together with that of light plant and tools.
It will also be necessary to examine the financial administration itself. It is often desirable to find financial operations under a single manager – a director of finance. This title is used advisedly. The often-used designations of chief accountant, accounts officer or revenue officer, for example, do not to carry the sense of seniority and comprehensiveness that is necessary for such a position. The director of finance must be a key member of the top management team. He or she will have some very specific responsibilities, around which the department should be organized.
One of the most important financial functions is revenue collection. This embraces: taxing or charging policies; relations with taxpayers or customers; assessment, measurement, record and collection of revenues; procedures for the follow–up of non–payment; and, write–off of bad debts. Often, state, central or federal government involvement is considerable. On the one hand, it may control or authorize the setting of charges or taxes. On the other hand, it – or several of its agencies – may be principal beneficiaries of services and yet, sometimes, among the slowest and least responsive of debtors. This situation, alone, may seriously diminish the prospects of a local public entity from operating in a financially viable manner.
Charges and taxes must, as far as is practicable, be easy to collect and difficult to evade. The customer or taxpayer must be treated with courtesy, respect and fairness, with payment of obligations made as convenient and painless as possible. However, remedies for non–payment should be firmly enforced, if only out of consideration for those against whom they are not needed.
In parallel with the collection of revenue comes its disbursement. A completely separate unit of the finance department from that concerned with revenue collection should, if possible, handle this. Expenditure, of course, does not usually begin within the finance department. It is normally concerned with disbursement of funds provided for in budgets, about which reference will be made elsewhere. The initiation for payment will often come from a department that is responsible for the work that the authority undertakes.
A common initiation procedure for payments is the official order system. An investigation of financial management should be concerned as to whether this system (and others fulfilling similar purposes) result in efficient and economical buying procedures and adequate controls over the outflow of funds. Some payments will, of course, arise from contracting procedures and tendering arrangements. These may, themselves, not be under the control of the finance department but will lead back into a review of the general management process. One of the most important contractual payments, of course, is that dealing with the employment of staff. Many of the records of staff activities will be maintained in a personnel department. However, the finance department will also need to keep vigorously updated all matters relating to staff affecting the amounts that they are paid for their services. Arrangements will also needed to ensure that the deductions that are made from staff payments for tax, pension funds and other matters are properly disposed of, to their intended beneficiaries, fully and promptly.
Where pension funds are in use, the management of these should also be of concern. However, it should be recognized that a generalist financial investigator is probably not well qualified to make detailed examinations of pension fund management. This will frequently require the services of actuaries, as well as monetary investment specialists. These might be employees of the finance department. However, they are much more likely to be outside specialists.
Linking the processes of payment and receipt of money will be the function of cash (treasury) management. This should preferably be in a section of the finance department separate from either the "collections" or "payments" sections. Cash management is concerned, among other things, with maintaining day-to-day cash resources to enable the entity to efficiently function.
Cash management is also concerned with the management of short-term and long-term debt. Included in the process of debt management will be the timing and frequency of the raising and repayments of loans and the making of advance provision for the contractual obligations to pay principal and interest obligations on specific due dates. This function also deals with investment of surplus funds, to optimize liquidity and safety with earnings.
Accounting, Reporting and Auditing
One principal function within the finance department will be accountancy. Here it will be that the more qualified and senior personnel are likely to work. Their responsibilities will include: bringing together, 24
codification and classification of receipts and payments of money; record of assets and liabilities; and, preparation of various kinds of financial reports. A basic concern of the accountancy section will be to analyze and classify financial data. This should be done in such a way that various kinds of reports needed for different purposes are all readily available from the financial data, with a minimum of further adjustment and preparation.
Among the reports that must be prepared are those for internal financial management. These reports will need to go to the finance director, to the general manager (mayor or chief executive) and to the executive board (or finance committee) of the entity. Just as important, but often not so frequent or so urgent, is the preparation of the periodic financial statements through which the entity will report its overall activities to the outside world, to the public, to lenders, to investors and to the government.
Depending on the legal status and operational characteristics of the entity, a decision will be needed as to the form in which the annual financial statements will be prepared. As a generality, it is probably true that revenue–earning enterprises will more appropriately produce accounts on commercial lines. Nonrevenue-earning enterprises will, currently, tend to produce fund-oriented accounts. However, there is plenty of scope for compromise between these two systems and others, in the interest of meaningful financial reporting. Moreover, full accrual accounting, even at current valuations, is becoming increasingly the norm under internationally recognized accounting principles 7. This is true, even for nonrevenue-seeking activities.
Coupled with external financial reporting goes the question of external audit, because financial reports cannot become fully acceptable unless they are regarded by those who receive them as credible and authentic. When one considers who is best qualified to give such an assurance, one often runs up against the question of whether this should be an independent commercial auditor or a government auditor. Frequently, public enterprises and entities are required by law to have their accounts audited by public officials, such as an auditor–general or state auditor. In some countries, including the newly independent states and restructured economies of the former Soviet system, there has been reliance upon a central “court of accounts.” In other cases, a commercial type of audit is considered more appropriate. No matter who does the audit, it should be capable of being carried out with independence, efficiency and promptness, using auditing standards that are acceptable within the profession and consistent with best practices, internationally.
Preparation of accounts for management purposes may well demand that there be a separate unit within the accountancy function, dealing specifically with management or cost accounting. This type of accounting is, in essence, a system of recording and classifying activities in such detail as is necessary to enable managers to make better decisions. This should be the guiding principle of cost–accounting systems. As a consequence of this, cost-accounting should be user–orientated. However logical a system of classification, it seems pointless, beyond a certain stage, to continue with detailed analysis and allocation, merely to produce an elaborate output in which no–one is interested!
There is a corollary to this. The greater the details of analysis, the more it becomes necessary to arbitrarily allocate overheads of various kinds. This can sometimes be to the point where the overheads become more significant than the prime costs to which they relate. This is obviously an area requiring professional judgment, rather than the mere slavish following of detailed rules and regulations. The fairly recent emphasis on “activity-based” accounting, budgeting and costing recognizes that many activities
7 The expression “internationally recognized accounting principles” is used here as a generalization. The full extent to which
such principles exist, are recognized, by whom, or for what purpose, is not addressed in this document. However, at all times, it is necessary to seek out and to use the best and most appropriate standard practices currently available.
have become less physical and more information-based. Thus, concentration on the allocation of overheads becomes more important than base primary costs.
Complexities and interrelationships within a finance department can only be kept in context and looked at in their entirety if there is an efficient system of internal audit. The responsibility of an internal auditor is, among other things, to continuously appraise and review the systems of internal management and control, to ensure that they achieve their intended purposes.
In some public entities, an internal auditor's role is seen mainly as confined to verification of receipts and (especially) payments. This seems wrong. Instead, such verification should be routinely carried out by those within the respective payments and receipts sections of the finance department. The internal audit section should, instead, be a more "lean and mean" organization, reporting directly to the chief financial officer, or to the chief executive. It should address how the financial management system, as a whole, performs. There is, however, some contention as to whether an internal auditor should normally report to the chief financial officer (the auditor's professional peer and supervisor) or directly to the chief executive (of greater independence).
The former requirement may facilitate greater awareness and comprehension of financial complexities: the latter may promote a broader overview and possibly swifter (and more decisive) action to remedy shortcomings. A compromise might be to require routine reports to go to the chief financial officer, whilst allowing the internal auditor, in appropriate circumstances, to go “over the head” of the chief financial officer and report directly to the chief executive. This could be where the chief financial officer is perceived to have a conflict of interest in directly receiving the report. It must not be overlooked that an internal audit might uncover concerns relating to the chief executive personally. In such a case, discretion and subtlety will be necessary, not least because the auditor might, eventually, prove to have been wrong, or too zealous. To quote from a former president of the Chartered Institute of Public Finance and Accountancy (UK), an internal auditor must discover ways to be “...friendly to all and too friendly to none; to be able to disagree without being disagreeable...”
Before leaving the subject of financial administration, attention should be given to the question of risk management within the organization. This was touched on briefly, earlier, with regard to the management of property. However, there are many other aspects of risk management, which affect the financial activities of the entity. Risk management might be placed into two main categories. The first, as already indicated, is the projection of the entity's own properties. The second concerns the protection of the entity's financial position against claims by outside parties. The first risk is often dealt with by what is referred to as “hazard insurance,” covering damage resulting from such things as fire, floods and theft. The second risk is sometimes referred to as “public liability” obligations or “third party” insurance.
Risk management and insurance management are not the same. Insurance is only one way by which risk management may be dealt with. First, the risks must be identified. Secondly, decisions must be taken as to how the risks might be minimized by appropriate management action. Then, a judgment must be made as to whether the risk, as modified, is acceptable to the entity and whether (or to what extent) it should bear the risk from its own resources or through a system of insurance. Over–insurance can sometimes be just as costly as under–insurance, so the entity may well wish to receive specialized advice on the management of its various types and levels of risk.
One turns now from an evaluation of financial administration to that of financial performance. Since financial performance reflects the operations of the entity, it seems appropriate to examine the system whereby the entity plans, programs and budgets for this performance. While the budget is often a key document within a public enterprise or governmental unit, its preparation is often done in ways that leave much to be desired.
A budget may be described as the financial interpretation of a plan to put into effect the policies of management. Preparation of a useful budget, therefore, must go back to an assessment of the basic policies which management has (or should have) laid down for the entity’s operations. Inside the bounds of those policies, operating departments and technical specialists should have prepared plans and programs to carry on the operations within defined limits of resources. This will usually be translated into an operating or recurrent budget.
In addition, the growth of operations, as well as their sustenance, will require plans and programs for capital investment in land, infrastructure, buildings, plant, machinery and equipment. These activities will usually result in a capital budget. It will be the responsibility of financially and economically trained staff, in the finance department or in a separate budget department, to evaluate (in detail and in total) the various components of operating and capital budgets and the relationships among then. The financial implications of the programs and plans must be brought to the attention of the entity's management, so that the operational policies and the financial implications of these may be brought into equilibrium.
Closely related to the planning and budget activity is the question of the entity's overall financial performance. A starting point for this is often a preparation of pro-forma financial statements and forecasts. For past activities these statements can usually be derived from the accounting information and financial statements, provided, of course, that these are up-to–date. For this purpose, a useful tool is the electronic spreadsheet, used with microcomputers. Using this device, it becomes relatively easy to test 30
any number of operating scenarios to determine their financial implications8. Mention of computers implies that no analysis of financial management capability can be complete without thorough review of the management information system as a whole and of the computer processes within which it will operate. Financial forecasts will normally be based upon the plans, programs and budgets, taking account of operational policies, particularly with regard to revenue generation9. A review of past statements will give an indication of the extent to which the entity has met its past obligations with regard to its financial objectives. It may also indicate whether those financial objectives were realistic or whether, for the future, they should be modified. A key ingredient is the establishment of the present financial position of the entity, to determine whether this is a sound base from which to go forward into new and expanded activity. Future financial performance can, of course, even within well defined policies, be highly speculative. It is, therefore, appropriate to examine a number of possible scenarios, using sensitivity and risk analysis procedures10. This will enable judgments to be made as to whether the entity will be able to operate with margins of safety.
In the past, for many enterprises, the accountancy system probably was the management information system, or at least most of it. Now, with the increasing and less costly use of more sophisticated computerization, the accountancy system is seen as only one module in total management information systems dealing with financial, economic, statistical, technical and other data, in an increasingly integrated fashion.
Recommendations for Project Institutions
Appraisal of financial management capability should obviously result in a series of recommendations. What should such recommendations concentrate on? An overriding concern would undoubtedly be that the entity will have a continuous supply of material, human and financial resources to sustain its intended level of operations. Within this overall concern, perhaps attention should be directed at four main issues: motivation, organization, policies and skills.
8 Spreadsheet systems, though excellent for analysis, are usually unsuitable to use for permanent database systems, such as budgets or
accounts. One reason is that the flexibility of spreadsheets makes it difficult to establish audit trails or to recover from errors.
9 Forecasting software is now available for this purpose. One example of this (CB Predictor) may be obtained from an
organization called Decisioneering: (www.decisioneering.com/orderchoice_index.html). Although this software is expensive, there are special rates for teaching institutions.
10 Risk analysis software is also available for this purpose. The above company, Decisioneering, supplies “Crystal Ball.” 31
No good ideas for the improvement of operations are likely to succeed unless those concerned with implementing or supporting those ideas can be properly motivated. Included in those to be motivated are: the entity's own staff; investors and lenders; customers of the entity; the public at large; and, higher levels of government, to the extent that they exercise control. Sometimes, motivation can be facilitated or enhanced by monetary incentives (e.g. prices and personal remuneration). Sometimes, other motivations are necessary.
The appraisal would also be concerned with organization, both within the entity itself and within the administrative and financial environment within which it operates. Among policies to be considered are those related to financial performance, accounting, pricing and financing of the enterprise. These will including a decision about the extent to which it should be financed by debt or equity or, if a local government unit, by local or national revenue sources. Among the means used to measure and monitor the effectiveness of financial policies will be appropriately designed accounting ratios. These must be used with caution and only to measure what is related to them. Focus upon skills draws attention to needs for training, staff development and personnel policies. This, perhaps, comes full circle to motivation, for it is only through the employment of dedicated and wellmotivated people that public entities will fulfill their intended objectives.
APPRAISAL OF DEVELOPMENT PROJECTS
The appraisal of financial management capability is often a prerequisite to the appraisal of a development project. Such an appraisal demonstrates the limitations, as well as the strengths, of financial information systems and the need to relate these to other disciplines, typically engineering and economics.
In addition to being financially viable, a development project cannot usually be considered acceptable unless it is economically, technically and institutionally sound. It should be the least–cost feasible solution to the problem being solved and should expect to produce net economic and/or social benefits. It should also have a feasible and flexible financing plan, with adequate margins of safety.
Forecasting of probable results, though based upon available financial information, requires skill and judgment going well beyond accounting. Thus, accounting represents only one input to the appraisal process, albeit an essential and important one. Furthermore, as the project is implemented, financial performance, measured through the accounting process, becomes an important feature of internal and external monitoring.
Financial and managerial specialists can largely carry out appraisal of financial management capabilities. However, it is almost impossible to appraise a development project without the assistance of engineers, planners and other technical specialists, whose practical skills lie in the evaluation of the technical and economic soundness of whatever is to be constructed or operated.
To some extent, appraisal should be concerned with the curtailment, postponement or elimination of projects, to the extent that needed goods and services can be more efficiently provided in ways that are more economic. Projects, as already indicated, are engendered from vision, enthusiasm and leadership. Nonetheless, it is not the purpose of the appraisal team to provide this. An appraisal is clearly intended to be critical and constraining.
It is, however, necessary for an appraisal team to be able to empathize with project owners and promoters. Considerable emphasis should be directed at producing a project that is more effective, efficient and economical, rather than merely finding ways to damn it and to criticize it. It is clearly in the interests of 33
both the promoters and the public for the appraisers to be objective and professional, with the courage to report fairly, even if negatively. In the last resort, if the project is not expected to make sense, or to work effectively and efficiently, it should be so reported.
An important aspect of this process is the perspective or "accounting stance. 11" This has at least four principal dimensions:
perspective – a project not seen as viable for one group of promoters or observers may be perceived as viable for another;
space – a project perceived of as dealing with issues within one set of spatial boundaries may have different outcomes when perceived of within a different one;
time – a project perceived of as a success (or failure) over one time frame may produce a different result over a different time frame; and,
accountability – the viability of a project may be judged from different methods of accountability, for example: straightforward financial profitability; using financial or economic analysis; including or omitting economic externalities; and, valuation or assessment of economic costs and benefits, not easily quantified in money terms.
It is not the purpose of this document to detail how technical specialists carry out their own professional functions with regard to development projects. It is however, necessary to understand broadly what they are responsible for, so that the financial professional can carry out his or her duties within the right context.
Among the skills required for the appraisal of development projects, as well as engineering and technical, are financial, economic, managerial, legal and commercial skills. There is also, as indicated, a need for empathy with project leadership. This does not necessarily mean that individual professionals in all these skills need be concerned with the appraisal. However, the professionals that carry out the appraisal must have regard to all of the inputs referred to.
11 This has been encapsulated in the idiom "Where one stands often depends upon where one sits!"
A development project, almost by definition, usually results in the construction or acquisition of physical infrastructure (or other building or engineering structures) intended to provide additional capacity in meeting the service for which the entity is responsible. This additional capacity may be either to meet growth in demand or merely to replace existing capacity that is falling out of use, through deterioration, due to age or lack of repair and maintenance. In the age of rapidly changing technology, projects may be more concerned with the replacement of well-operating facilities that have yet become too slow or cumbersome, due to obsolescence12.
12 In one situation, a water supply project was designed for the remote operation of "source of supply" facilities by an expensive
buried cable. By the time of construction, this task could be much more economically performed by radio. Huge ontract savings thus provided for some needed additions to the corporate offices.
There is an important time dimension to a relationship between technical specialists and financial specialists in the appraisal of physical development projects. It is, to some extent, unfortunate that the substantive work of the financial specialist can hardly begin until engineers, architects or planners have done a considerable amount of technical work, on feasibility and design. This is also an unfortunate dilemma from the economic perspective of “sunk costs.” When much design work, and some initial physical work, has been performed, this lowers the “marginal” costs of the project, because these consist only of the costs remaining to be incurred. Consequently, the project under consideration is more and more likely to be chosen, because its gradually declining marginal costs are comparable with the total costs of all the other choices. For this reason, it is important for project appraisal to take place early in the evaluation or decision process. Otherwise, project implementation will become a foregone conclusion, with the appraisal process merely perfunctory and relatively meaningless. What this may really mean is that the appraisal process should be a continuous one, rather than a one-time event. This, however, can be turned to advantage. While the technical specialists are concerned with the physical project, this provides time which the financial specialist will need, and hopefully use, to examine the management capability of the project entity, as a prerequisite to carrying out a financial and economic analysis of the project itself. This process has already been described.
Assessment of Demand and Capacity
Among the first things that the technical specialist must examine is the estimated physical demand for the service or product provided by the entity. This may be, for example: numbers of passengers (per-hour or at peak times) on a bus or rail system; kilowatt-hours (and kilowatts of maximum demand) of electricity; or, cubic meters (gallons) of water. These, of course, relate to revenue-earning enterprises and are, as stated later, sensitive to prices intended to be charged. Demand estimates based on purely physical requirements will not, in these circumstances, be a fully reliable guide for the sizing of projects. On the other hand, non-revenue-earning projects, such as roads, will require assessments of demand derived from traffic counts and an overview of real estate development prospects for different areas where roads will be used.
Peak loads and average demands are both important. The estimated peak load largely determines the design size of the project, if the upgraded system is to meet every conceivable demand placed upon it. How the peak is to be handled is very dependent upon the operating characteristics of the service. For example, a railroad may run more frequent or longer trains on the same track, up to its capacity. A water supply system may use service reservoirs to handle daily peaks, adding to the source of supply only for seasonal peaks. Electricity systems must usually provide for all the peaks to be met from increases in generation capacity. However, since it is relatively easy and inexpensive to transport electricity (or balance the loads) over long distances, the use of a national (or regional) grid means that increased 37
capacity is needed only for simultaneous peaks in the system as a whole. Otherwise, peaks in one part of the system can be compensated for by slack demand elsewhere. Peaks on roads13 will be constrained (to a limited extent) by traffic congestion and might (also to a limited extent) be dealt with by tolls. Differential fares might (to a limited extent) deal with peak loading on buses and trains. Overall economic efficiency, within an urban environment, may well need to be traded against specific goals for raising revenue14.
Whilst the question of peak loading is crucial to system design capacity, it is also of concern to the financial analysis. Peak load largely determines the system costs. Capital costs and related financing costs are, almost entirely, determined by the overall capacity. Operating costs, also, are strongly influenced by system size, though these are somewhat curtailed when the system is not operating at full capacity. Revenues, on the other hand, are largely a function of average demand and sales. Therefore, the greater the divergence between peak and average demand, in both quantity and time, the more is the excesscapacity cost, borne by the average user of the service, thus increasing the unit charge. This can sometimes be mitigated by the use of differential peak–pricing systems – but these are often impractical or expensive to operate. Road tolls are a special example of peak pricing. Users choose to pay either the peak charge (the toll) or nothing!
Equally important is to establish demand for services of a non-revenue nature, when dealing with roads, (subsidized) trains and other urban infrastructure improvements. Here again, designs are influenced by peak demands. Although revenues are not direct charges upon consumers, it is important to appreciate that these revenues must still be raised –– from limited tax resources. Whereas larger revenue–earning projects may often increase sales and therefore revenues, larger non–revenue–earning projects will usually mean higher taxes per head on a limited number of taxpayers. Many of these taxpayers might not use the (e.g. train) system at all, although they may still benefit from it being used by others
It is principally by engineering analysis that the physical demand for services will be related to the existing capacity to provide them and the incremental capacity needed to add to the existing supply. Normally, it will not be the appraising engineer's responsibility to carry out the detailed physical design
13 As for electricity grids, but to a less dramatic extent, peaks on roads relate to the entire system, not just the particular road,
because traffic congestion induces some motorists to take roads that they would not normally use at less-congested times.
14 If a higher toll deters motorists from using an under-used toll road, this might create more costly congestion on another part of the
road system. Thus, it might become more economic to keep down tolls than to extend the rest of the road system. Alternatively, such a policy might deter the use of shared rides, which might be considered as of greater economic benefit.
of the project structures. Instead, he will become involved at a stage usually referred to as a "feasibility" stage. Engineers employed by the project entity itself, either as staff or consultants, will have prepared an analysis of the need for a particular type of development project. This will postulate its size, broad design parameters and the timetable for implementation. The appraising engineer will examine these proposals with the entity's engineers to determine whether they are, indeed, feasible. An examination will be made of the technical soundness of the proposed construction and also of the plans for carrying out the construction in the most economical way. Also to be examined are the capabilities and requirements for maintenance of the structures once they are completed, as well as the need for rehabilitation of other structures, intended to operate in harmony with the proposed project. Cost estimates will be required for the interim replacement of shorter-life assets within the project, such as pumps or transformers, together with the costs of inspection of assets that are safety or health hazards, such as dams or smoke-emitters.
This physical appraisal is an important prerequisite, and is closely related to, economic evaluation of the project. It can be said, almost categorically, that however soundly constructed the project and however financially viable it is likely to be, a key determinant to going ahead with it is a satisfactorily economic and/or social cost benefit analysis.
One of the first things to determine is that the project proposed represents the least (economic) cost and feasible solution to the concern being addressed. It is highly unlikely that there is only one sound technical solution to the problem. It is also not at all unlikely that the proposed solution does not necessarily represent the least economically costly way of solving the problem. The appraising engineer (or other specialist) must therefore examine a number of feasible solutions. He or she must analyze the overall costs and the timing of such costs, to determine which of the solutions has the least present value in economic terms. Once the least–cost feasible solution has been determined (and this is not as easy as it sounds) another step in the economic analysis is to determine, as far as possible, the economic rate of return likely to result from the project. This, too, is often far from easy, for it frequently requires the assessment of benefits that are difficult to measure in monetary terms. Sometimes social benefits result from the project, which are almost impossible to measure at all. Furthermore, the interrelationship of costs, benefits and prices and how they affect one another means that it is often difficult to operate on the basis that "all other things are equal."
One aim of economic analysis, at least in theory, is to establish an economic rate of return, which is perceived as in excess of the "opportunity cost of capital" that will be invested in the project15. Put another way, an attempt is made to measure the return from the project against possible returns from other projects into which the capital might, alternatively, be invested. The common implication that economic analysis is somewhat theoretical should not detract from its usefulness. To imagine that economic analysis can yield a single rate of return number (or, more correctly, postulate a target discount rate) to several decimal places is, indeed, illusory.
15 One economist, Joseph Stiglitz (former Chief Economist of the World Bank) questions the efficient allocation of capital by
the free market, explaining his concern through the mechanism of interest rates. If the demands of borrowers outstrips the supply of funds, banks will raise interest rates. But, absent well-appraised projects and complete information, the banks will then lend only to those willing to pay higher rates. These might turn out to be those investing in riskier projects, because the investors in the safer ones, with lower expected returns, may have dropped out. Whether or not this is valid, it does provide a good argument for sound project appraisal, rather than relying on investor speculation or even on the crude judgment of banks.
It is, however, often perfectly reasonable to seek a number adequate within a range of one or two percent on either side, which will act as a focal point, derived from the quantification of all measurable data. Costs and benefits can then be tested for sensitivity and risk, both with regard to their amount and their timing. Furthermore, if all quantifiable benefits have been assessed, the non–quantifiable or social benefits of the project can be judged for their adequacy within much narrower limits.
With many public utility projects, revenues from sales of the output from the project are likely to be used as surrogates for the benefits to the consumers. This sometimes leads to difficulties. The first one arises because often the existing service is being provided at sub–optimal prices, fixed far below the marginal cost of providing the service. With the advent of the new development project, the marginal cost is likely to be even higher, meaning that prices of services are almost certain to have to be raised. Thus, with such a wide disparity between the existing and likely future prices, the revenues used in an economic forecast can hardly be said to be based on observed willingness to pay by the consumer. They are based, instead, on an assumed willingness to pay, which is a far less rigorous concept. Depending upon demand elasticities also, any significant increases in price are likely to result in reductions in demand for the service. This might, in turn, require a redesign or postponement of the project.
The prices assumed for the revenue calculations will be average prices 16, representing what every likely consumer is prepared to pay (at the margin) as a minimum. As already indicated, they take no account of the possible willingness to pay of individual consumers above the average price. Thus, no allowance is made for the so–called "consumers' surplus. Thus, the economic analysis is based upon a minimum measure of benefits. From a financial viewpoint, this may not much matter. Unless the "consumers' surplus", or part of it, can be captured by the entity through a system of differential prices, these additional economic benefits will not be translated into improved financial performance, by way of extra revenues.
Finally, whereas the financial analysis will need to be done in current prices, to reflect funds requirements, economic analysis will normally be carried out in constant prices to eliminate the effect of inflation upon both costs and benefits, in determining real or economic values17. This is explained, further, in a later section. The Cost Estimate and Financing Plan
16 There is an anomaly here. The determination of the least cost solution implies the use of the discounted cash flow methodology.
This, in turn, implies the use of a specific discount rate, representing an “opportunity cost of capital.” The project rate of return will be the discount rate at which the net present value of the project is zero. If prices are set to equate the (marginal) benefits to the (marginal) costs, this implies a certain amount of circular reasoning. One remedy, for a (natural) monopoly, is to calculate the “average incremental (marginal) cost price.” This can be tested against the current price and the future price possibly chargeable. WARNING: The calculation involves the discounting of quantities of (say) water or electricity, rather than money values. Although completely valid, this confuses people! Confusion can, however, be mitigated by assuming each physical unit of the quantities to be sold at a price of one currency unit. This turns quantities exactly into money values, without altering the amounts.
The linking of the economic analysis to the physical evaluation of the project, to some extent, jumps ahead of some of the aspects of financial appraisal and analysis. A most important outcome from the technical analysis is the preparation of a cost estimate. This should be broken down by components and include adequate provision for technical contingencies and price escalation.
Technical contingencies must be included, allowing for changes in physical construction that almost inevitably occur and are beyond the control of either the contractor or the project entity. Cost estimates should be separated into cost components and phased over the years of project implementation. Price escalation must also be included. This is because, as the project proceeds over several years, the costs of its inputs are likely to rise, in money values, due to inflation.
The development of a financing plan can be done from two alternative perspectives. The first alternative is to regard the project as standing on its own and to develop a financing plan which meets the construction costs of that particular project. The other alternative is to regard the project as merely one component in the overall investment program of the project entity, at least for the period of project construction. In this case, the financing plan will be addressed to providing all of the funds necessary to meet the entire investment program of the entity, including the investment requirements of the project and any necessary increases in working capital.
Intended sources of finance will have to be assessed, both with regard to the amount and the timing of their availability. The financing plan cannot be too tightly drawn but should leave adequate margins of safety. In addition, there should be a fallback position, in case something should go seriously wrong with the cost or timing of project implementation or, indeed, with the availability of funding in the financing plan itself.
One thing to consider, in such an emergency, is whether additional funding can be made available from other sources. This additional funding may, of course, be more expensive than that considered originally, or it may be more administratively irksome to obtain. It may also be linked with unpalatable or onerous conditions, not initially envisioned. This would be particularly true if the additional funding were to be from governmental sources or from an international entity.
17 This is not always strictly accurate. If project costs and expected system maintenance (perhaps involving foreign costs) are
expected to rise at a faster rate than (say) customer revenues, perhaps held down by economic privation, forecasts made at constant prices will tend to overstate the project’s financial (and consequently economic) benefits, unless adjustments are made in the calculations for differential rates of inflation – such as cost and wage inflation. In theory, one should also allow for different exchange rates, at least by acknowledging these as risk or sensitivity factors.
If additional funding, at least on reasonable terms, is unlikely, then a contingency plan would be necessary, to facilitate the cutting–back or postponement of the project itself or perhaps of other less essential parts of the investment program. This is certainly not as easy as it sounds. After all, if a project has been finely designed as an integrated package, any reduction in its components is likely to make it, at least temporarily, sub-optimal to its intended purpose. In other words, it may be (at best) less economically efficient or (at worst) not really work at all! Moreover, the project will, likely, be just one component of an entire capital investment program. Many of the components of this may be interdependent. Sometimes, however, hard choices must be made and there are no more viable alternatives. Sometimes, moreover, a project must be either finished or abandoned. There is no point, for example, in building half a dam or a road to nowhere! Sources of funds for a financing plan can include borrowing, equity contributions or grants from governmental sources. They might sometimes include contributions from customers or participating enterprises. One other important source can often be that of internally generated funds. These will only be available after the enterprise has covered all of its operation, maintenance and debt service requirements for its ongoing activities. These may be highly sensitive to the prices currently being set (or intended to be set) for the sale of its products. In assessing the quality of the various sources of funds, one thing to be concerned about is the extent to which any or all of them are contractually fixed, even in the event of substantial cost overruns. It is not uncommon, for example, for financing plans to be highly levered against a residual provider of funds. Often, this will be a (national, state or local) government, already hard pressed to come up with a minimum contribution to match those of others.
Suppose, for example, that ninety percent of project funding is in fixed contractual terms, with the (state or local) government undertaking to provide the remaining ten-percent and to meet any cost over–runs. In such circumstances even a modest ten percent increase in project cost would double the contribution of the government, creating a serious situation.
Even if a satisfactory package of funds can be assembled, to cover full project cost, the analysis is not complete. The financial plan must be examined for its effect upon the revenues of the project entity. This is particularly so with regard to both additional debt service and the operation and maintenance of the new facilities. At this point, it will usually become necessary for the financial analyst to prepare a complete set of financial statements and forecasts stretching into the future beyond the intended startup date of the project. It would need to cover all financial aspects of the project entity, including that of the project itself. Forecasts of operating statements
will need to have regard to revenues and expenditures. The expenditure will include operation, maintenance, repairs, administrative costs and (especially for a revenue–earning enterprise) depreciation.
Cash flow forecasts will also be necessary. These will include forecasts, derived from income statements, of internally generated funds. Provision for debt service will be needed, both for debt already current and also for debt expected to be incurred as a result of the current and future investment program. When the net internal sources of funds have been ascertained in this way and matched against investment requirements, it will be possible to determine the amount and timing of external financing needed. Indeed, a summary of the cash flow statement for the period of project construction or implementation can quite often be used as the financing plan. This is sometimes referred to as a “time-slice” financing plan.
For a revenue-earning enterprise, the expected revenues will, of course, result from charges to customers for goods and services. For a non–revenue–earning enterprise it will be necessary for additional costs, resulting from the project and other investment activity, to be covered from additional revenues, through the raising of additional taxes or from some other appropriate sources.
To ensure that adequate revenues are available, both to cover operating costs and also to contribute towards investment, it will be necessary for the financial specialist to analyze, with the project entity, its revenue policies. This will include the examination of present and proposed prices or tax levels and also collection efficiencies. If existing policies and practices are unlikely to result in the necessary generation of funds, it will probably be important to get a commitment from the project entity to change these policies. This may sometimes be done as a condition precedent to financing the project or to going ahead with construction or implementation.
Sometimes, pricing policies will be directly concerned with interest rates. These, of course, are interlinked with the overall financial market of the country and in turn to its macro–economic policies. It is unlikely that the interest rate policies and practices of a single entity can be changed without reference to the financial sector as a whole. In this case, discussions with the banking system or with macroeconomists may prove to be inevitable. Discussions with governments may also be essential where pricing policies are subject to government controls.
Procurement of Goods and Services
Of particular importance to financial performance is the manner in which goods and services for the project are to be procured. Decisions will be necessary as to how much of the project, and which components, will be carried out by contractors and how much (if any) by the project entity's own staff. Unless there is a continuous and constant level of capital works, it probably makes sense to contract out most of the work. The employment of a large direct labor force causes somewhat the same problems as the meeting of peak demand, discussed earlier. The staff can only be fully and efficiently employed during peak construction periods. For the rest of the time, part of the force will remain idle, which is costly. It may also be potentially disruptive of labor harmony, in the sense that “the devil makes work for idle hands.”
Where contracts are used, their selection should be on the basis of competitive bidding. Where foreign exchange costs are involved, there is often an advantage to making the bidding international. The overriding principle should be to get greatest value for money. Contracting procedures should, therefore, be examined to ensure that they operate to the maximum advantage of the enterprise, albeit fairly to the contractor. There is no long-term merit in trying to “ambush” a contractor with unexpected obligations or expenses. Later contracts will either allow for this directly or else include financial “booby-traps” for the employing entity18. Moreover, it is imperative that a local government or public utility establish a reputation – and a public example – for fair dealing and straight talk. Indeed, capital construction contracts are notorious sources of corruption and fraud. These must be prevented or investigated to the greatest possible extent. 18 It is, perhaps, worth noting that private contractors may well be able to pay to employ cleverer or slicker lawyers (or
accountants) than are available – or wished to be available – to the public sector!
Finally, a review should be made of the overall managerial technical, administrative and financial capability of the project entity to undertake the project. This will include a review similar to that conducted for general financial management capability. The financial professional will also need to be concerned with whether there will be a satisfactory project accounting system which, in turn, will be properly audited.
7-Types of Investment Decisions
One of the classifications is as follows, • Expansion of existing business • Expansion of new business • Replacement and moderation Expansion and Diversification A company may add capacity to its existing product lines to expand existing operation. For example, the Company Y may increase its plant capacity to manufacture more “X”. It is an example of related diversification. A firm may expand its activities in a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. If a packing manufacturing company invest in a new plant and machinery to produce ball bearings, which the firm has not manufacture before, this represents expansion of new business or unrelated diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue. Investment in existing or new products may also be called as revenue expansion investment. Replacement and Modernization The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firm’s revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. If a Garment company changes from semi automatic washing
equipment to fully automatic washing equipment, it is an example of modernization and replacement. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cost reduction investments. However, replacement decisions that involve substantial modernization and technological improvements expand revenues as well as reduce costs.
iv-FAINANCIAL APPRAISAL IN DETAIL i.Investment Evaluation Criteria
Three steps are involved in the evaluation of an investment: • Estimation of cash flows • Estimation of the required rate of return (the cast of capital) • Application of a decision rule for decision rule for making the choice Investment decision rule The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that is should maximize the shareholders wealth. The following other characteristics should also be possessed by a sound investment evaluation criterion: • It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects from bad projects. • It should help ranking of projects according to their true profitability. • It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. • It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth. • It should be a criterion which is applicable to any conceivable investment project independent of others. These conditions will be clarified as we discuss the features of various investment criteria in the following posts.
V-EVALUTION CRITERIA Investment Appraisal Criteria
A number of investment appraisal criteria or capital budgeting techniques are in use of practice. They may be grouped in the following two categories:
Discounted cash flow criteria
• Net present value (NPV) • Internal rate of return (IRR) • Profitability index (PI)
Non discounted cash flow criteria
• Accounting rate of return • Discounted payback period Discounted payback is a variation of the payback method. It involves discounted cash flows, but it is not a true measure of investment profitability. We will show in our following posts the net present value (NPV) criterion is the most valid technique of evaluating an investment project. It is consistent with the objective of maximizing the shareholders wealth.
Discounted cash flow criteria:i-Net Present Value Method (NPV)
The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is discounted cash flow technique that explicitly recognizes the tine value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present values are found out. The following steps involved in the calculation net present value (NPV): • Cash flows of the investment project should be forecast ed based on realistic assumptions. • Appropriate discount rate should be identified to discount the forecast ed cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk. • Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.
• Net present value (NPV) should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if net present value (NPV) is positive. Project acceptance rule using net present value It should be clear that the acceptance rule using the net present value (NPV) method is to accept the investment project if its net present value (NPV) is positive and to reject it if the net present value (NPV) is negative. Positive net present value (NPV) contributes to the net wealth of the shareholders, which should result in the increased price of a firm’s share. The positive net present value (NPV) will result only if the project generates cash inflows at a rate higher than the opportunity cost of capital. A project with zero net present value (NPV) may be accepted. A zero net present value (NPV) implies that project generates cash flow at a rate just equal to the opportunity cost of capital. The net present value (NPV) acceptance rules are: • Accept the project net present value (NPV) is positive • Reject the project net present value (NPV) is negative • May accept the project when net present (NPV) is zero The net present value (NPV) can be used to select between mutually exclusive projects; the one with the higher net present value (NPV) should be selected. Using the net present value (NPV) method, projects would be ranked in order of net present values; that is, first rank will be given to the project with higher positive net present value (NPV) and so on.
Limitations of Net Present Value
The net present value (NPV) method is a theoretically sound method. In practice, it may pose some computation problems.
Cash flow estimation. The net present value (NPV) method is easy to use if fore casted cash flows are known. In practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty. Discount rate. It is also difficult in practice to precisely measure the discount rate. Mutually exclusive projects. Further, caution needs to be applied in using the net present value (NPV) method when alternative projects with unequal lives, or under funds constraint are evaluated. The net present value (NPV) rule may not give unambiguous results in these situations. • Ranking of projects. It should be noted that the ranking of investment projects as per the net present value (NPV) rule is not independent of the discount rates
Importance of the Net Present Value (NPV)
Net present value (NPV) is the true measure of an investment’s profitability. It provides the most acceptable investment rule for the following reasons:
Time value. It recognizes the time value of money-a $ received today is worth more than a $ received tomorrow. Measure of true profitability. It uses all cash flows occurring over the entire life of the project in calculating its worth. Hence, it is a measure of the project’s true profitability. The net present value method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations.
Value additively. The discounting process facilitates measuring cash flows in terms of present values that is in terms of equivalent, current $. Therefore, the net present values of projects can be added. For example, NPV (A+B) =NPV (A) +NPV (B). This is called the value additively principle. It implies that if we know the net present values (NPV) of individual projects, the value of the firm will increases by the sum of their net present values (NPVs). We can also say that if we know values of individual assets, the firm’s value can simply be found by adding their values. The value additively is an important property of an investment criterion because it means that each project can be evaluated, independent of others, on its own merit. Shareholder value. The net present value (NPV) method is always consistent with the objective of the shareholder value maximization. This is the greatest virtue of the method.
ii-Internal Rate of Return (IRR)
The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implied that the rate of return is the discount rate which makes net present value (NPV) =0. There is no satisfactory way of defining the true rate of return of a long term asset. Internal rate of return (IRR) is the best available concept. We shall see that although it is very frequently used concept in finance, yet at times it can be a misleading measure of investment worth. The internal rate of return (IRR) method is another discounted cash flow method for investment appraisal, which takes account of the magnitude and timing of cash flows. Other terms used to
describe the internal rate of return (IRR) method are yield on an investment, marginally efficiency of capital, rate of return over cost, time adjusted rate of internal return and so on.
Evaluation of Internal Rate of Return Method
Internal rate of return (IRR) method is like the net present value (NPV). It is a popular investment criterion since it measures profitability as a percentage and can be easily compared with the opportunity cost of capital. Internal rate of return (IRR) method has following merits: Time value. The internal rate of return (IRR) method recognizes the time value of money. • Profitability measure. It considers all cash flows occurring over the entire life of the project to calculate its rate or return. • Acceptance rule. It generally gives the same acceptance rule as the net present value (NPV) method. • Shareholder value. It is consistent with the shareholders wealth maximization objective. Whenever a project’s internal rate of return (IRR) is grater than the opportunity cost of capital, the shareholders wealth will be enhance.
Here is the briefly mention the problems that internal rate of return (IRR) method may suffer from.
Multiple rates. A project may have multiple rates, or it may not have a unique rate of return. These problems arise because of the mathematics of internal rate of return (IRR) computation. Mutually exclusive projects. It may also fail to indicate a correct choice between mutually exclusive projects under certain situations.
Value additively. Unlike in the case of the net present value (NPV) method, the value additively principle does not hold when the internal rate of return (IRR) method is used internal rate of returns (IRRs) of projects do not add. Thus, for projects A and B, IRR (A) + IRR (B) need not be equal to IRR (A+B).
Profitability index is the ration of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. Profitability index is another time adjusted method of evaluating the investment proposals is the benefit-cost (B/C) ratio or profitability index (PI).
PI = Present value of cash inflows/ Initial cash outflow
Acceptance Rule The following are the profitability index (PI) acceptance rules: • Accept the project when profitability index is grater than one • Rejected the project when profitability index is less than one • May accept the project when profitability index equal one The project with positive net present value will have profitability index grater than one. Profitability index less than one means that the project’s net present value is negative Evaluation of profitability index (PI) method
Profitability index (PI) is a conceptually sound method of appraising investment projects. It is a variation of the net present value (NPV) method, and requires the same computations as the net present value (NPV) method. • Time value. It recognizes the time value of money. • Value maximization. It is consistent with the shareholder value maximization principle. A project with profitability index grater than one will have positive net present value (NPV) and if accepted, it will increase shareholders wealth. • Relative profitability. In the profitability index (PI) method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project’s profitability. Like the net present value (NPV) method, this criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.
Non discounted cash flow criteria:i-Payback Period Method
Payback is the number of years required to recover the original cash flow outlay investment in a project. The payback is one of the most popular and widely recognized traditional methods of evaluating investment proposals. If the project generates consistent annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:
Payback = Initial investment / Annual Cash inflow Acceptance Rule Many firms use the payback period as an investment evaluation criterion and method of ranking projects. They compare the project’s payback with a predetermined, standard payback. The project would be accepted if its payback period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period. Thus, if the firm has to choose between two mutually exclusive projects, the project with shorter payback period will be selected.
Advantages of Payback
Payback is a popular investment criterion in practice. It is considered to have certain virtues.
Simplicity. The most significant merit of payback is that it is simple to understand and easy to calculate. The business executives consider the simplicity of method as a virtue. This is evident from their heavy reliance on it for appraising investment proposals in practice. Cost effective. Payback method costs less than most of the sophisticated techniques that require a lot of the analysts’ time and the use of computers. Short term effect. An investor can have more favorable short term effects on earnings per share by setting up a shorter standard payback period. It should, however, be remembered
that this may not be a wise long term policy as the investor may have to sacrifice its future growth for current earnings. Risk shield. The risk of the project can be talked by having a shorter standard payback period as it may ensure guarantee against loss. An investor has to invest in many projects where the cash inflows are and life expectancies are highly uncertain. Under such circumstances, payback may become important, not as much as a measure of profitability but as a means of establishing an upper bound on the acceptable degree of risk. Liquidity. The emphasis in payback is on the early recovery of the investment. Thus, it gives an insight into the liquidity of the project. The funds so released can be put to other uses.
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