Corporate finance
Corporate value maximization coupled with proper management of financial risks brings up a need for strong financial decisions through efficient corporate finance management. Decisions on major corporate activities such as capital investment, working capital management and financial risk management require vast knowledge and skills on corporate finance. Finance managers ere faced with difficulties in making decision especially where various alternative course of actions are present (Megginson, 2008). In order to decide rightfully with consideration of corporate value, mangers and financiers utilize selected method of evaluation. Investment appraisal is carried out by using a variety of techniques, with which results differ. Methods of investment appraisal commonly used include NPV, IRR, ARR and payback. These capital budgeting techniques are mostly used during the planning process to enable determination of viability of long term investments such as new plants and/or products, replacement of assets, development projects and other capital investments. Potential investments incremental cash flows are used as the bases for computations involving investment procedures named (Thompson, 2007).
Among the named methods of appraisal, NPV is commonly used in many organization that bother techniques. Payback approach is also viewed as a simple and hybrid technique of capital budgeting compared to ARR method which remains questionable by various economists (Kent & Powell, 2005). Widespread application of NPV by many corporate globally rates this technique as the most appropriate method for use during planning for investment. Some of the reasons behind superiority of NPV include facilitation of comparison between future value and present values for any investment through discounted valuation of cash flows. Through NPV future estimates of the project can be compared to current values of the same project hence helping in determination of more viable projects i.e. projects with higher net PV. In order to effectively evaluate reasons behind prosperity of NPV method in capital budgeting, an analysis of other techniques such as ARR, IRR and Payback is essential. Again, illustration of these methods application through computation is included to clearly elaborate their difference.
NPV
NPV is a common method that is used by modern managers in carrying out investment appraisal in regard to capital value management.NPV analysis satisfies investor due to its ability to show whether investment benefits are sufficient to cater for thing such as Assets costs, risk premium and cost financing the project. NPV may be explained as the variation between cash flows taking into account hurdle rate and economic factors such as inflation. Present value of costs and that of benefits is computed using hurdle rate and comparison is made on the results (Vishwanath, 2007). Difference between the two may either be a positive value, neutral i.e. zero or negative. Higher cash outflows than inflows result into a loss which is represented by a negative NPV while positive NPV represent benefit from the project. The higher the NPV the more viable a project is in comparison to similar investments. An investment with a zero NPV may be considered indifferent though no loss anticipated. At this point the project is considered to be at breakeven where no loss or benefits are made out of the project. Such investments call for other capital budgeting methods to be used to substantiate the projects viability. Decisions made according NPV evaluations puts into consideration TVoM, profitability and comparison on independent projects. As well this technique can be used together with other methods to obtain accurate solutions. Method such as payback period can be integrated in NPV method to evaluate viability in terms of currency and period of investment costs recovery. In formula format NPV is equivalent to summation of discounted cash-inflows at given rate of return and period less cash-outflows PVs.
IRR
Investment decisions regarding long-term projects can be based on evaluation by application of IRR method that utilizes NPVs for projects in comparison. In most cases, IRR is applied in measurement of investment efficiency before investments conclusions can be made.IRR is similar to expected RoR that an investor anticipates to earn from investments. After computation of NPVs, those projects with a NPV equivalent to zero are considered viable. An unconstrained environment which allows positive returns after a period of negative cash flows provides a favorable ground for use of IRR in analyzing projects worthiness (Thompson, 2007). For mutually and non-mutually exclusive projects, IRR ratings are used to determine projects viability. Mutually exclusive investments decisions are achieved using IRR to select investment with lowest IRR as if agree with higher NPV. On independent projects, IRR achieved is compared to capital rate and those projects with high IRR are considered viable for investment. IRR is a method preferred by many executives in decision making due to detailed results acquired from IRR computations. Comparison of IRR to RoR is possible and those projects with zero NPV can be evaluated further by use of MIRR. Again, IRR gives evaluation in terms of percentages compared to NPV which only references it evaluation in currency terms. Contrally to these benefits, IRR does not show the actual level of profitability as NPV does. Additionally incremental cash-flow is overlooked hence lowering actual RoR.
NPV vs. IRR
Despite application of NPV techniques in determining IRR, NPV is prominent more than IRR due to the following reasons. First, NPV accounts reinvestment of cash flows which is not accountable on IRR. According to IRR reinvestment is meant to earn IRR rather that hurdle rate in accordance to NPV (Dayananda, 2002). Secondly, IRR technique may present multiple solutions that require further evaluation. With NPV occurrence of such issues is not present hence proving an effective method of appraisal. Lastly, IRR method gives results in percentage which are difficult in evaluating real profitability level. NPV is noted in currency figures which directly reflect profitability value of the project.
Payback period
This is a technique that provides the duration that an investor will wait to fully recover investment. According to economists, TVoM principles are overlooked when using Payback technique. Period in days is computed by a division of cost of investment on annual cash-flows despite their Present value. Value of investment at the time of recovery is not considered hence making this method weak in capital budgeting procedures (Caplan, 2009). Projects with shorter payback period compared to alternative projects are considered worth in accordance to Payback method. Practice of this method of evaluation is used in many organizations despite its inferiority to NPV for various reasons. To start, project ranking incase of liquidity constraints and urgent need of investments repayments payback is the most efficient method of appraisal. Again, risky investments in a dynamic environment may necessitate use of payback to evaluate soonest an investment is likely to recover investment costs. Additionally, payback method is applied due to its simplicity and easier to understand by managers in all levels of management. Lastly, mangers opt using this method because it can be integrated with other method such as NPV and also provides an essential summary method of investment appraisal.
NPV vs. Payback period
Payback period appraisal method ignores investments benefits happening after the payback period is reached. Profitability measure using payback period method can not be achieved as NPV method does. As well, NPV takes into account TVoM which enables an investor to value investment at particular stage (Watson & Head, 2006). Similarly, payback method fails to offer distinction between projects of similar payback period. In such instances, NPV approach becomes necessary in order to assist in distinguishing between projects of that nature. Lastly, excessive investment on short-period projects is inevitable incase payback method with other constraints constant is continually used by an organization. With these drawbacks of Payback method, NPV remains appropriate in investments appraisal.
ARR
Financial ratio applied in investments appraisal which assists in evaluation of RoR on investments. Projects RoR as computed is compared to the targeted rate to identify the beneficial projects on which a company then invests in. In computation of ARR, all expenditures not of capital nature including depreciation are deducted fro investment total costs. This ensures only capitalized costs are used in computing ARR (Peterson & Fabozzi, 2002). Viable projects in regard to this technique are those with an ARR equivalent to RoR or higher than RoR. Comparison of independent project, those with the highest ARR are worth of investment according to ARR principles. For instance, with a RoR of 5%, viable projects are expected to yield a 5% return or more on every unit of investment.
NPV vs. ARR
Undertaking investments after capital decisions are made according to ARR evaluations remain lowly undertaken practice compared to usage of NPV approach due to several limitations associated with ARR procedures. ARR assumes stable cash inflows over time hence loosing track on profitability timing on investments (Dury, 2008). Again, TVoM and project length considerations when using ARR approach is not present hence ranking this approach below NPV which is desirable to many investment managers. Similarly, ARR approach is supported by accounting profits rather than cash-flows. Depreciation and other expenses are deducted from cost value to be used in ARR computation hence rendering the process cumbersome compared to NPV. Again, accounting profits undergoes different accounting treatments therefore ARR may not reflect the real state of the anticipated investment. Lastly, ARR acts as a relative measure of investments viability without consideration of investment size and length (Kinney & Raiborn, 2008). With NPV, investment cash-flows are used and computations results act as absolute measure due to accountability of investment size.
Computations
An illustration, Pute Co. plans to invest in a project costing $120,000 and has a yearly inflow of $ 40,000. Projects salvage value is equivalent to zero and project RoR at 10%. Project's viability can be evaluated through various methods as shown. Depreciation is assumed on a straight-line method.
IRR
According to information given, at NPV=0, PV factor =$120,000/ $40,000=3.0
From PV of annuity tables 3.0 coincides with 4 years at 13% column. Hence Pute's project IRR is approximately 13% which is above RoR of 10%. In accordance to IRR, Pute's project is viable.
Conclusion
Results from different investment appraisal techniques used show that the project in question is a viable investment. Viability of a project can be determined by either of the approach though each approach has its limitations as reviewed earlier. Al other methods apart from NPV have not indicated the profitability level of the investment from the computations. This makes NPV the most preferable method considering other benefits such as TVoM, inflation and comparability.NPV indicates the project through which a firm can reach its optimal level of investment due to ability to measure return in non-ratio form. Similarly, NPV is tends to favor long-term projects which are beneficial to long term stability of a company.
