Use and definitions of investment appraisal methods: Investment appraisal methods are highly used in capital budgeting decisions. Jacobs (2007) claims that "capital budgeting decisions are among the most important choices made by managers; selection or rejection of investment proposals defines the firm's profitability and, in the end, its survival." The last word of this sentence highlights the importance of these methods and their accurate usage. This kind of methods are used in both small and big sized companies which operate in a highly regulated and competitive market. According to Lumby (1988) this kind of companies "exist for one overriding purpose: in order to benefit their owners." This fact is highlighted in order to link this aim to the aim of capital decision making. So, use of capital decision making is highly related and aiming to maximise shareholders wealth. There are lots of methods in investigating and evaluating possible projects or decisions in businesses. Although, we will examine 4 of them;
The payback method
Accounting rate of return
Internal rate of return
Net present value
a) The Payback Method: The payback period includes the time period of covering the initial outflow with the net cash inflows from the possible project. The company sets the limit for the payback period duration and it is obvious that the shorter period is better for a company.
ADVANTAGES OF PP METHOD
DISADVANTAGES OF PP METHOD
Quick and simple to calculate
The decision rule is too ambiguous to give a definitive ruling
Helps to choose the less risky project (high risk in estimating future cash flows)
Cash-flows that arise out of payback period are ignored. ( only the cashflows in payback period are considered )
Saves the management the trouble of having to forecast cash flows.
Says nothing about the project as a whole
Convenient method to use in capital rationing situations.
Ignores time value of money
Table 1- Source: Lumby, 1988 Atrill, 2006
b) Accounting Rate of Return Method: "is the method takes the average accounting profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project" (Atrill, 2006) This method is also uses the same approach with Return on Capital Employed Ratio in a way that they both investigates the profit related with the assets employed to the project. Atrill suggest that this method seems to be a sound one because "private sector businesses are normally seeking to increase the wealth of their owners." (Atrill, 2006) On the other hand, Magni claims that "The ARR is usually considered economically meaningless or, at the very best, a poor surrogate for the IRR." (Magni, 2009) Lots of academics point many limitations to ARR method. Some of them like Rappaport (1986) commented that "comparing the ARR with the cost of capital is clearly like comparing apples with oranges"(Rappaport, 1986). In this respect, we can conclude that other methods of appraising are superior to this method in most of the cases. In case of application decision rules are as follows;
It must achieve the target ARR which is decided by company as a minimum limit.
All other equal, the project with higher ARR should be selected.
Advantages of ARR Method
Disadvantages of ARR Method
Can be used to measure the business performance
Uses accounting profit rather than cash flows which are more important.
Gives the result as a percentage making it comfortable for managers.
Cares about profit which is nor directly linked to increasing shareholders' wealth.
Can be used to compare mutually exclusive projects
Ignores timing of profits by taking averages.
Uses accounting profit which is more appropriate for reporting achievement on a periodic basis.
Ignores size of investment and time value of money.
Table2 - Source: Atrill, 2006
c) Internal rate of Return (IRR) Vs d) Net Present Value (NPV)
For decades, academics are discussing which one of the methods above is superior to the other. It is still debatable but it is true that both has good advantages and sharp disadvantages which make it hard to choose one. Osborne defines IRR as "the rate that brings the present value of the returns into equality with the amount of the initial investment. (Osborne, 2004) Atrill concludes by saying "it represents the yield from an investment opportunity."(Atrill,2006). On the other hand NPV is a method that helps us to calculate the present value of the project considering all of the costs and benefits of each investment opportunity. Osborne (2004) comments that "the academic community has long advocated as a superior methodology" (Osborne,2004). Though, Bhattacharyya (2004) says that "when we look at surveys of managers we find that more managers prefer to use Internal Rate of Return (IRR) for capital budgeting over NPV." (Bhattacharyya, 2004). This conflict and lack of clarity between these two methods comes from the fact that the both methods' deriving from the same equation- the time value of money equation. According to Bhattacharya, the superiority of IRR from the viewpoint of managers comes from the fact that "managers interpret IRR as something akin to a mortgage rate and this makes it easier for them to estimate the probabilities of financial embarrassment of not meeting the return expectations of security holders." (Bhattacharyya, 2004). All remains equal, according to Dury (1997), the selection of method is highly related to the size of the organisation. After careful consideration and a big survey he concluded that, "the larger ranking IRR as the most important, payback as the second most important and intuitive judgement as the least important. In contrast, smaller organizations ranked payback as the most important and intuitive management judgement as the second most important technique." (Dury, 1997
Table 3&4 - Source: Dury, 1997
To add, Brijlal (2008) investigated and found out that the choose of capital budgeting method is varies from sector to sector as well.
The reason of accepting NPV as the best method to use when appraising investment opportunities is the number of disadvantages/pitfalls IRR method has. For better understanding, I will create a table consisting of the advantages of NPV and the disadvantages IRR methods.
Advantages of NPV Method
Disadvantages of IRR Method
It takes account the time value of money
IRR, by itself does not show whether the project is borrowing or lending
It uses cash flows, not accounting profits
Possibility of multiple rates of return
It takes account of all the relevant cash flows over the life of a project
Inconsistency when mutually exclusive projects are under consideration
It can take account of both conventional and non-conventional cash flows
IRR rule cannot be used when the term structure of interest rates is not flat.
It gives an absolute measure of project value
NPV can accommodate changes in discount rate during project, but IRR ignores them
Table 6 - Source: Atrill, 2006, Osborne,2004, Bhattacharyya, 2004
2- Calculations:
3- Conclusion:
Methods
Option A
Option B
Payback Period, PP
Second year
Third Year
Accounting rate of return
40,950413
64,033058
Net present value
555,2496933
848,5823126
IRR
43,636879
39,605994
Selected option
Academic theories tells us to select the project with higher NPV no matter what other methods show us. Osborne summarizes this fact by saying "most textbooks on financial management devote a section to debate, usually arguing in favour of the NPV." (Osborne, 2004) Therefore, we should select project B for our company. Because looking at NPVs of both projects we see that option B has higher NPV compared to option A. Option A could be a better alternative for companies which are in cash difficulties and need cash immediately after project. Also Internal rate of return (IRR) of option A. At part 1- c) "Internal rate of Return (IRR) Vs d) Net Present Value (NPV)" part at page 3 and table 6 at page 5, it is discussed and explained that why the decision is made according to the NPV method and why this method is superior to the IRR method.
