Methods of Investment Appraisal

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Abstract

The resultant evidence of the disparity in investment appraisal methods arouses the need for the conclusion of whether there exists a correct method of evaluation appraisal, where justification of the incongruences in the investment appraisal methods could give lead to judgment of the viability of investment appraisal methods and the consequences therein. The major determinants of the correctness of an investment appraisal method lie in the cash flows, and discount rates, where the incremental cash flows has a set back of the hurdle rate effect on one hand, while the methods that herald their basis on the payback period like the payback method bear the setback of the assumption that projects with shorter payback periods are the best investments since they have higher return margins. This influences the preferences to alternatives as it gives a the reflection through the current and future investment prospects. This also gives the need for the explanation of the correctness of the investment appraisal methods in order to help in understanding the viability of the model, which is the essence of this paper (Lucey, 2003).

Introduction

Investment appraisal is the process of determining the viability of an investment project in an organization, where the long term prospects of a company are analyzed according to the worth of pursuance. This mode of evaluation is also known as capital budgeting, where a company deliberates on the best course of action that leads to better performance resulting from proper resource allocation. There are different methods of investment appraisal applicable in the business world, which include the payback period, the net present value method, the profitability index method, the accounting rate of return method and the profitability index. These methods of investment appraisal lie in the broader category of either discounting or non-discounting depending on the calculation of the discount rates, while they also have a perceived common entity of employment of the incremental cash flows from the valuable venture. Conversely, the common disparity in the methods of appraisal lies in the system of employment, where modes like the “accounting rate of return” and the “return on investment” methods of investment appraisal employ the conventional basis of accounting earnings, while the payback method, which is also a hybrid method uses the payback period as the basis of evaluation of the worth of an investment (Harris, 1996)

Consequences of Non-Discounting Investment Appraisal Methods

            Firstly, the correctness of non-discounting investment appraisal method lies in the determination of the cash flows, which proves to be difficult. The essence of cash flows determination in this case is hampered by the fact that the cash flows cannot collude to the attributes of a single project. For instance, when a there is an increase in the production capacity resulting from  an increase in the saleable products due to increased number of probable projects, then determination of the attributes of a single project would be difficult. Consequently, the cost accounting datum could be helpful in provision of the information about the incrementing and the decrementing trends within the investment project resulting from an increase in the current cash flows, although such information is insufficient. In other cases, the appraisal model could lead to a rationalized form of investment, which could result in reduced cash flows in terms of costs.

            This has an impact of increased net cash flow, which consequently impacts on the productivity of the company. This implies that there is need for analysis of the cash flow within the company in order to address all the areas for the best productivity. The rule of thumb is that once the evaluation is done amid the constraints of cash outflows, there would be difficulty in isolation of additional cash outflow due to increase in number of the investment projects, which forms the greatest setback to the correctness of an investment appraisal (Lucey, 2003). This also shows that once there is impossibility of evaluation of the single attributes of an investment project, then the whole affair would be in jeopardy resulting in the doubt about the correctness of an investment appraisal method.

            Secondly, the investment appraisal methods like the “accounting rate of return” employ the use of discount rates, which must fulfill the fundamental aspects of current or future reflection of opportunities and comparability of differing investment projects. This proves to be a result of difficulty in uniformity in that in comparison of the alternatives, there is consideration of the cost of capital as a factor underpinning the variation in the alternatives. In this case, choice of the discount rate is hampered by the fact that the cost of capital is inclusive of the project’s cash flow, where it is just a reflection of the discount rate viable for the NPV calculation. The relevance of the discount rate lies derivation from the financing costs where the cost of capital or the financing cost is the rate of returns from an alternative investment with better prospects, forms varied sources of constraints emanating from lack of knowledge on the source of the finances for the projects especially in times of company debts where a common internal source is used to finance all the prospective projects.

            Moreover, it is difficult to determine the alternative returns since there exists a common funding that is internal for all the projects. This implies that once a company gives preferences to alternatives due to the viability of returns, calculation of such alternative returns could be hampered by the internal financing system, which brings about jeopardy to the whole investment appraisal affair. Consequently, the discount rate calculated from the costs of financing bars correspondence between the current financing costs and the additional payments for future investment projects. This shows that the factors that influence performance of currencies such as inflation are liable for the erosion of correspondence between the interests levied on future opportunities and the contemporary costs of financing, which seals the incongruences in the appraisal methods.

Consequences of Discounting Investment Appraisal Methods

            The other common incongruence of the discounting investment appraisal methods lies in the discount rates that are time-span dependent. The rule of application is that the discount rate is not dependent on the time-span between the viability of a cash flow and the period for planning of the project. This shows that extrapolation of a segment of the curve gives a flat line that has a null gradient, which is linear with the expectations of the time-span especially in terms of the cash flows. The most evident challenge of evaluation of the investment appraisal under the context of the time-span dependence lies in the fact of ignorance in the timing of the cash flows. This is the constraint evident in the payback mode of investment appraisal, where there exists the tendency of the assumption that the viability of the project lies in the length of the payback period. Taking such considerations for the choice of an investment appraisal method has a setback of real time evaluation of what is perceived and reality.

            The common practice of assuming that the shorter the payback period, the more viable the project elucidates the aspect of ignorance into conclusive research that could lead to the most viable project. This implies that more resources could be wasted in generation of less viable projects while the most viable projects, whose payback period is longer, would not be put forth for consideration. This also implies that once a company opts for the alternative that is more of perceived than reality, the assets and resources would go to waste as the best alternatives would be ignored. This brings a bout the incongruence in the appraisal methods especially the hybrid system where the payback period in the payback discounting method of investment appraisal is used to determine viability of the investment appraisal model.

            The other element that affects the correctness of an appraisal method is the viability of risk evaluation, which gives a preamble into the probability of achievement against the deviations from the normal. In any business environment, risk factors form the line of separation between uncertainty and viability. The most evident condition that is befallen by the risk factors in evaluation of an investment appraisal method is in calculation of the payback periods and their consequent values. This is practice that defines the payback model of investment appraisal, where the viability of the value of the payback period and the value therein might not conform to the internal risks (Garrison & Noreen, 2003). Once the calculation for the value of the pay back period is done, it gives a trend of performance of the project, which also necessitates increased cost stipulations in terms of cash flows and the costs of finance on one hand, especially if the project is viable.

            On the other hand, if the evaluation of the pay back period does not correlate to good performance, such projects are eliminated for consideration of increased financing costs. The increased financing costs in the former situation might be hampered by the occurrence of a risk such as liquidation due to performance of currencies in the global market, which renders the project void hitherto increased investment prospects. This leaves a company at a loss bearing in mind that the preferences to the best alternatives had a good future structure emanating from the past trends. This also implies that the modes of evaluating an investment appraisal could lead to sidelining the risk free projects due to presumed returns, which affects the future performance of the project in times of risks, which proves the incongruence of the investment appraisal methods calling for a critical evaluation of alternatives before forging ahead in project work.

            The other problem posed by the investment appraisal methods is in the determination of urgency of the project. This is a common practice evident in the no-discounting methods of investment appraisal, where the linearity between the most urgent project and the least urgent does not exist. Such appraisal models only give a projection into the long term investment prospects of an organization without the consideration of short time expenditures like repairs in times of breakage. This instills an aspect of reduced production and consequent reduction in performance of the organization especially due to lack of funds for repairs. Such breakages come about as a matter of urgency, which the appraisal models lack the capability to offer timely resolutions and as such, it affects general outcomes and expectations of the appraisal model Van- (Horne, 1990).

             This leads to a failure of the investment appraisal method since it does not have the capacity to reassure continued production resulting from lack of urgency in replacement of the broken equipment. Moreover, the preferences of allocation of resources to projects that have shorter payback periods with the assumption that they are rich in terms of viability of performance could lead the higher management astray in terms of what should be given priority. This implies that once a company relies on the investment appraisal methods, it would not be able to know which projects should come first as a form addressing performance. The result would be poor resource allocation emanating from poor judgment of datum resulting from the improper calculation of values like the NPV. This leads to the preferences to the highly performing projects at the expense of mandatory and urgent correctional efforts within the organization like repairs leading to reduced production.

            The other common justification of lack of correctness in the investment appraisal methods the ignorance given to the cash flows that are not bounded within the payback period. This is a view of common practice in the payback method of investment appraisal, where the cash flows that occur beyond the payback period are ignored. Once the cash flows that occur beyond the payback period are ignored, this leads to the discrimination against those specified projects that would generate reliable cash flows in the subsequent business periods. For instance, once the payback period for a business period ends at a one year term, the projects that provide the substantial cash flow outlines in the second year would be ignored in the second year business period, giving rise to lower rates of cash flow. This has an impact on the general performance of the organization since the net cash flow determines the viability of capital affordability (Kemmerer, 2006).

            On the other hand, such an action of discrimination against projects in the subsequent years validates lack of time value for money. This is because the model employs calculation of the payback through addition of cash flows with no room for discounting. This is against the rules of financial analysis which give a correlation between the cash flows within a payback period and the discounting or compounding. For instance, the cash flows for a stipulated of time should be incremented or decremented after discounting, which proves the essence of time value for money. This also proves that the involvement of the payback criteria does not lead to the best results especially in terms of creation of timely value for money. This also correlates with the general argument that the correctness of an investment appraisal method lies not in the method but in the valuable adjustments made as a proactive measure to define performance of an organization based on the fundamental principles of resource management (Guell, 2011).

Conclusion

            Conclusively, the investment appraisal methods are used to determine the long term performance of an organization through giving a preamble into the best modes of resource allocation especially to project work, which forms the business environment of any organization. These methods of investment appraisal range from the discounting methods to the non-discounting methods, where the general rule of evaluation of the viability of a project lies in the rates of cash flows. The non discounting methods of investment appraisal bear the setback of lack of time value for money, where the cash flows are added without any form of suitable discounting, while the discounting methods have the major setback of discrimination against the projects generating substantial income due to the assumption that reduced timelines for the pay back period gives the most viable project (Anandaraian & Wen, 1999).

            The best form of practice in alleviating the magnanimity of time value for money through brought about by the non-discounting method of investment appraisal is the incrementing of the cash flows and either consequent incrementing or decrementing of the discounting or the compound, while the urgency of the project investment prospects should be the factor of consideration in determining the viability of an investment appraisal. This is in relation to the fact that the urgency of an investment project determines the short term risks that the company may face, which should also be well articulated, since it affects the current performance of the company in line with productivity, which also affects its future performance. Overly, the constraints brought about by the investment appraisal models including lack of timely value for money, ignorance to the subsequent cash flows after pay back period and the urgency of the project proves incongruences in the investment appraisal methods.

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