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Management Accounting
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Introduction Project appraisal techniques are a useful tool to assess the potential benefits and impacts of undertaking a project or a new development. Three widely used and accepted methods used by finance and project managers are: Payback Method Accounting Rate of Return Net Value & Net Present Value This paper will exemplify and evaluate each of the three project appraisal techniques and highlight validity as an aid to decision making. The following example will be used to illustrate each technique: Initial Capital Cost Ðˆ500,000 Lifespan 6 years Cost of Capital 6 % Residual Value 4 % of the initial capital cost Additional Net Cash Flows: Year 1 Ðˆ50,000 Ðˆ75,000 Ðˆ100,000 Ðˆ120,000 Ðˆ90,000 Ðˆ80,000 Discount Factors based on a 6% cost of capital: Year 1 0.943 0.890 0.840 0.792 0.747 0.705 Payback Method This is the simplest method of looking at one or more investments projects or ideas. The payback method calculates the length of time it will take for the net cash flows to recover the initial capital costs. When comparing projects this technique holds that, all other things being equal, the better project is the one with the shorter payback. A company may also compare the payback period of a project with the companyâ€™s average or target when deciding whether to undertake a project.
This technique has been illustrated in Example 1. Example 1 Initial capital Ðˆ500,000
Year Net Cash Flow (Ðˆ) Cumulative Net cash flow (Ðˆ) Remainder (Ðˆ) 1 50,000 50,000 450,000 2 75,000 125,000 375,000 3 100,000 225,000 275,000 4 120,000 345,000 155,000 5 90,000 435,000 65,000 6 80,000 515,000 1. payback is after 5 years. The number of months is calculated as below: Payback period = 65,000 x 12 = 9.75 80,000 Payback period is 5 years + 9.75 months. Payback period = 5 years 10 months 2. Payback period = 65,000 x 365 = 296.56 days 80,000 Payback period = 297 days From the table in example 1 it can be seen that the project earns the initial investment of Ðˆ500, 000 in year 6. Calculation 1 shows the actual period is approximately 5 years and 10 months or 296 days (calculation 2). Standing alone this information does conclude whether the project is viable or not. Where there are two or more projects the one with the shorter payback is considered the better project. For example if another project had a payback of 10 years, and all other factors were constant, then using payback this project should be accepted. In the case of just one project being appraised then the payback period needs to be compared with the companyâ€™s target requirement the current average. Benefits of Payback. The main benefit of the payback method is that it is a very simplistic and easily understood model. It is very simple to understand, so even non-financial departments can calculate and understand the what the payback calculation shows. The outcome also gives a simple measure of risk, where if the payback period is long there is more risk and if the payback period is short there is less risk. This may be particularly important for high risk projects or for high capital investment projects. Selecting projects based upon the payback period may avoid problems with liquidity and aid cashflow forecasting and control. Payback uses actual cash flows not subjective accounting profits, and emphasises the cash flows in the earlier years of the project, usually the most critical for a company having paid out a large initial capital outlay. A company may raise finance for the project using a bank loan and therefore it is important they know the amount of time they will be able to repay the loan and the implications in its cashflow. . Drawbacks of Payback Method Payback has the virtue easy to compute and easily understood by financial and non-financial managers. However, the simplicity of the method carries weaknesses with it. The main criticism of payback method is that it ignores the time value of money ie Ðˆ1000 today is not the same as Ðˆ1000 in 3 years time. External factors like inflation will affect the value of money. E.g. if inflation is 6% then your money would halve every 12 years. Cashflows will have a different value in the future depending on political, social environmental and economical factors which all affect the financial climate. There is a method to be overcome this drawback of payback by using the Discounted Payback Method. This converts future earnings into their present value. This introduces the time value of money into the method and will give a more accurate result. It can be argued that by introducing discounted cashflows into the technique the usefulness of payback as a simple method is compromised. The other drawback of payback is not a measure of absolute profitability. It will not show whether the project is financially viable. There is no objective measure as to what length of time should be set as the minimum payback period, therefore any investment decisions made based on this method are subjective. The method will show how long it takes to recover the money invested, however the purpose of investing in projects or machinery is to gain a benefit i.e. a profit or reduced costs. Payback ignores any benefits that occur after the payback period and does not measure total incomes. A project which does not give a return on the initial investment is futile. If the company was to purchase the new machinery, using the above information, the payback period calculated is a long time and the machinery may by that time become out of date and need replacing again, before it started to yield a profit in terms of reduced costs or efficient usage. Payback is a useful screening process and should be used in the initial stages of a project appraisal to assesses liquidity. Payback is best seen as a screening tool and is an appropriate method for relatively straight forward projects. In spite of its limitations and weaknesses, the Payback method is still one of the most common project appraisal methods used in the UK. The weaknesses of the model should not be isolated from its simplistic and comprehendible use. Therefore the technique should not be used as the main decision criterion when selecting projects. It is best used in conjunction with other methods and should not be used exclusively Accounting Rate of Return (ARR) ARR is another simple method of calculating the return of a project and is expressed as a percentage. ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest. The accounting rate of return treats the net cash flow as a return on the initial capital cost, and expresses the profits from a project as a percentage of that capital cost. Example 2 uses the most common formula for the account rate of return. The average net cash flow used is usually the operating profit and the average investment is usually the book value of assets. Example 2 Please note: In this example the effect of depreciation has been ignored. Average net cash flow x100 = A.R.R % Initial capital cost ∑ net cash flows = Ðˆ515,000 (515,000 / 6) x 100 = 17.2 % 500,000 Example 2 shows that this investment would yield a return of 17.2% on the initial investment. The decision rule is to accept investments which exceed a particular accounting rate of return This can be compared to the minimum required by the company and also with other projects. Benefits of ARR As with the Payback period, the Accounting Rate of Return is very simple to calculate. It is expressed as percentage it is readily accepted by managers and can be used to compare different projects. Studies have shown that percentages are more likely to be understood by non-financial managers. It is easy to calculate from figures which can be obtained from readily available financial accounting data. This also makes it easy to bench mark the ratio by calculating the ARR of other companyâ€™s and benchmarking against them. Drawbacks of ARR Although, like Payback, ARR is widely used, it also ignores the time value of money. As a result, by itself, the accounting rate of return can easily misidentify the best investment alternatives. It should be used with extreme care. It is not a measure of absolute profitability for the company and should not be used as a sole method to decide whether to invest or not as the decision remains subjective due to the lack of an objectively set ARR target. ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organisation. It is rarely used by investors because investors are interested in cashflows and ARR includes non-cash items such as depreciation. Although th ARR is traditionally regarded as a an important profitability measure in ratio analysis, it is flawed. Its only advantage is that it is very easy to calculate and it is fairly easy to construct realistic examples. There are better alternatives which can be considered which are not significantly more difficult to calculate. Net Value and Net Present Value (NPV) The net present value (NPV) method offsets the present value of an investment's cash inflows against the present value of the cash outflows. Present value amounts are computed using a firm's assumed cost of capital. The cost of capital is the theoretical cost of capital incurred by a firm. This cost may be determined by reference to interest rates on debt, or a blending of debt/equity costs. In the alternative, management may simply adopt a minimum required threshold rate of return that must be exceeded before an investment will be undertaken. If a prospective investment has a positive net present value (i.e the present value of cash inflows exceeds the present value of cash outflows), then it should be selected. If an investment has a negative net present value (i.e., the present value of cash inflows is less than the present value of cash outflows), the investment opportunity should be rejected. The NPV takes into consideration that money loses value over time i.e. a sum of money will not have the same purchasing power in the future as that sum of money has today. Example 3
Year Detail Amount (Ðˆ) Discount Factor NPV (Ðˆ) 0 Initial capital cost [500,000] 1 [500,000] 1 Net cash flow 50,000 0.943 47,150 2 Net cash flow 75,000 0.890 66,750 3 Net cash flow 100,000 0.840 84,000 4 Net cash flow 120,000 0.792 95,040 5 Net cash flow 90,000 0.747 67,230 6 Net cash flow 80,000 0.705 56,400 6 Residual value 20,000 0.705 14,100
Net Value = 35,000 NPV = [69,330] Example 3 Example 3 shows that the financial gain for the new machinery in todayâ€™s monetary terms would be Ðˆ35,000. However because money loses value over time this will be worth negative Ðˆ69,330 in terms of it equivalent purchasing power in year Ð¨. The figures used to discount top get the present value of future cashflows is used from a NPV table. (see Appendix I). The project has a negative NPV and is not financially viable the project should rejected and the capital invested elsewhere Benefits of NPV The main benefit of the Net Value and Net Present Value technique over the other two techniques in this paper is that it takes in to consideration the time value of money as the whole life of whole life of a project is considered This method also gives a measure of absolute profitability. NPV calculates a projectâ€™s expected cash flows and includes the unique risks of obtaining those cash flows. Using NPV helps to eliminate accounting inconsistencies, since the cash flows represent the benefits of the project, not just the profits. NPV incorporates the risks associated with a project via the expected cash flows and/or discount rate used. If the project is considered more risky then a risk premium may be added to adjust for the risk and make projects more comparable. NPV provides flexibility and depth, since the NPV equation can adjust for inflation and be used with other tools such as Scenario analysis and also the internal rate of return (the point where the NPV is zero). This can be used as part of a sensitivity analysis. A company selecting projects on the basis of NPV maximisation should maximise shareholders wealth and it is argued that this is the purpose of any company is to increase shareholder wealth. NPV is consistent with maximizing the value of a firm and is used by investors in the evaluation of a company or in capital budgeting decisions when comparing the value of different projects. Drawbacks of NPV The many benefits of using NPV have lead to widespread acceptance in the Information Technology industry. Despite its many benefits, NPV has some limitations of which managers need to be aware. The criticisms of Net Value and NPV are that it is a fairly complex method and may not be well understood by non-financial managers. The results are not given in the form of a percentage but rather in currency which does not give an obvious answer as with ARR. In some cases it may actually be difficult to determine the cost of capital which would hinder the calculation of NPV. NPV assumes capital to be readily available, no matter how much is needed or what are the constraints on the company. This is rarely the case in reality because access to capital markets is limited according to the overall performance of the company. Therefore, projects with large NPVs may be foregone, given the capital requirements for the company. The opportunity cost needs to be considered. NPV uses the information available today and assumes that it will remain constant. This may nob the case as the finacila climate is very uncertain and political and socil factors affect it. A method which uses Real Options takes the main benefits of the NPV concept while providing the flexibility of uncertainty and risk may be a more accurate model but will create more complex calculations. Conclusion Net Present Value (NPV) is one of the best financial tools to establish the value of a project or investment. Where the other methods portray conflicting results NPV usually takes precedence. A decision to invest must not simply be made based on just financial factors. Complex decisions when deciding to invest or not should also include a value analysis because they usually involve a number of non-financial components as well. The final decision may involve consideration of branding, engineering, marketing, global reputation and numerous other variables. References D. Potts, Project Planning and Analysis for Development, First Published 2002, Lynne Reinner Publishers, ISBN1555876560. HM Treasury, The Green Book - Appraisal and Evaluation in Central Government, 2003, London: TSO, ISBN0115601074. ^ Baker, Samuel L. (2000). Perils of the Internal Rate of Return. Retrieved on Jan 12, 2007. |