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Investment Appraisal: Effective Managerial Decision

Investment Appraisal A Guide to Effective Managerial Decision (A Case Study of Selectred Manufacturing Company In Nnewi, Anambra State)

 

CHAPTER TWO

LITERATURE REVIEW

2.1     RESEARCH QUESTIONS / HYPOTHESIS

MODELS THEORIES

Investment appraisal plays an important role in manufacturing firm. Investment appraisal leads to management investing on the right project. Investment appraisal with the firm capital are correlated. Investment appraisal right project increase firms profitability. Appraisal techniques used in evaluating investment or project are adequate.

HYPOTHESIS MODEL

H0 1: Investment appraisal does not aid effective managerial decision making.

Hi 1: Investment appraisal does aid effective managerial decision making.

Ho 2: There is no significant relationship between investment appraisal and the firm’s increased in productivity.

Hi 2: There is significant relationship between investment appraisal and the firm’s increased in productivity.

2.2     CURRENT LITERATURE ON THEORIES MODEL HYPOTHESIS AND RESEARCH QUESTION CAPITAL BUDGETING DECISION

From time to time, managers of business and manufacturing firms are faced with the problem of investing their funds. Monwuba (1995) in this book management accounting said, that such funds may be invested on short term investment of project or long term investment an project for the purpose of this research, the researcher wishes to use time to differentiate between such two investments.

“All investments of direction of one year or less are considered short term while all investment of duration of over one year are considered as long term” it is been noted that not all investment considered by management will be chosen or accepted, hence, ******* decision whether to accept or reject an investment will have direct effect on the future income of the manufacturing firm or by increasing future efficiency and reducing cost.

According to Adeniyi (2004) he said that the process capital budgeting is for the managers ot received on the information provided by the caccountant of firm which will arrive in decision making concerning the investment of capital funds.

He further numbered examples of such decision as

i         Replacement decision

ii        Investment for expansion

iii       Investment for product improvement and cost reduction

iv       New ventures

v        Strategic investment, where investment may be undertaken to the benefit of the overall objectives but might not satisfy the normal financial criteria.

vi       Investment because of statutory requirement of employee or community welfare.

According to Aguolu (1998) defined investment appraisal on capital budgeting decision as that financial decision, involving an outlays of funds, in the present time with he expectation of returns over a period of time in the future hence, it is assured that all of the firms expenditures are made in expectation of realizing future benefit. Therefore expenditure involving significant charged in a production process beyond the current year ***** regarded as CAPITAL EXPENDITURE. Capitla and its efficient allocatiosn very important in the business industries. Especially the manufacturing firm as fund is committed to a long term investment before any material commitment is done. Decision of capital expenditure normally represent the most important decision on capital expenditure than an organization. Makes, since the commit a substantial proportion of a firm resources to action that are likely to be irreversible. This decision is applicable to all section of business investment in plant and machinery research and development and others.

Absolutely. It is believed that where these capital expenditure are not well appraised fundamentally, the success, growth and profitability of the firm will be at state. Hence a proper research work should be carried out with regards to investment appraisal before an investment will be undertaken.

PROJECT CLASSIFICATION

Analyzing capital expenditure proposals is not a costless operation, benefit can be gained from careful analysis, but such an investigation does have a cost for certain type of investment relatively detailed analysis may be needed.

According, firms generally classify project or investments into the following categories.

a        Replacement of fixed assets.

b        Expansion and modernization

REPLACEMENT DECISION ON CAPITAL EXPENDITURE

It is obvious that the asset age, the maintenance and perhaps the operating cost will also increase with age. As the assets age it’s operating capability decrease with age.

Monwuba (1995) said “the more an assets is kept the more the capital outlay that would be involved in its replacement is postponed”. Hence decision in replacement or a change of work out or depart of fixed assets used in producing profitable products.

It is necessary to carry out their investment where the firm wishes to continue its current business as new technology in equipment is fast replacing old ones for firms to meet is profitability index there is needed to undertake this project seriously.

EXPANSION AND MODERNIZATION

This is as to when a firm wishes to grow from it’s present stage and perhaps meets up with the standard of other organization to come with a new product line. It must pass through research and development. This aspect of expenditure is continuous task, including technology innovation, finding, creativity, marketing mix and other strategies that should be used in replacement of the existing procedure for growth and profitability.

 INVESTMENT PROCEDURE

One of the objective of a firm is t maximize the shareholder’s wealth and in doing these, one of the ways is through investment appraisal.

The nature of investment will in part determine the investment procedures that are utilized. Adeniyi (2004) numerated some steps to be undertaken in carrying out an investment or execution of a project.

These are included:

i         Identification of possible project

ii        Evaluation of project

iii       Authorization of project

iv       Monitoring and control of project.

  1. IDENTIFICATION OF POSSIBLE PROJECT

Ideas concerning capital investment may be generated at all level of a organization. The search for investment opportunity screening of project in order to determine ones to the accepted and one to be rejected that are unsuitable in terms of technical feasibility likely risk or cost lace of compatibility or other factors.

2        EVALUATION OF PROJECT:

This stage will involve identification of expected incremental cash flows and the application of the appropriate rate of return. Net present value (IVPU) and others. Also, at this stage there should be widespread consultation among interested parties which will include:

i         Accountant

ii        Production staff

iii       Marketing staff

iv       Trade unions.

3        AUTHORIZATION OF PROJECT:

At this state, the investment is likely to be reappraised which might involve a reassessment of the assumptions and cash flows, or an appraisal of how the investment fits within the corporate strategy and capital budget constraints. Hence, it is subject for the top management decision on whether to accept or reject any project.

4        MONITORING AND CONTROL PROJECT

After the project implementation. It is important to regularly review the project to ascertain whether any may variation exist from cash flow that had been estimated. Also a formal control pro********** using critical path analysis or other techniques might be implemented.

DETERMINATION OF HURDLE RATE

The choice of a hurdle rate is a complex problem in finance this is determined by the rate this is the rate of return the organization can earn on it’s best alternative investments of equivalent risk. Hence one can say that hurdle rate is the yardstick used in measuring every decision on capital.

THE COST OF CAPITAL

According to Aguolu (1998) defined eh cost of capital as the rate of return on investment at which the price of the firm’s common stock will remain unchanges. He further defines the rate that must be achieved from the investment to satisfy the investors required rate of return.

Hence, cost of capital is important for investment and financial decisions of the firm as it provides a way of linking both decision as in the above. By cost of capital. It meas the cost funds to finance the projects. The cost of using the capital for an investment project is the interest forgone on the original investment. This is the rate of return that is available from investment insecurities in financial market represent the opportunity cost of an investment in capital investment, it cannot be invested also where to earn return. Firm shareholders therefore invested in capital project only if they yield a return ***** excess of the opportunity cost of the investment is also known as the capital discount rate or the interest rate.

For example, this cost of capital approach is well illustrated below suppose a firm earns interest at a rate of 12% from a given investment, and the same firm used the proportion form these fund invested to replace an asset, the cost of capital is the 12% interest rate is no longer earned on the fund removed form the investment.

THE SCOPE OF CASHFLOW

Cash flow could be said to be inflow (receipts) and out flow (payment) of cash for any investment to be effectively executed, there must be commitment of cash in one or the other. This is in turn expected to yield return for future benefits. It is implied that in any given venture or investment there should be proper appraisal of cash to determine the viability of the investment in question. In this analysis cash is combine with the cash outflow to arrive at the net cash flow. This will show whether a project is viable or not. In investment appraisla decision making there is every tendency to predict the cash flow of investment over a given period of time for proper appraisla cash flow is reffered to as the future benefit or loss. It is historical and incremental and this means that investment analyst should which aspects that will suit a particular investment. It is suggested to use historical form or method in computation of cash flow and some percentage of increment should be made where necessary. Furthermore, this approach is not complete on itself, the futuristic approach should be considered where necessary.

 THE LIFE SPAN ON CAPITAL PROJECT

According to Monwuba (1995) he classified all investment of duration of once year or less as short term while all investment of duration of over one year are considered as long term. Many capital investment or project required a longtime to complete, such project are building, new plant and development of a new product line and so on the determination of the life span of a given investment is necessary in the investment appraisal since it is corrected with the cash flow. The flow of cash benefits from an investment depends on the life value of the investment. As it is discussed that investment with longer period of life span needs to consider the risking of the project in flows over the given year. A critical study must be carried out to see that such investment maintains the streams of benefits proposed. Many investors consider investment with longer life span such decision is usually affect by factors such as:

a        The discounting or appraisal techniques to be considered.

b        Time values of money

c        The risk and uncertainties attached to the investment.

THE INVESTMENT APPAISAL TECHNIQUES

Aguolu (1998) in his write up said, in evaluating an investment, it is necessary to obtain the necessary information. Then good criterions chosen so that worthwhile and letter project may be selected. He further listed some characteristics of this criterion as:

a        It should distinguish between acceptable and unacceptable projects.

b        It should be able to rank projects or investment in order of acceptability.

c        It should be conceivable to every project.

d        It should recognize the fact that bigger benefits are preferable to smaller ones and earlier benefits are preferable to late ones.

Adeniyi (2004) said in practice, it is possible to examine the viability or otherwise of a project using four different methods. These methods may be properly classified graphically into two main approaches as follows.

Example form the above definition by Adeniyi (2004)

TRADITION OR NON DISCOUNTING RECHNIQUES

These appraisal methods fdo not recognize the time value of money. It should be noted that N100 received today is not equal to N100 received after one year from now an investor can have the original N100 plus a year interest. Assuming, that interest rate is 10% each N100 invested now. In one year such money will yield N110. That is N100 received today is equal to N100 one year from today a t 10% interest, under this concept, the N10 difference is the appreciation in value for one year. Hence these method do not consider the time value of money. As already classify in the diagram above, the researcher wishes to write on them briefly.

ACCOUNTING RATE OF RETURN

According to Adeniyi, the accounting rate of return method of appraising a capital project is to estimate the accounting rate of return or return on investment (ROI) that the project should yield. It is calculated using.

ARR  =       Estimate average profits          x        100

Estimate average Investment

The accept or reject criterion is comparing the date with the mininim rate set by management. A project is acceptable if the internal rate is higher than the minimum set by management otherwise, the project will be rejected. And then the project are mutually exclusive, we accept the one with the highest rate of return above the company’s rate payback period- The CIMA’S official terminology (1990) defined payback as the time required for the cash inflows from a capital investment project to equal the cash out flow. That is, it the length of time it takes the investment to pay itself. Hence, if is commonly used as a first screening method that is in considering a capital investment project, what comes to the mind first is how long will it take to pay back the cost of investment this could be determined as:

Initial outlay

Cash inflow

A project is not accepted unless it pays itself back within a specified period. And where there are mutually exclusive project, the one with a shorter payable period is accepted provided it pay back period is accepted, provided it payback itself within the specified period. One of the advantages of this method is that it is easily understood by managers. And it also has some disadvantages such as:

a        Does not consider he time value of money

b        Does not consider cash flows after the payback period and others.

THE DISCOUNTED CASHFLOWS TECHNIQUES

With reference to Adeniyi, definition, he emphasis that the accounting rate of return method (ARR) of project evaluation ignores the timing of cash flows and the opportunity cost of capital tied up. Payback considers the time it takes to recover the original investments cost but ignores total profit over a project’s life.

Hence, discounted cash flow as an investment appraisal technique, which takes into account both the time value for money and also total profitability over a project’s life. These implies that this method consider the time value of money as the researcher has previously comment that N100 body is not the same thing as N100 in a year time. Thus, the discounting appraisal techniques are been shown on the above diagram as:

a        Net present value (NPU)

b        Internal rate of return (IRR)

c        Profitability index (PI)

NET PRESENT VALUE: According to Adeniyi, net present value (NPV) is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target rate by return of cost of capital. This is, it is the difference between the present value of the cash outlays required to make an investment and the present value of cash inflows the investment is expected to produce, using a particular discounting rate of capital.

Hence:

NPV = CFI   +   CE 2 CF 3 + …………CFn ……1

(I + k) (I + K)2 (I + K)3 (I + K)7

 

Where: CFI, CF2, etc cash flows in respective period.

I        =       Initial outlay or cost

K       =       Cost of capital

In accept or reject oriterion project with positive NPV of the project will be zero. An IRR technique is commonly used along with NPV approach, this discount rate, which equals the present value or expected after tax income or cash flow of an investment with its cash initial outlay, this discount rate I called the project or investment’s internal rate of return (IRR). Alternatively, IRR is defined as that discount rate which causes the project to have zero not present value. The calculation of this most often require trial and error method when there are uneven cash flow and for this, it makes the computation burden some, a time problems may arises as regards ot decision making where we have more than one rate of return on a particular investment.

To solve this problem of trial and error for calculation the IRR interpolation method should adopted in this approach, the negative NPV is combined with the positive NPV to come to natural NPV where the IRR is equal to zero.

IRR   =       n G CFT – LO

( I + IRR) t

 

When the value of r is obtained it is compared with the required rate of return, if it is equal to or more than the required rate of return, the project should be accepted otherwise rejected.

DISADVANTAGES OF IRR

a        It involves a lot of time in computation

b        there may be more than one internal rate of return

PROFITABILITY INDEX (PI)

The profitability index is the third method of appraisal investment proposals that take into account the time value of money. The method is simply a variation of the NPV method. It is computed by dividing the present value of cash proceeds by the initial cost of investment. If the profitability index is less than 1****** investment should be rejected, also if it is greater than 1, the investment should be rejected, also if it is greater than 1, the investment should be accepted. This method is consistent with the NPV method. Since index can be less than 1 when NPV is

a        Negative. Conversely an index is greater than 1 arise when the NPV is positive. The profitability index cost ration is always preferable during investment ranking, with this investment that ranked highest should be considered first before others under mutually exclusive investments, profitability a times differs significantly with NPV.

This is an off head example for profitability index or proper investment adviced.

Example PV cash flow Initial invest Outlay P.I
Investment a 150,000 75,000 2
Investment B 270,000 150,000 1.8

According ot profitability index investment A is considered but under mutually exclusive investment, it is advised to choose investment B because it gives the largest absolute NPV. In this approach, profitability index is weak in measuring and selecting between mutually exclusive investments.

PI      =       Total discounted inflow

Cost of investment

Having considered these appraisal / techniques the financial analyst and experts ranked the NPV superior among other appraisal techniques, for this opinion, it is advised to consider and use the NPV often even where other techniques give a rejection criterion and NPV give an acceptable criterion. Ignore other approaches and consider NPV.

SPECIAL PROBLEM IN CAPTAL BUDGETING

The usually occurs some problem within the firm when undertaking investment appraisal such as:

a        Mutually exclusive investment

b        Capital rationing.

MUTUALLY EXCLUSIVE INVESTMENT

This is a situation where there are two or more profitable investments or project to undertake which the firm has to embark on one of the investment or project.

Managers are usually face with conflicting decision as to which project to accept, where this is applicable, it is possible for the NPV and the IRR method to suggest different ranking as to which project or investment should be given priority. Where this investment criterion and ignore the result ranking criterion and ignore the research of other techniques

CAPITAL RATIONING

Monwuba (1995) said that capital rationing is a situation where by he available funds in a company is not enough for the firm ot invest in all available viable profit under consideration. This simple means that many active managers do not implement by usually may not has sufficient fund to numeration. This simple means that many active managers to undertake such project. Thus when the investment to implement but usually may not have sufficient fund to undertake such project. Thus when the investment funds are scarce elative to the available investment. The problems, the option is to choose the best set of investment that the firm can finance. The allocation of investment fund among a set of investment required more financing than in available capital rationing. In addressing this problem. It is advisable for managers to use the NPV and PI to rank the investment and make selection form the investment taking in consideration the available capital outlay required for the investment. The correct selection is to choose from one collection of investment out of all possible collection that had the highest net present value (NPV).

INVESTEMNT APPRAISAL AND INFLATION

The average rate of inflation for all good and services traded in a economy is known as the general rate of inflation.

Assuming that your cash flow of N100 has increased at the same rate of the general rate of inflation (Assuming the general rate of inflation is 10% therefore the purchasing power has remined unchanged if all the cash flow increased at a general rate of inflation. The NPV of a given investment will also remain unchanged, thereby not affecting the NPV and cash flow.

RISK ANALYSIS IN PROJECT EVALUATION

The estimates used to analyze capital investment are projections of future conditions. Therefore as known as before capital investments involves risk because of the uncertainties surrounded the variable involved in the analysis calculations and management using these result for decision purpose must allow for a range of possible outcomes. Even the best alternative or projections can go wrong as events unfold, yet the decision have to be made ahead of time.

Risk is defined as the estimated degree of uncertainty with respect ot expected future returns around the most likely estimates the more risk the investment.

APPROACHES TO COPING WITH RISK

Investment risk has been recognized by business of every size and type either formally or otherwise various approaches are used by decision makers to cope with risk or uncertainties associated with proposed investment. Such approaches includes:

a        Raising the bundle rate of risky project in relation to the overall cost of capital is 10% the hurdle rate of the following investment show be cost saving 10% expansion 15% new business 20%.

b        Requiring a lower payback from risky period for normal risk project for normal risk project.

c        Reducing the best estimates of future cash inflows for risky investment base on management decision or judgement.

d        Applying risk analysis using a computer simulation model (monte control) and probability concept.

These simulation techniques, uses computer to calculate many possible outcomes of an investment decision the computer choose values at random form the profitability distribution of each factor affection and the future cash flow over the investment life.

2.3     SUMMARY OF THE LITERATURE REVIEW

In this chapter the researcher reviewed the works already done by accounting practitioner. The researcher also reviewed textbook, journals and unprinted works. The researcher based his literature mainly under the capital budgeting decision, scope of capital expenditure, project, classification, investment procedures, determination of bundle rate. He cost of capital the scope of capital flow, the life span techniques, capital rationing risk analysis in project evaluation and approaches to cope with such risk in investment appraisals.

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