Evaluation of investment opportunities - Free Essay Example

Deveraux Deloitte Brief: 100673 A) The evaluation of investment opportunities that absorb capital assets, also known as investment appraisal, is a primary concern for corporate decision makers. Investment appraisal is of crucial importance for the financial future position of big firms, since it determines the financial flows of the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s allocated budget and ultimately defines the level of the shareholders wealth. Primary theoretical finance suggests several techniques for appraising investment opportunities. These techniques were initially devised so as to assist financial managers or management accountants to evaluate future cash flows with a high level of certainty the potential viability and profitability of different investment opportunities. For this reason, the different methods suggested in theory are tailored to different approaches, according to the investment objectives each firm might envisage. However, previous empirical papers suggest that decision makers frequently fail to adopt in vestment appraisal methods that theory provides[1]. A possible justification for the practical deviation from theoretical instruments might be that in the light of business experience the evaluation of investment projects is less concise and clear-cut than in theory, since most investments are also subject to factors that cannot be encompassed from theory. The practical difficulties associated with the implementation of various appraisal techniques will be discussed in this essay. The long-term financial position of the firm, and thereby the future of shareholdersà ¢Ã¢â€š ¬Ã¢â€ž ¢ wealth, is greatly affected by the deployed source of capital assets that are used to finance investment projects. Therefore financial managers, who should aim at the maximisation of the shareholders wealth, come across an additional objective that follows investment appraisal. This additional objective will be discussed in the second section of this essay, with reference to the first section. A basic method for investment appraisal only accounts for the required repayment period of the invested funds, which for this reason is called the payback method. Financial managers, that are primarily concerned how soon the invested capital will be ready for re-investing, frequently prefer this method because of its simplicity. Payback is explicitly handy to smaller companies that are in short of available capital, thus they want to track rapidly and easily their cash flows. However, payback ignores returns that might appear right after the end of the repayment period and as such it might indicate short-eyed decisions. If, for instance, a project yields higher returns right after the end of the pre-specified payback period, payback method will evidently ignore the returns. Also, an additional disadvantage of this method is that it ignores the widely recognised property of money to devalue through time. Fundamentally, between alternative investment opportunities with the same repayme nt period, the one that yields more returns sooner should be clearly preferred. Thus payback entirely falls short to account for different patterns of cash flows that occur within the payback period. Another widespread method of investment appraisal is the accounted rate of return (ARR) that is also known as Return On Investment (ROI) or Return On Capital Employed (ROCE). This method, which is defined as the average percent profitability-on-investment ratio, is also quite popular due to the fast and easy evaluation of the investing performance of any firm straight from its balance sheet. ARR also takes no account of the inequality in the value of subsequent cashflows. Moreover, given that profits are not certain at the beginning of the period, ARR method is likely to be misleading in the selection of the most appropriate investment opportunity. Rather than overall evaluation prior to the project, ARR is more frequently used to measure the aggregate profitability after the end of the investment period. This ex ante evaluation can also rate the ability of managers to decide on the most profitable and risk free investment opportunity, although this capability is only appropriate for short-term periods. A basic distinction between investment appraisal methods is whether they take account for the devaluation of money in the very long run. The two methods discussed above do not recognise the fact that the nominal value of a cashflow today is different from the real value of a cashflow with the same nominal value in future terms[2]. Therefore, a method that discounts the future value of a cashflow into present real value can provide a better evaluation criterion on which investment project is more profitable[3]. The discounting principle is incorporated in the Net Present Value (NPV) method. NPV transforms all future cashflows into real present values, and so if net cashflows are positive an investment decision can be made. Essentially, the discounting rate that transforms future values to present values is the cost of capital, which of course has to be less than the rate of return for the project to be profitable. The discount principle allows financial managers to select between alte rnative and mutually exclusive projects, according to which NPV is greater. The cost of capital, expressed as the rate of return above, can alternatively be used in another investment appraisal discounting method. Instead of comparing discounted future values, one can compare directly the rate of return with the cost of capital. This comparison method is called the Internal Rate of Return (IRR) method, the rate of return of which is exactly the same one used in NPV above. Business experience has shown that IRR can be sometimes tricky to calculate and its use might not be of clear understanding to managers. It is true that if more than one outward cashflow is needed for a project (and this is a realistic scenario), the rate of return might take different values after subsequent cashflows are made in the life duration of the project[4]. However, IRR is not very handy for mutually exclusive projects that cannot be directly compared. This is due to the fact that discounting takes place for the whole amount of the one-off outward cashflow for each project, while other inward capital can be re-invested. In that case, NPV might seem appropriate. All the above methods of investment evaluation take only into consideration profit orientated decisions. However, big corporations nowadays might take up investment projects that have negative present value. The explanation to this seemingly irrational phenomenon is that firms wish to acquire a place in markets that have a great potential in the future, even if the markets are non-profitable at the moment. Thus firms are willing to accept a small loss today (considered as an opportunity cost) in exchange for a huge profit tomorrow. Nonetheless, it is always easier for firms to enter the competition in a market that is small and has not yet been deluged with investment funds than to attempt to enter an integrated market with huge entrance costs and fierce competition. Of course, companies always face the risk that the undeveloped market might never boom and thus never return significant profits. This risk is a necessary part of all entrepreneurial activities. Furthermore, many major investments are subject to non-financial factors that cannot be incorporated in any investment appraisal method. Such factors might be sociological or environmental concerns, changes in the relative law frameworks or unexpected economic fluctuations. For instance, some investment might have very low rate of return but still might be of vital importance for society. In that case, the project will proceed with support from the local community or public funds. Similar arguments can be put forward for the development of renewable forms of energy, the investment on which seems very unattractive at the moment. However, their development is of crucial important for the environmental and energy future of the planet. Thus, investment on renewables has to be publicly supplemented. Hereby, this section concludes that there is not a single à ¢Ã¢â€š ¬Ã…“correctà ¢Ã¢â€š ¬Ã‚  method for appraising investments. On the contrary, it is argued that financial managers or accountants should have thorough understanding of all the techniques available in theory and deploy them accordingly to the needs and properties of each investment opportunity. B) Investment appraisal is followed by the decision on what assets should be used and from where will they be acquired. This decision lies entirely on the hands of the financial decision makers that are assumed to operate under the objective of maximising shareholdersà ¢Ã¢â€š ¬Ã¢â€ž ¢ wealth. Investment funds can derive from several capital sources: quoted shares, long term loans, derivative instruments, government subsidiaries (like in the sustainable energy case above) or internal finance. However, various capital sources create different sets of obligations to the firm and also are rated differently in terms of risk. Equity capital is drawn from shareholdersà ¢Ã¢â€š ¬Ã¢â€ž ¢ equities. When a firm sells a share, it agrees to pay back the buyer a dividend at the end of each year as compensation for the money received from the shareholder. Thus, this obligation of the firm to the shareholders lasts to infinity. That is the main difference between the equity capital and debt capital, which is acquired from loans. A loan represents an investment of an individual or institution for a contracted pre-specified period that yields subsequent contractual returns. On the other end, a loan represents a legal obligation for the borrower to repay the whole capital and its cost (the rate of return for the investor). When an investment is financed with loans, a sum of outward cashflows is created until the whole amount of the loan is repaid and the borrowerà ¢Ã¢â€š ¬Ã¢â€ž ¢s obligation is redeemed. Apparently, the investment is evaluated as profitable, so as to create inward cashflows (returns) that can repay t he loan (nominal capital plus interest). If the evaluation is not precise or if the investment, for some reason does not yield profits, repayments are impossible and the firm is liquidated; all unpaid debt has to be repaid, by law, before any dividends can be paid back to the shareholders. In that sense, equity providers participate indirectly to the entrepreneurial risk of the firm and as such they face a higher risk of not acquiring returns than lenders. A firm acquires a long-term loan by issuing bonds, or otherwise notes that certify the nominal value of the loan, its cost to the lender (the coupon rate) and the specific repayment dates. The cost of the debt capital as expressed by the coupon rate is actually the rate of return for the creditors, but in the same time it is the opportunity cost for the firm. It is important to stress that debt capital has to be repaid by all means. For this reason, it is important for financial managers to have access to debt capital that can be repaid and in the same time invested such that it yields the maximum expected rate of return, for a specific level of risk. The more expected rate-of-return on an investment financed with debt capital the less the danger of default. However, if loans are expensive in capital markets (thus yielding less profit for the same rate-of-return) firms have the ability and authority to alter their financial structure and thus their risk-profile. If bond prices are hi gh, the firm can issue more bonds or if share prices are high the firm can issue more stocks. Of course, the extent of this decision lies entirely to the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s predictability of profits, a part of which is dependent on investment appraisal. If an investment appraisal is precise and returns can guarantee repayments, then the firm can issue more bonds. On the other hand, if the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s inward cashflows are volatile and repayments are not always certain, creditors realise that they face higher danger of default from the company and so ask for greater interest on loans. In this case a company will issue more shares in order to acquire cheaper capital. In other words, debt capital should only be invested in projects that yield the highest possible returns for the same risk levels, especially if financial managers wish to maximise shareholders wealth. Thus, a company that issues more long-term bonds should make sure that the investing of this debt capital should be done in the highest possible rate of return. Otherwise, the shareholders face unnecessary increased debt capital risks and the firm should limit its borrowing to avoid bankruptcy. Given the fact that debt capital is less risky to creditors that equity capital to shareholders, the firm should be expecting a higher rate of return from investments financed from equity capital than investments financed from loans[5]. However, this is not always possible because there is a limit to the number of shares that a company can issue. For this reason, firms issue preferred stock or different kinds of bonds in an attempt to acquire capital in the best possible terms but also to reduce the possibility of default. This procedure is called risk hedging and has greatly developed the last 30 years. The basic financial instruments used for hedging are all kinds of derivatives (options, futures, forwards, FRAs, swaps and others). With the use of derivatives, firms reduce the risk imposed on equity capital and so provide further insurance on their shareholders financial position. In conclusion, this essay examined the different methods used in investment appraisal and their potential implementation from firms to evaluate investment opportunities. The payback method, based on a simple principle, is particularly useful to firms that do not have broad access to finance and need to invest with increased certainty. However, payback method can be very misleading. The Accounting Rate of Return method can be an easy median to evaluate ex ante investment decisions, especially after their fulfilment, but does not take into account the time devaluation property of money. Thus it can be also misleading, especially when ARR is directly compared with the cost of capital. Money devaluation methods are in practice more accurate. Such methods incorporate the discounting principle and account for the opportunity cost of capital. The Net Present Value method accounts for the time value of money and is more appropriate if the cost of capital needs to be re-invested or if the pro ject selection has to be made from mutually exclusive investment opportunities. On the other hand, the Internal Rate of Return method, similar to the NPV method, provides a direct realistic comparison with the cost of capital and also can be very useful when the investment decision has to be made between two or more simultaneous projects, in which case IRR provides a direct comparison. These methods of investment appraisal cannot however be the single selection criteria. Realistically, firms often have to adhere to selection criteria that overcome financial theory suggestions. In the second section, the discussion continues on the sources of capital that firms use to finance their investments. Capital allocation in a firm depends greatly on its source. It is argued that a firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s decision to increase debt capital within its financial structure should be accompanied by the increased certainty and ability to cover the firmsà ¢Ã¢â€š ¬Ã¢â€ž ¢ obligations to creditors. T his assumption, however, is not always sound. If a firm wishes to maximise the shareholders wealth, then the expected rate of return from investments that are financed with debt capital should not exceed the rate of return expected from investments financed with equity capital, otherwise the firm might face liquidation. And in the case of liquidation, shareholders are the last to be repaid. (Word Count:2517) References Arnold, G., (2002), Corporate Financial Management, (2nd edit.), Pitman Publishing Arnold, G., and Hatzopoulos, P., (2000), The Theory-Practice Gap in Capital Budgeting: evidence from the United Kingdom, Journal of Business Finance Accounting, 27(5) (6) June/July, p.603-624 Bratton, W., (2003), Corporate Finance: cases and material, (5th edit.), West Group publishing Brealey, R., and Myers, S., (1991), Principles of Corporate Finance, (7th edit.), Higher Education Publishers Dugdale, D., (1991), Is there a à ¢Ã¢â€š ¬Ã…“correctà ¢Ã¢â€š ¬Ã‚  method of investment appraisal, Management Accounting (UK), May, p.46-50 Dugdale, D and Jones, C., (1991), Discordant voices: accountantsà ¢Ã¢â€š ¬Ã¢â€ž ¢ views of investment appraisal, Management Accounting (UK), (November), p.46-50 Lefley, F., (1997), The sometimes overlooked discounted payback method, Management Accounting, vol.75, iss.10, (November), p.36 Lumby, S., and Jones, C., (2003), Corporate Finance: theory and practice, Thomson Publishers Pike, R., (1996), A longitudinal survey on Capital Budgeting, Journal of Business Finance and Accounting, 23(1), (January), p. 79-91 Sangster, A., (1993), Capital Investment Appraisal Techniques: A survey of current usage, Journal of Business Finance and Accounting, vol.20, iss.3, (April), p. 307-333 Watson, D., and Head, A., (2003), Corporate Finance: principles and practice, (3rd edit.), Pitman Publishing 1 Deveraux Deloitte Footnotes [1] Some of these papers are the studies from Arnold Hatzopoulos (2000), Pike (1996) and Sangster (1993) [2] However, a discounted payback method has also been suggested, see Lefley (1997). [3] In that sense discounting is the opposite of compounding. [4] Clearly, in an investment project that requires only one outward cashflow and regular inward cashflows, both NPV and IRR methods will produce the same results. [5] Following the basic principle that higher risk comes with great return.