CAPITAL INVESTMENT DECISIONS

CAPITAL INVESTMENT DECISIONS

INVESTMENT ANALYSIS

Any company will invest finance for the sake of deriving a return which is useful for four main reasons:

1.         To reward the shareholders or owners of the business for staking their money and by foregoing their current purchasing power for the sake of current and future return.

2.         To reward creditors by paying them regular return in form of interest and repayment of their principal as and when it falls due.

3.         To be able to retain part of their earnings for plough back purposes which facilitates not only the companies growth present and the future but also has the implication of increasing the size of the company in sales and in assets.

4.         For the increase in share prices and thus the credibility of the company and its ability to raise further finance.

Such a return is necessary to keep the company’s operations moving smoothly and thus allow the above objective to be achieved.

A financial manager with present investment policies will be concerned with how efficiently the company’s funds are invested because it is from such investment that the company will survive.  Investments are important because:

            i)          They influence company’s size (fixed assets, sales, and retained earnings)

            ii)         Influence growth

            iii)        Influence company’s risks

In addition, this investment decision making process also known as capital budgeting, involves the decision to invest the company’s current funds in viable ventures whose returns will be realised for long term periods in future.

 Capital budgeting as financial planning is characterised by the following:

1.         Decisions of this nature are long term i.e. extending beyond one year in which case they are also expected to generate returns of long term in nature.

2.         Investment is usually heavy (heavy capital injection) and as such has to be properly planned.

3.         These decisions are irreversible and any mistake may cause the company heavy losses.

Importance of Investment Decisions

a)         Such decisions are importance because they will influence the company’s size (fixed assets, sales, and retained earnings).

b)         They increase the value of the company’s shares and thus its credibility.

c)         The fact that they are irreversible means that they have to be made carefully to avoid any mistake which can lead to the failure of such investment.

d)         Due to heavy capital outlay, more attention is required to avoid loss of huge sums of money which in the extreme may lead to the closure of such a company.  However, these decisions are influenced by:

i)          Political factors – Under conditions of political uncertainty, such decisions cannot be made as it will entail an element of risk of failure of such investment.  Thus political certainty has to be analysed before such decisions are made.

ii)         Technological factors – These influence the returns of the company because such technology will affect the company’s ability to utilise its assets to the utmost ability in particular if such assets become obsolete and cannot generate good returns or the output of such machines may be low with time and may not meet planned expectations which in most cases will have an impact on inflows from a venture.

Methods of Analyzing Investment/Capital Budgeting Methods.

There are two methods of analyzing the viability of an investment:

a) Traditional methods

• Pay back period method
• Accounting rate of return method

b) Modern methods (Discounted cash flow techniques)

• NPV – Net present value method
• IRR – Internal rate of return method
• PI – Profitability index method

For the above two (a & b) methods to be used, they have to meet the following:

i)          They should rank ventures available in the investment market according to their viability i.e. they should identify which method is more viable than others.

ii)         They should rank a venture first if the venture brings in return earlier and in large lumpsums than if a venture brought in late and less inflows over the same period.

iii)        Should rank any other projects as and when it is available in the investment market.  Such methods should take into account that all returns (inflows), must be cash returns as it is necessary to be able to finance the cost of the venture.

TRADITIONAL METHODS

Pay back period method

This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can payback and for this reason PBP (or payout period or payoff) is that period of time or duration it will take an investment venture to generate sufficient cash inflows to payback the cost of such investment.  This is a popular approach among the traditional financial managers because it helps them ascertain the time it will take to recoup in form of cash from operations the original cost of the venture.  This method is usually an important preliminary screening stage of the viability of the venture and it may yield clues to profitability although in principle it will measure how fast a venture may payback rather than how much a venture will generate in profits and yet the main objectives of an investment is not to recoup the original cost but also to earn a profit for the owners or investors.

Computation of payback period:

1.         Under uniform annual incremental cash inflows – if the venture or an asset generates uniform cash inflows then the payback period (PBP) will be given by:

PBP     =          Initial cost of the venture

                                    Annual incremental cost

2.         Under non-uniform cash inflows:

Under non-uniformity PBP computation will be in cumulative form and this means that the net cash inflows are accumulated each year until initial investment is recovered.

Accounting Rate of Return Method (ARR)

This method uses accounting profits from financial statatements to assess the viability of investment proposal by diving the average income after tax by average investment.  The investment would be equal to either the original investment plus the salvage value divided by two or the initial investment divided by two or dividing the total of the investment book value after depreciating by the life of the project.  This method is also known as financial statement method or book value method.  The rate of return on asset method or adjusted rate of return method is given by:

ARR    =             Average income    x 100 

                        Average investment                           

The salvage value should be treated as follows:

If the asset produces a salvage value at the end of the year, this will increase inflows for payback period.  This value is only used to ascertain how much the company will reduce original cost of investment to obtain average investment.

Acceptance Rule of Payback Period (Pbp)

Using PBP method a company will accept all those ventures whose payback period is less than that set by the management and will reject all those ventures whose PBP is more than that set by the management.  Alternatively, PBP may be gauged against the term of the loan in which case the PBP method will give a high ranking to all those ventures paying back before the term of the loan and the highest ranking will be given to those projects with shortest PBP.  However, in assessing the viability of a venture it is also important to see which venture brings returns earlier, other things being equal.

Advantages of Payback Period

1.         Simple to use and understand and this has made it popular among executives especially traditional financial managers in ascertaining the viability of a venture.

2.         Ideal under high-risk investments because it will identify which venture will payback earlier thus minimising the risks with a venture.

3.         Advantageous when choosing between mutually exclusive projects because it will give a clue as to which venture is viable if one considers the shortest PBP and the highest inflow of a venture.

Disadvantages of Payback Period

1.         Does not take into account time value of money and assumes that a shilling received in the 1^st year and in the Nth year have the same value so as to rank them together to ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now.

2.         PBP method does not measure the profitability of a venture but rather measures the period of time a venture takes to pay back the cost.  The method is outside looking (lender oriented rather than owner oriented).

3.         PBP method ignores inflows after PBP and as such, it does not accommodate the element of return to an investment.

4.         This method will not have any impact on the company’s share prices because profitability which is one of the most important factors in gauging the company’s value of shares is not a function of PBP and as such the method fall short of meeting the criteria of investment appraisal.

Acceptance Rule of Accounting Rate of Return (ARR)

ARR method will accept those projects whose ARR is higher than that set by management or bank rate and it will give highest ranking to ventures with highest ARR and vice versa.

Advantages

1.         Simple to understand and use.

2.         Readily computed from accounting data thus much easier to ascertain.

3.         It is consistent with profitability objectives as it analyses the return from entire inflows and as such it will give a clue or a hint to the profitability of venture.

Disadvantages

1.         It ignores time value of money.

2.         It does not consider how soon the investment should recover the cost (it is owner looking than creditor oriented approach).

3.         It uses accounting profits instead of cash inflows some of which may not be realisable.

MODERN METHODS OR DCF i.e. Discounted Cash Flow Techniques

1. Present Value Concept

This concept acknowledges the fact that a shilling losses value with time and as such if it is to be compared with a shilling to be received in n^th year then the two must be at the same values.  This means that an investor’s analytical power is increased by his/her ability to compare cash inflows and outflows separated from each other by time.  He/she should be able to work in the reverse direction i.e. from future cash flows to their present values.

Net Present Value Method

The method discounts inflows and outflows and ascertains the net present value by deducting discounted outflows from discounted inflows to obtain net present cash inflows i.e the present value method will involve selection of rate acceptable to the management or equal to the cost of finance and this will be used to discount inflows and outflows and net present value will be equal to the present value of inflow minus present value of outflow.  If net present value is positive you invest, If NPV is negative you do not invest.

Pv(inflow) – Pv(outflows) = NPV

Note   

Initial outflow is at period zero and their value is their actual present value.  With this method, an investor can ascertain the viability of an investment by discounting outflows.  In this case, a venture will be viable if it has the lowest outflows.

ACCEPT OR REJECT RULE OF NPV

Under this method, a company should accept an investment venture if N.P.V. is positive i.e. if present value of cash outflows exceeds that of cash inflows or at least is equal to zero. (NPV ≥0).  This will rank ventures giving the highest rank to that venture with highest NPV because this will give the highest cash inflow or capital gain to the company.

Advantages of NPV

• It recognises time value of money and such appreciates that a shilling now is more valuable than a shilling tomorrow and the two can only be compared if they are at their present value.
• It takes into account the entire inflows or returns and as such it is a realistic gauge of the profitability of a venture.
• It is consistent with the value of a share in so far as a positive NPV will have the implication of increasing the value of a share.

4.         It is consistent with the objective of maximising the welfare of an owner because a positive NPV will increase the net worth of owners.

Disadvantages of NPV

• It is difficult to use.
• Its calculation uses cost of finance which is a difficult concept because it considers both implicit and explicit whereas NPV ignores implicit costs.
• It is ideal for assessing the viability of an investment under certainty because it ignores the element of risk.
• It may not give good assessment of alternative projects if the projects are unequal lives, returns or costs.
• It ignores the PBP.

IRR (Internal Rate of Return)

This method is a discounted cash flow technique which uses the principle of NPV.  It is defined as the rate which equates the present value of cash outflows of an investment to the initial capital.

IRR = Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0.

It is also called internal rate of return because it depends wholly on the outlay of investment and proceeds associated with the project and not a rate determined outside the venture.

Acceptance Rule of IRR

IRR will accept a venture if its IRR is higher than or equal to the minimum required rate of return which is usually the cost of finance also known as the cut off rate or hurdle rate, and in this case IRR will be the highest rate of interest a firm would be ready to pay to finance a project using borrowed funds and without being financially worse off by paying back the loan (the principal and accrued interest) out of the cash flows generated by that project.  Thus, IRR is the break-even rate of borrowing from commercial banks.

Advantages of IRR

§  It considers time value of money

§  It considers cash flows over the entire life of the project.

§  It is compatible with the maximisation of owner’s wealth because, if it is higher than the cost of finance, owners’ wealth will be maximised.

§  Unlike the NPV method, it does not use the cost of finance to discount inflows and for this reason it will indicate a rate of return of interval to the project against which various ventures can be assessed as to their viability.

Disadvantages of IRR

• Difficult to use.
• Expensive to use because it calls for trained manpower and may use computers especially where inflows are of large magnitude and extending beyond the normal limits.
• It may give multiple results some involving positive IRR in which case it may be difficult to use in choosing which venture is more viable.

PROFITABILITY INDEX (P.I.)

P.I. (benefit-cost ratio)            =             Present value of inflows     

                                                            Present value of cash outlay

If P.I. is greater than 1.0, invest.  If less than 1.0, reject.

Advantages of profitability index

a)         Simple to use and understand.

b)         The element of NPV in the venture will indicate which venture is more powerful as the most profitable venture will have the highest P.I. as the difference or net P.I. will continue to the company’s profitability.

c)         It acknowledges time value for money and at the same time the NPV of a venture at its present value which is consistent with investment appraisal requirements.

Disadvantages of profitability index

a)         It may be useful under conditions of uncertain cost of finance used to discount inflows and yet this cost is a complex item due to the implicit and explicit element.

b)         It may be difficult to ascertain if the economic life of a venture is long and it yields large inflows because their discounting may call for use of computers that are expensive.

COMPARISON OF METHODS

Both traditional and modern methods will show or indicate strong weaknesses such that a company cannot use either to select a viable venture and for this reason the selection of the investment will depend on which method the company has identified it can meet its investment needs.  The choice should not be limited to one method but at least 2 modern methods.  In all, when ranking projects, a conflict will rise between IRR and NPV especially under the following conditions:

i)          If the lives of the projects are different.

ii)         Where the cash outlay is larger than the other.

iii)        When the cash flow pattern differs i.e the cash flows of one project may overtime increase while those of the other decrease.  In this case NPV may give consistently correct solution especially so because it does not yield multiple rates.