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 1st 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 nth 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.
