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Techniques

Yongsheng Guo

Teesside University Business School

Tel: 01642 342834

E-mail: Y.Guo@tees.ac.uk

1. Introduction

The Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI),

Payback (PB) and Accounting Rate of Return (ARR) are widely used methods as

investment selection criteria. Most large companies use several methods to make

investment decisions. The argument is that investment decisions are too important to be

left to a single method of appraisal. However, it is important to critically evaluate these

methods and have a better understanding about using these techniques in practice. This

article discusses these methods and particularly points out the drawbacks of these

techniques. This article argues that PB, PI, IRR and ARR maybe have some fundamental

problems as investment appraisal criteria and combined using of these methods may be

misleading rather than enriching the decision process. Probably, the NPV method could

be used as the sole criterion under all conditions.

2. Accounting Rate of Return (ARR)

The ARR method may be known as the return on capital employed (ROCE) or return on

investment (ROI). The ARR is a ratio of the accounting profit to the investment in the

project, expressed as a percentage. The decision rule is that if the ARR is greater than, or

equal to, a hurdle rate of then accept the project. Profit is based on accounting concepts of

income and expenses relating to a particular accounting period, based on the matching

principle. This means that income receivable and expenses payable, but not yet received

or paid, are involved. Moreover, profit calculation takes account of depreciation charges.

The ARR numbers can be calculated by different methods and regulations. This

flexibility may tempt decision makers to abuse the technique to suit their purposes. In

other words, it is not reliable. Moreover, it is argued that the inflow and outflow of cash

should be focus of investment analysis appraisals. The investment decision is the decision

to commit the firms financial and other resources to a particular action. We focus on

strategic capital projects and concentrate on the allocation of a firms long-term capital

resources. Cash flow analysis considers all the cash inflows and outflows resulting from

the investment decision. Profit figures are very poor substitutes for cash flows. Non-cash

flows, such as depreciation charges and other accounting policy adjustments, are not

relevant to the decision. Therefore, we need to estimate the stream of cash flows arising

from a particular course of action and the period in which they occur.

The most important criticism of accounting rate of return is that it fails to take account of

the time value of money. One of the components of time value of money is risk. The

capital investment is treated as taking risk and getting return. Any method without taking

account of risk is meaningless. ARR uses information which is not relevant to the

investment project and therefore provides irrelevant information.

3. Payback (PB)

The payback period for a capital investment is the length of time before the cumulated

stream of forecasted cash flows equals the initial investment. The decision rule is that if a

projects payback period is less than or equal to a predetermined threshold figure it is

shorter period of payback is related with lower risk. The object of investment is not to

minimize either risk or illiquidity but to earn a return that compensates for the risk and

commitment of funds. Therefore it is an anti-investment measure; the best investment

project is of a zero year payback period, which is keeping all cash in the bank.

Another problem is that called reinvestment fallacy. It is assumed that early cash inflow

can be reinvested in an at least same project. However, the possibility of using a project's

cash flows to finance other investment opportunities is irrelevant. Early cash inflows

could be used to pay off the capital or make possible new investment. It is irrelevant

whether the firm actually uses the cash to repay the capital or chooses to use it to finance

new investments. Why not finance a project effectively at current time instead of waiting

for the cash flow from a particular project?

Other criticisms are that it ignores the cash flows after the payback period and the time

value of money. An investment appraisal technique is used to articulate risk and measure

return. Payback does consider risk and measure return but misleads that a short payback

period associates with a lower risk. It is important to recognise that, for a given NPV, the

longer the payback period the better. If it is agreed that an acceptable investment is good

then it is better that a project lasts two years than one year, and so forth.

Discounted Payback is proposed that the future cash flows are discounted prior to

calculating the payback period. It takes account of risk and time value of money.

However, the weakness with PB is not only that it ignores some cash flows and the time

value of money but that it is based on the misconception that long-term investment is

intrinsically bad.

If we accept that an investment project which satisfies the market criteria is good, other

things being equal, then the longer an investment lasts the better. Capital budgeting is a

dynamic process. The firm will develop a control system over the risk and timing of a

projects future cash flows throughout the life time of the projects. If the PB criterion is

employed and a project with a short period is adopted, this could inhibit management

from seeking long-term strategies in pursuit of a short-term yield advantage. In addition,

long term investments make a great contribution to a stable macro economic growth and

social welfare. Therefore, PB is irrelevant and misleading.

4. Internal Rate of Return (IRR)

The IRR is the rate of return which equates the present value of future cash flows with

the outlay. The IRR tells you the rate of interest you will receive by putting your money

into a project. Research shows that IRR is widely used even more popular than NPV. The

argument is that businessmen are familiar with expressing financial data in the form of a

percentage. Businessmen believe that ranking projects to select between them is most

accurately and most easily carried out using the percentage based IRR method.

Furthermore, IRR can be calculated without knowledge of the required rate of return.

Actually, it is irrelevant that an absolute number or percentage is used for ranking. The

second argument is meaningless because, although IRR can be calculated without

knowing the cost of capital, it cannot be used without it since the cost of capital is the

benchmark for deciding whether the project is acceptable. This article argues that IRR is

not only fundamentally invalid but also misleading.

4.1 IRR ignores cost of capital

It is argued that IRR has an advantage in not requiring a precise estimate of the cost of

capital. This argument raises a fundamental question: is cost-of-capital relevant to project

worth? What does an IRR indicate? The opportunity cost of capital is the yield forgone

on the best available investment alternatives. It indicates the risk level of the alternative

being the same as for the project under consideration (Arnold, 2005). Without knowing

the risk level of the projects, a high IRR always means a high risk level. It is an adverse

selection by using the IRR as a criterion.

Even if the cost of capital was known and the excess of a project's IRR over the cost of

capital indicates that the project has a positive NPV. However it does not reflect the

projects degree of desirability. IRR is not suitable for project selection.

4.2 IRR disregards investment scale

It is sometimes assumed that IRR is a better method because it is expressed in percentage

terms. The fundamental concept is that to compare or rank investment projects one must

put them at same scale. Equating the size of a project with its initial outlay, without

taking account of the duration or pattern of the cash flows, is analogous to equating

the size of a building with the area of land it occupies without taking account of the

height of the structure or the configuration of its architecture. Even for investment

project with same outlay, which reflects the initial allocation of capital to the project, it

does not capture the scale of the capital invested throughout the projects life.

This raises another problem, the scale issue, which cannot be avoided even in a singleproject context. There are three dimensions of scale - outlay, cash flow pattern and life.

Every project may have a unique scale, whatever the outlays, cash flow patterns, or lives

of the projects. Using IRR may result in conflicts with NPV. Even when IRR accords

with NPV it remains incorrect in principle, and at a later date it will cause unnecessary

confusion. It gives a misleading signal about the projects degree of desirability.

The IRR technique implies that it is useful in discriminating between projects that happen

to have identical NPVs. IRR is a misleading indicator of a project's degree of desirability.

The project with the higher IRR is only by chance more desirable. It is possible that the

firm choose a wrong project with a higher IRR and small scale. If maximizing

shareholder wealth is accepted as the objective of an investment, a large scale project

with identical NPV improves shareholder wealth more than a small project. Hence the

project with the greater scale should be chosen rather than one indicated by an otherwise

irrelevant criterion.

All capital projects are different in scale implies that an absolute measure of added

value is the only relevant criterion of project worth. IRR as a ratio is fundamentally

unsuited for comparing competing projects.

4.3 IRR cheats non-financial managers and other users

The common argument is that a ratio, and therefore IRR, is more understandable to nonfinancial managers. The non-financial managers may not understand discounted cash

flows. The notion that the concept is more understandable is a myth. Actually it is not

easy as well to explain accounting information such as an ARR to a non-financial

manager. Few non-financial managers may admit that it is easy to understand the

depreciation and overhead allocation methods adopted. But if it is explain that the figure

is what we have earned during the past few months by deducting all cost and tax, we may

think it is understandable.

If you were to ask the average finance student to define NPV the answer would be

something like If the investment outlay is deducted from the discounted present value of

the projects future cash flows the difference represents the net present value which, if

positive, indicates that the project is acceptable. In effect, the natural tendency is to

define the concept by describing the method of its computation. This has become the

practice in textbooks and may make sense for examination purposes but it is of doubtful

help to the non-financial manager unfamiliar with the concept of discounting cash flows.

Similarly, we could make NPV more accessible to the general user by defining the

method in terms of its significance rather than of its method of computation. By avoiding

the complexities involved in NPV calculation, we may explain NPV as a measure of

Added Value or Incremental Wealth taking account of risk, size, lifetime and cash

flow pattern. It would become clear to the non-financial manager or other users why the

measure should be adopted and why a higher added value is always better than a lower

added value.

It is irresponsible to use a misleading concept by arguing that people may be hard to

understand the appropriate one.

4.4 IRR for preliminary screening and sub-sequential reporting

It is often claimed that it is unnecessary to use the NPV method to screen potential

projects. IRR could be satisfactorily used to screen out projects before the final analysis

by the NPV method. To screen out some projects using a theoretically invalid method

cannot be defended even if could save a little time. IRR involves estimating the same

future cash flows as the NPV method. The incremental time and effort in discounting

those cash flows to determine the respective NPVs is a small price to pay to avoid the

risk of rejecting worthwhile long-term projects. It would be a pity to screen out a good

project by using an invalid criterion before a formal capital investment appraisal.

The inclusion of IRR in the ex ante decision process has been criticized. One may wonder

if IRR has a role in sub-sequential reporting. The corporate financial reporting employs

profitability and rate-of-return measures to review the firms past investment decisions.

IRR links ex ante rate of return with the subsequent review process. It seems logical to

allow ex ante investment choices to be driven by ex post performance evaluations

systems. However, the performance evaluation or financial reporting systems measure the

effectiveness of investment choices that have been made. Moreover, the primary purpose

of periodic review is to evaluate managerial performance within a given time-frame. Ex

ante investment selection is concerned with evaluating possible project alternatives over

their total future lifespan. The investment process is dynamic where capital expenditure

is controlled. If the benefits claimed did not materialize the project might be modified or

abandoned. Moreover, Post-completion audit gain insights that are useful for future

capital investment decision. An invalid technique may have a bad result and damage the

development of investment mechanism

5. Profitability Index (PI)

The profitability index is the ratio of the present value of project benefits to the present

value of initial costs. The decision rule is that projects with a PI greater than 1.0 are

acceptable (Pike and Neale, 2003). It indicates the added value of 1 invested in the

project. It also can be shown on percentages of the incremental NPV that 1 invested in

the project. For independent projects, the PI gives the same advice as NPV. PI adds

nothing more than NPV. For mutually exclusive projects, PI may results in wrong

decisions when the projects happen to have save NPVs. Moreover, projects always come

in parcels and it is not possible to buy a quarter or half of a project, added value per

pound invested has little meaning to evaluate the whole projects. Only an absolute

measure of added value is relevant in the real market to compare projects of different

scale. This article discusses this issue under different circumstances, non-rationing and

rationing conditions.

It has been shown that, for listed companies, conditions of capital rationing should

normally not exist. They could, of course, arise if self-imposed, or in unlisted companies

without access to outside capital. Under non-rationing condition, all projects more than or

equal to 0 should be taken. There could be an underinvestment if we only accept those

projects with PI more than 1. Even under rationing condition, in a mutually exclusive

project selection, a large scale project with same NPV is more desirable if only the fund

is available because it increases more shareholder wealth. Therefore it is anti scale and

prefers a small project. However, using PI as a criterion a small scale project might be

selected because it has a higher PI. Indeed, about 70% of smaller companies exclusively

use one or more of the standard efficiency measures in preference to the absolute NPV

method (Runyon, 1983). However, if an investment satisfies the market criterion, its

degree of efficiency is irrelevant, only its contribution to value. Investment efficiency is

conventionally understood; the less efficient a project is in generating a given

(nonnegative) NPV the more desirable it is. It is an efficiency fallacy.

Only if under rationing condition and multiple choices, PI can be used to select projects.

For example as below, a company has some alternative projects but only a certain amount

of fund is available. PI can be used as a multiple choice selection criterion.

Capital rationing

Project

1.

2.

3.

4.

5.

6.

7.

8.

9.

Outlay

$2,000

1,000

3,000

1,000

4,000

2,000

1,000

3,000

5,000

PI

NPV

1.80

1.75

1.70

1.60

1.50

1.45

1.20

1.10

.95

$1,600

750

2,100

600

2,000

900

200

300

-250

An investment proposals net present value is derived by discounting the future net cash

receipts at a rate which reflects the value of the alternative use of the funds, summing

them over the life of the proposal and deducting the initial outlay. NPV 0 accept. NPV

< 0 reject.

NPV has been criticized as it is difficult to predict the future cash flows and measure

opportunity cost of capital. However, it emphasizes the importance of cash flows, time

value of money and project scales, which leads a right direction towards the development

of investment process. The NPV as a budgeting criterion reflects the liquidity implication

of an investment. It discounts each projects cash flows at the acceptable rate of return. It

is the only relevant measures that signal absolute wealth effects of investment projects

with different scale. This article addresses some issues when NPV is adopted as a capital

project appraisal technique.

Should 0 VPV projects be taken?

The answer is yes. First, in the perfectly competitive product market, only 0 NPV

projects are expected and the normal return is desirable. The role of management would

be to undertake as many non-negative NPV projects as possible to satisfy the demands of

new savers and investors. More over, due to the absence of positive NPV opportunities

shareholder wealth can be increased in term of share number instead of share price.

Second, in the real world the product market is unlikely to be perfectly competitive.

When a firm acquires a competitive advantage there is a reasonable expectation of

earning an abnormally high return, in effect to achieve a positive NPV investment. The

positive NPV fallacy consists that a project must have a positive NPV in order to improve

share price.

If the securities market had perfect foresight then, the price will full reflect the firms

abnormal return potential such that, thereafter, the growth in the price can be expected to

be no more than normal. Adjusting for inflation and retained earnings, the share price can

be expected to remain at its present even when the underlying investments of the

company are positive NPV investments.

But it is obvious that the stock market is unable to predict the future perfectly. But its

function is to make an informed guess about the companys future profitability. If the

market underestimates the firms future abnormal earnings the price will be too low and

can be expected to increase until in reaches its correct level. If the market

overestimates the firms future potential the price can be expected to decline. The firm

can expect the share price to constant revision but it cannot expect the revisions to be

systematically in an upward direction. Therefore in the imperfect product market, we

cannot expect abnormal return by undertaking positive NPV projects.

Should negative NPV projects be taken?

This question is beyond the capital investment appraisal but the answer is it depends.

NPV as a technique is only one element needed for successful project appraisal. Other

factors such as strategy, social context, and intangible benefits should be considered.

7. Summary and conclusion

This article critically evaluates the capital investment appraisal techniques including

ARR, PB, IRR, PI and NPV. NPV should be used as a sole criterion under all conditions.

Using of a multi-criterion approach to investment appraisal is misleading.

ARR provides invalid information by manipulating irrelevant information. PB is an anti

investment approach under fundamental flawed assumptions. There is a reinvestment

fallacy Keane (1979) by assuming early cash back can be reinvested in an at least same

project. IRR as a criterion for evaluating competing projects is criticized with ignoring

cost of capital, disregarding scale. IRR should not be used as a budgeting criterion or a

supplementary tool. It is subjectively calculated without considering risk, scales and

discriminates those projects of same value of NPV. Even in the condition of capital

rationing, it misleads selecting suitable projects. It is misunderstanding for preliminary

screening and sub-sequential reporting even for non-financial managers. PI is anti scale

thus susceptible to under-investment and therefore should only be used as in capital

rationing condition. It is an efficiency fallacy by assuming a project with a given NPV is

more beneficial for having a smaller rather than greater outlay, or a quicker rather than a

slower payback period. When choosing between competing projects with identical NPVs,

the project that employs most capital is generally to be preferred because it creates more

wealth for the same wealth accretion.

and possibly even under rationing conditions. If the firm only undertakes the positive

NPV projects, the Profitability Index (PI) becomes the criterion of acceptance rather than

NPV therefore the firm may reject some positive-NPV projects. The positive NPV fallacy

consists that a project must have a positive NPV in order to improve share price.

However, in an efficiency market, the share prices have already reflected all positive

potentials or fluctuate around a correct level. In an inefficiency market, one can not

expect that share prices reflect a positive NPV rationally.

References

Arnold G., 2005, Corporate Financial Management, 3rd Edition, Prentice Hall.

Keane S. M., 1979, The Internal Rate of Return and the Rein-vestment Fallacy",

Abacus, Volume 15, No 1, pp 48-55.

Pike R. and Neale B., 2003, Corporate Finance and Investment, 4th Edition, Prentice

Hall.

Runyon L. R., 1983, Capital Expenditure Decision Making in Small Firms, Journal of

Business Research (September, 1983), pp 389-397.

Shapiro, 2003, Multinational Financial Management, 7th Edition, J. Wiley.

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