Discuss about the Capital Budgeting: Evaluation of Investments.
Besides the financial aspects of a project appraisal, it is crucial for the investor to consider the various non-financial aspects facing that project appraisal (Mohamed and McCowan, 2001). This should be done before the final decision to undertake the project is made. On noting that there exist many limitations to financial data, Ittner and Larcker (2000) concluded that other measures would be better in the evaluation of a company’s performance. For instance, they suggested that quality would be better in forecasting. However, they noted that some of these measures could be difficult to implement. The traditional systems that were financially oriented have been in the modern period been disregarded by most managers, with allegations that its working is no longer adequate. They criticized the insertion of major emphasis on accounting returns and earning, rather on the drivers of value i.e. innovation, employees and customer satisfaction and quality (Ittner and Larcker, 2000). Pest and swot analysis will be used in the identification of these factors.
Strengths
The key role played by the system of performance measures is that of strategy development, organizational objectives evaluation and achievement and on managers’ compensation. They are the strength of considering the non-financial factors.
Weakness
However, companies are faced with a major challenge in choosing the performance measures; this is a major weakness in considering the non-financial factors (Götze, Northcott and Schuster, 2015). There are many non-financial factors which proofs an investment to be performing well. First, the climatic issues.
Opportunity and Threats
Recently, green activities have gained popularity such that a company that is not investing in preserving the environment is viewed by the public as irresponsible and unresponsive (Chinweike, 2009). This is the environmental analysis part; the company should avoid pollution of the environment. The public are the potential customers to a company’s product. A company that includes some non-financially sound projects in its investment is able to preserve the benefits. Consideration of the impacts that could result on the environment from investment on a project is important (Ingram, 2016).This is one of the major opportunities posed by this consideration. The major threat of considering the non-financial factors is that most projects may not pass the test for non-financial evaluation to be considered viable.
Political Analysis
Second, government’s regulation. There are relevant laws set by the government concerning investments. The actions and inactions of the government have consequences that should be considered by managers (Chinweike, 2011). This is the political analysis part. While this is obvious, many investors have disregarded it in appraising projects.
Economic Analysis
Third, backend profits/sales. These sales result from the inclusion of some non-profitable projects in the company’s investment. According to Chinweike (2009), these projects are targeted to bring in more customers into the business. Fourth, the actions of competitors. A company may be considered financially viable without considering the aspect of competitors. As soon as the project is initiated, the competitors could implement various strategies that would make the project less profitable, or rather losses could be made. By considering the impact that could be caused by all the possible actions of the competitors, investors will have some assurance that the project will generate some profit, and if not, it’s not a good investment.
Social Analysis
Fifth, the customer’s satisfaction. Customers are the kings of investments. It is, therefore, crucial to consider the extent of satisfaction they will derive from the intended project investment (McMenamin, 2002). The products of a project should be affordable and yield many benefits to the consumers. This is, therefore, an important non-financial factor as it will determine the level of the company’s sales. Sixth, the motivation of staff. Some investment discourages the motivation of the staff (Ingram, 2016). Therefore, an investment project should only be engaged into, if and only it proofs to motivate the staff (Chinweike, 2011).
Technological Analysis
Seventh, availability of manpower. In the real sense, manpower is an essential requirement for every investment. The equipment invested needs manpower to be in operation. The company should, therefore, consider the availability of sufficient supply of the same. This is the technical analysis part. It may be difficult to connect with skilled manpower after the project is initiated if this was not considered earlier.
When an investor is interested in measuring the possible benefits that could be derived from making a certain investment, the net present value (NPV) and the internal rate of return (IRR) are the two commonly used methods (Kaushal, 2015). The NPV method gives a direct measure of the dollars that will be received by the stockholders i.e. it is measured in currency terms, while the IRR method gives the return on the original invested money. I.e. it is measured in percentage returns expected. With IRR a project can be chosen if returns are higher, by ignoring the initial investment size (Schmidt, 2013). Large projects with lower returns may be having huge positive NPVs. While the measure of NPV is absolute, that of IRR is relative. On the analysis of mutually exclusive projects, both the IRR and the NPV are useful metrics. However, the direction pointed by these metrics is not always the same. This is due to the variation is the timing of cash flows and the size of the projects. IRR depends on the internal factors of the projects and not the predetermined required rate of return (RRR) (Arshad, 2012). The major pitfall of IRR is that if losses are being made from the operation of a project and the company may be required to provide more capital, the problem of multiple IRR arises. I. e this occurs when negative cash flows are received. This type of cash flow is referred to as non-normal.
In situations where the cash flows are changing, only the NPV method is applicable; the IRR method cannot be used for evaluation. When the project under evaluation is an independent project, meaning that the decision to invest in the project is independent and not compared to other projects, the ranking produced by the NPV and the IRR methods are not conflicting. They are similar such that, a project that is accepted through NPV is accepted with IRR. On the other hand, a project rejected when using NPV is also rejected with IRR (Investopedia, 2012).
Both the two metrics are used in estimating profitability. However, there has been a debate that one of the methods is superior to the other. The NPV has been considered superior to the IRR by various studies. Understanding and grasping of the NPV by the general public is easy. Business managers are the most common user of the IRR method since its expression as a percentage makes returns be easily understood. NPV is better than IRR since the results from the same project changes with a change in the discount rate. With IRR, the same results are obtained even with a change in the discount rate for the same project (Schmidt, 2013). Hence with IRR, it is difficult to estimate the discount rate that will maximize the shareholder’s wealth. The consideration of different discount rate for a single project makes the NPV preferable for long-term investments as discount rates may change with time (Kaushal, 2015). Also, the NPV also considers the cost of capital. During the calculation of the project’s profitability, the additional shareholder’s wealth is only taken into account when NPV is used but disregarded when IRR is used. For this reason, it is considered to be not consistent with the maximization of the shareholder’s wealth.
The wealth of the shareholders is maximized when the returns from a project yield a positive NPV. Therefore, there exist a conflict in that; a project may be yielding a higher positive NPV, but its IRR could be lower. In this case, the firm’s goal of maximizing shareholder’s wealth (high NPV) is conflicted by that of reduced expected returns (lower IRR) (boundless.com, 2016).
Fig: Two mutually exclusive projects compared using NPV and IRR
Source: boundless .com
For certain discount rates, the NPVs of project A are higher even though the IRR (x-axis intercept) is lower than that of project B.
Conclusion
In today’s world, so many uncertainties are experienced especially in finance. Non-financial factors have therefore been of great important to the today’s management. Most of this factors sound obvious and real. Their ignorance could make most investors to engage in projects that will later yield negative NPVs. Hence, they should be taken seriously.
When deciding on the best method for the evaluation of projects, the NPV is a better method especially for long term projects. It is also better than IRR since the results reached are dependent on the rate of discount. IRR is not useful when the discount rate keeps on changing since the results do not change. Also, when there are more projects to be evaluated NPV is the best since problems arise when IRR is used in such a situation.
References
Arshad, A. (2012). Net Present Value is better than Internal Rate of Return. [Online] ijcrb.webs.com. Available at: https://journal-archieves26.webs.com/211-219.pdf [Accessed 26 Jul. 2016].
Chinweike, (2009). Investment Appraisal-8 non-financial factors that every accountants and managers should consider – Investment & Small Business Accountants. [Online] Investment & Small Business Accountants. Available at: https://www.accountantnextdoor.com/investment-appraisal-8-non-financial-factors-that-every-accountants-and-managers-should-consider/ [Accessed 24 Jul. 2016].
Chinweike, (2011). Non-monetary and financial factors of investment appraisal. [Online] HubPages. Available at: https://hubpages.com/money/non-monetary-and-financial-factors-of-investment-appraisal [Accessed 24 Jul. 2016].
Götze, U., Northcott, D. and Schuster, P. (2015). Investment appraisal. Heidelberg: Springer.
Ingram, D. (2016). Qualitative Factors in Capital Investment Decisions. [Online] Smallbusiness.chron.com. Available at: https://smallbusiness.chron.com/qualitative-factors-capital-investment-decisions-73769.html [Accessed 25 Jul. 2016].
Investopedia. (2012). Advantages and Disadvantages of NPV and IRR – Complete Guide to Corporate Finance | Investopedia. [Online] Available at: https://www.investopedia.com/walkthrough/corporate-finance/4/npv-irr/advantages-disadvantages.aspx [Accessed 25 Jul. 2016].
Kaushal, N. (2015). NPV vs IRR – Which is better? – WallStreetMojo. [Online] Free Investment Banking Tutorials | WallStreetMojo. Available at: https://www.wallstreetmojo.com/npv-vs-irr/ [Accessed 24 Jul. 2016].
McMenamin, J. (2002). Financial Management: An Introduction. Routledge.
Mohamed, S. and McCowan, A. (2001), “Modelling Project Investment Decisions Under Uncertainty Using Possibility Theory”, International Journal of Project Management, Vol. 19, Nº 4, pp. 231-241.
Ittner, C. and Larcker, D. (2000). Non-financial Performance Measures: What Works and What Doesn’t – [email protected] [Online] [email protected] Available at: https://knowledge.wharton.upenn.edu/article/non-financial-performance-measures-what-works-and-what-doesnt/ [Accessed 25 Jul. 2016].
Schmidt, R. (2013). Understanding the Difference between NPV vs IRR. [Online] Propertymetrics.com. Available at: https://www.propertymetrics.com/blog/2013/06/28/npv-vs-irr/ [Accessed 26 Jul. 2016].
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