Investment Appraisal Definition
Introduction
This chapter consists with the back ground of the study, research issue, objective of the study, significant of the study, flow of the study and the limitations which are occurred during the research.
Background of the study:
Rapidly changing technology, innovations and globalization are lead to make more competition in modern businesses context. The business that can compete with this competition be able to survive in the market and earn profits. Organizations which are having more flexible structure and strong financial position be able to compete with the market changes. Making capital nature expenses for unforeseen future may not be best solution to the organizations. On the other hand having zero investment also may not be the best scenario. Therefore organizations should undertake the projects which may give sustainable competitive advantage to the businesses. Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firms resources to actions that are irreversible. Expansion of business operations, acquisitions, modernization and replacement of long term assets and sale of a division or business can be identified as investment. Normally such investment will take more than one year period and those includes investments in plant and machinery, research and development, advertising and warehousing facilities. These types of investments carry huge cash inflows and outflows as well as risk associated with; therefore managers are evaluating the project before it is accepted. In 1 this case, managers apply different criterion to evaluate investment decisions in which maximize the wealth of the shareholder’s. In current practice, managers use Traditional method and Discounted Cash flow (DCF) analysis to evaluate the investment in financial terms. In which traditional Method includes Payback method and Accounting Rate of Return (ARR) which make no adjustment for the time value of money. But in DCF method considers the time value of money in which reduces the time value of money progressively and it consist with Net Present Value (NPV) approach and Internal Rate of Return (IRR) method. This could lead to more popularize investment appraisal techniques among the managers. In theory would suggest that DCF method is more superior than the traditional method, on that NPV is superior than to IRR. Even though in theoretically NPV technique of investment appraisal is superior in pragmatic ground its rivals are over. It is proved that survey conducted by Arnold & Hatzopoulos (2000) and Graham & Harvey (2001). These surveys done in UK and more generally and they have revealed that techniques less behind for it rivals. In addition to that Koller (2006) have identified most frequent ten errors in application of DCF model. He also stated that DCF model should be economically sound and transparent. Therefore Koller has strongly emphasized without looking at those issues managers may not be able to end up with good decisions. In this case he suggests that application of DCF method need to be adjusted and assumptions to be made accurately. Because accuracy of the decision is relies on such assumptions. Surveys of capital budgeting practices in the UK and USA reveal a trend towards the increased use of more sophisticated investment appraisals requiring the application of DCF techniques. Several writers, however, have claimed that companies are under 2 investing because they misapply or misinterpret DCF techniques. Such claims have been made on the basis of observations in only a few companies, or anecdotal evidence, without any supporting statistical evidence. Reports on a recent survey conducted by the Drury C. & Tayles M. (1997) suggest that many UK firms are guilty of misapplying DCF techniques. On this survey they have tested the three areas where misapplication could be taken place. They are selection of investment appraisal techniques, treatment of Inflation and Uses of discount rate. In addition to that they have tested the major reason that is cited to explain why the financial appraisal often fails to justify investment in Advanced Manufacturing Technology’s (AMT). It is because those benefits which are difficult to quantify are either understated, or frequently omitted from the financial appraisal. Because of that UK organizations may be rejecting the profitable investment. On the other hand, when we are considering the appraisal of AMT project different researchers established diverse arguments. Kaplan (1986) argued that conventional DCF method to be used based on the financial data available to appraise the AMT projects. Meredith & Suresh (1986) also developed the new approach consist with flexibility, high level of risk and the synergy of Flexible Manufacturing Systems (FMS) when linked together with other systems. These three levels tested on different appraisal techniques and try to overcome the problems associate with Kaplan’s Model. But later Browmich & Bhimami (1991) developed the model in which quantify all the benefits either financial terms or score value terms. However DCF approach is still widely used investment appraisal techniques. It is prove according to the surveys carried out by Lawrance, Gary & Williams (1978) 65% and 56% respondent of Large US firms were applied IRR and NPV respectively and recent survey carried out by the Pike (1996) reported 75% and 81% UK firms are 3 applying NPV and IRR respectively. According to the study carried out by the McIntosh (1993) among major valuation firms in Australia and the Sangster (1993) among largest 500 Scottish companies they have revealed that more than 75% firms are currently practicing the DCF method.
Research Issue:
According to the literature survey we can see that there is an ongoing debate among the managers of all industries whether to use DCF analysis or any other method in capital investment evaluation process. However it was found that DCF analysis is the more accurate and flexible decision making technique that can be used. But as far as practical application is concern DCF models cannot be applied as it is. It has to be developed and to be made the necessary adjustments to minimize errors that can be occurred in decision making process. Therefore validity of the DCF analysis is susceptible. So that researcher undertakes research on following issue. Whether DCF analysis is validated by the Managers of Milk Food industry as an Investment Decision making Tool.
Objectives of the study:
To identify, whether DCF analysis is validated by the managers of milk food industry as an investment decision making tool.
Significance of the study :
Investments are the most critical aspect for the success of an organization. So that it has given the highest importance in financial management. It is because it’s impact upon the long term future of the business, the amount of scare resources utilized anddegree of irreversibility. Misguided decisions can endanger the survival of the business and cause difficulties in obtaining additional finance from more costly sources. On the other hand it showed that investment decision is at a high risk. Therefore investment must be carefully analyzed in a systematic and logical way. All of the projects will generate financial or non financial benefits to the organization. To evaluate the financial benefit pre determined appraisal techniques are developed and existed. But in case of appraising non financial benefits there is no specified method is developed. Therefore organizations evaluate the non financial benefits based on the judgments of the specialized persons and their experiences. When managers are evaluating the financial benefits of the generally accepted techniques such as Pay back, NPV or IRR most of the calculations based on the assumptions. Therefore validity and acceptability of such techniques is in doubt. According to the Sri Lankan context it is a collection of different industries like Transportation, Telecommunication, Garment, Milk food, Construction, Paddy etc. Considering the milk food industry it is more competitive and widely spread their activities all over the country. Therefore organizations which are currently running in milk food industry make frequent investments to keep their market by way of doing innovations. In addition to that major organizations which acquired majority of the market is foreign own companies. They make frequent investment according to the changes in technology, consumer preference all over the world. Therefore it is significant to study the decision making process of the milk food industry and there validity of the decision making techniques.
Flow of the study:
Introduction:
This chapter includes the background of the study, research issue, objective of the study, significant of the study, flow of the study and limitation of the study.
Literature Review This includes the literature review of the study.
Limitation of the study:
• Quantitative information is more confidential and more prices sensitive therefore companies are reluctant to give that information to outsiders • Milk food industry is comprised with large organizations as well as small scale organizations such as yogurt manufactures. Due to the insignificant capacity and unable to make more financial investment they are dismissed from the research.
Literature Review:
Capital budgeting define:
Drury (2000) stated, “ The theory of capital budgeting reconciles the goals of survival and profitability by assuming that management takes as its goal the maximization of the market value of the shareholders’ wealth via the maximization of the market value of ordinary share”. Capital budgeting decisions may be defined as “the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow benefits over a series of years”. (Pandy, 2005) According to the above definitions of capital budgeting, following features can be identified, I. Exchange current funds for future benefits II. Funds are invested in long term assets and III. Benefit will occur to the firm over a series of years. Therefore main objective of the capital budgeting decisions are to maximize the wealth of the shareholders by, • Determining which specific investment projects to be undertaken • Determining the total amount of capital expenditure which the firm should be obtained • Determining how this portfolio of projects should be financed. In capital budgeting process different investment appraisal techniques are used to evaluate the investments. They are mainly traditional and Discounting Factor (DCF) methods. In traditional method consist of Payback and Accounting Rate of Return (ARR) which don’t have the time value adjustment. But in DCF method Net Present Value (NPV) and Internal Rate of Return (IRR) are included and they are adjusting the time value of money to the cash flows. These techniques give different benefits and limitations in investment evaluation process, although as per the theoretical view DCF analysis may give more benefit to the organization. However successful completion of a project mainly depends on the selection criteria adopted while choosing the project in the initial phases itself and the choice of a project must be based on a sound financial assessment and not based on impression. DCF techniques are being widely used in both public and private sector. This is the method recommended for evaluating investment proposals. In this method, the incremental cost and benefits of proposals are discounted by a required rate of return in order to obtain the net present value of the proposal.
Discounted cashflow (DCF)
DCF focuses on the time value of money, Rs.1 is worth more today than Rs.1 in the future. The reason being that it could be invested and make a return (yes, even in times of low interest, so long as interest rates are positive). So that's the discounting methodology, DCF has two methods.
Net Present Value (NPV)
The annual cash flows are discounted and totaled and then the initial capital cost of the project is deducted. The excess or deficit is the NPV of the project, it goes without saying that for the project to be worthwhile the NPV must be positive and the higher the NPV the more attractive is the investment in the project.
Internal Rate of Return (IRR)
The IRR or yield of a project is the rate of return at which the present value of the net cash inflows equals the initial cost, which is the same as the discount rate which produces a NPV of zero. For an investment to be worthwhile the IRR must be greater than the cost of capital. Due to the following reasons, DCF method is identified as a best method for investment appraisal processes, • They give due weight to timing and size of cash flow • Thy take the whole life of the project in to irregular cash flows do not invalidate the result obtained. • Estimate of risk and uncertainty can be incorporated • Use of discounting methods may lead to move accurate estimating and • They rank projects correctly in order of profitability and give better criteria for acceptance or rejection of projects than other method. Because of that in theoretically said that DCF analysis is best method to evaluate the investment over its rivals. A survey carried out by the Arnold & Hatzopolous (2000) and Graham & Harvey (2000) to identify the practical usage of investment appraisal techniques among the large manufacturing firms of UK had revealed that NPV and IRR are less behind its rivals in practically. Therefore they have commented that there is a gap between usages of appraisal techniques in practically and theoretically. But according to the Koller (2006) have identified the errors which may occur frequently while application of DCF techniques. He also commented that DCF model should be economically sound and transparent to get the expected output. Economically sound means the company’s return and growth are consistent with the company’s positioning and the ample empirical records. Transparent means you understand the economic implications of the method and assumptions you choose. As per his comment most DCF models fail to meet the standards of economic soundness and transparency. Following are the frequent errors identified by Koller, • Forecast horizon that is too short. One of the most criticisms is that any forecast beyond a couple of years is suspect. • Uneconomic continuing value. The continuing value component of a DCF model captures the firm’s value for the time beyond the explicit forecast period which can theoretically extend in to perpetuity. • Cost of capital. You will rarely see a grate equity investor point to an ability to judge the cost of capital better than others as the source of meaningful edge. But you do see many DCF models debilitated by non sensible cost of capital estimates. • Mismatch between assumed investment and earnings growth. Companies invariably must invest in the business in order to grow over and extended period. Return on investment (ROI) determines how efficiently a company translates its investments into earnings growth. So that investor must treat the relationship between investment and growth carefully. • DCF models commonly underestimate the investment necessary to achieve an assumed growth rate. • Improper reflection of other liabilities. Most liabilities, including debt and many pension programs are relatively straightforward to determine and reflect in the model. Some other liabilities like employee stock option are trickier to capture. Not surprisingly most analysts do a very poor job capturing these liabilities in an economically sound way. • Discount to private market value. The discount to private market value model lacks sufficient transparency because it conflates the base and synergy cash flows. • Double counting. Models should not count a rupee of value more than once. Unwittingly, DCF models often double count the same source of value. • Scenarios. Probably the most often cited criticism of a DCF model is that small changes in assumptions can lead to large changes in the value. Because of such errors, they have commented that an investor must ensure the models are economically sound and transparent to apply DCF models to the real world. Drury and Tayles (1997) argued uses and limitations of DCF analysis in different view. They have done a survey on application of DCF method based on 886 UK manufacturing organizations. On that survey they have identified companies are under investing because of the misapplication and misinterpretation of DCF techniques. That survey showed smaller organizations place less emphasis on formal appraisal techniques and staff responsible for making capital investment decisions are likely to be involved in the invitation process. Hence they will have detailed “knowledge of the business” and intuitive managerial judgment. The survey findings also indicated that non-discounting methods continue to be used by both smaller and large organizations. Firms are guilty of rejecting worthwhile investment because of the improper treatment of inflation in the financial appraisal. Inflation affects both future cash flows and the cost of capital that is used to discount the cash flows. It must be noted also that inflation is likely to affect different components of cash flows in different ways. Inflation also affects the cost of capital because investors require higher monetary returns to compensate for inflation. The correct treatment of inflation requires that we compare like with like in the financial appraisal. Thus real cash flows should be discounted at a real discount rate or nominal rate. In order to ascertain how inflation was dealt with in financial appraisal they asked from the respondent to specify whether real or money discount rate used to discount the cash flows. In that case 49% of respondent were understating the IRR by using current or real cash flow estimates to compute the IRR and then comparing the resulting return with a normal discount rate. Results were almost similar to largest and smallest organizations. Therefore it is important to ensure that inflation is dealt with correctly in financial appraisals. Another misapplication of DCF analysis is uses of excessive discount rate uses for investment appraisal. During that period there was a debate on UK companies for using high discount rates to appraise investment and as a result these companies in danger of under investing. According to their survey, they have identified approximately 50% of respondents are using nominal and real discount rate more than 19%. It showed majority of respondents use rate significantly in excess of those calculated above for average risk projects. These findings show that many companies in UK were using excessively high discount rates. In case of Advanced Manufacturing Technological (AMT) investments, different researchers are having various ideas. Because AMT investments generate more benefits on financial and non financial terms as well. Benefits like quality improvement, manufacturing flexibility, higher level of customer service and delivery, shorter lead times and greater product innovations cannot be quantify are distorted by the DFC analysis. It means that investment in AMT projects are often fails because of non financial benefits which are difficult to quantify or either understated or frequently omitted. Kaplan (1986) argued that conventional DCF method should be used to evaluate investments based on the financial data available. He also stated that if the net results of the cash flows results in a negative NPV, then it becomes necessary to estimate how much the annual cash flows must increase before the investment does give a positive net present value. Kaplan goes on to argue that the management must then decide if the value of the intangible benefit will be greater than this figure. If the answer is yes, then he project would meet the criteria for acceptance. But Meredith & Suresh’s (1986) argument was financial appraisal methods used by industry to evaluate investments may be inappropriate on their own for today’s high technology business environment, since they fail to capture many of the strategical benefits from important AMT projects. Therefore he suggested three stages appraisal techniques. It can be identified as 1. Flexibility, 2. High level of risk and 3. Synergy of Flexible Manufacturing Systems. Flexibility can be identified by way of conventional investment appraisal techniques and at the second stage company must sue techniques such as value analysis, portfolio analysis and risk analysis. Final stage requires a more strategic justification. Bromwich & Bhimami (1991) had a different approach for the appraisal of AMT projects. In their approach, they attempted to quantify either financial terms or score values of benefits of investing in AMT. Still there is no specifically developed technique to appraise AMT projects. Different researchers have been developed different models for appraising AMT projects. Even though there are different models, different arguments still managers are compel to use DCF analysis for their investment decisions. According to the past survey carried out by Lawrence, Gary & Williams (1978) inquired about the capital budgeting techniques employed by large US firms and computation of the discount rate and cash flows. Of those responding firms indicating that a discount rate is applied. 65% of the respondents were applied IRR and 56% uses NPV method. Over 86% of the respondents use either IRR or NPV or both. Another survey carried out by Pike (1996) on capital budgeting practices of large UK companies between 1975 and 1992 reported a substantial increase in the usage of discounted cash flow. According to survey he has identified 75% and 81% UK firms are applying NPV and IRR respectively. In a recent study carried out by the McIntosh (1993) to ascertain whether or not DCF technique is used by property investors as an investment decision making tool among the major property investors in Australia. It was reported that 75% of the respondents always use DCF and 25% usually use DCF analysis in the valuation of properties over $25 million. The survey carried out by the Sangster (1993) among the 500 largest Scottish companies to ascertain currently used techniques for capital investment appraisal. His findings indicated that companies are using several appraisal methods together, and application of discounted cash flow techniques is becoming more sophisticated. Although the survey does not directly indicate the use of DCF techniques for valuing property investments, it does suggest that the DCF technique of appraising investment is an accepted and widely used method by investment appraisers Due to these research findings we can identify there is an ongoing debate among managers for using DCF analysis for their investment decisions. And there is an unfilled gap for the uses of DCF analysis.
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This chapter consists with the back ground of the study, research issue, objective of the study, significant of the study, flow of the study and the limitations which are occurred during the research.
Background of the study:
Rapidly changing technology, innovations and globalization are lead to make more competition in modern businesses context. The business that can compete with this competition be able to survive in the market and earn profits. Organizations which are having more flexible structure and strong financial position be able to compete with the market changes. Making capital nature expenses for unforeseen future may not be best solution to the organizations. On the other hand having zero investment also may not be the best scenario. Therefore organizations should undertake the projects which may give sustainable competitive advantage to the businesses. Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firms resources to actions that are irreversible. Expansion of business operations, acquisitions, modernization and replacement of long term assets and sale of a division or business can be identified as investment. Normally such investment will take more than one year period and those includes investments in plant and machinery, research and development, advertising and warehousing facilities. These types of investments carry huge cash inflows and outflows as well as risk associated with; therefore managers are evaluating the project before it is accepted. In 1 this case, managers apply different criterion to evaluate investment decisions in which maximize the wealth of the shareholder’s. In current practice, managers use Traditional method and Discounted Cash flow (DCF) analysis to evaluate the investment in financial terms. In which traditional Method includes Payback method and Accounting Rate of Return (ARR) which make no adjustment for the time value of money. But in DCF method considers the time value of money in which reduces the time value of money progressively and it consist with Net Present Value (NPV) approach and Internal Rate of Return (IRR) method. This could lead to more popularize investment appraisal techniques among the managers. In theory would suggest that DCF method is more superior than the traditional method, on that NPV is superior than to IRR. Even though in theoretically NPV technique of investment appraisal is superior in pragmatic ground its rivals are over. It is proved that survey conducted by Arnold & Hatzopoulos (2000) and Graham & Harvey (2001). These surveys done in UK and more generally and they have revealed that techniques less behind for it rivals. In addition to that Koller (2006) have identified most frequent ten errors in application of DCF model. He also stated that DCF model should be economically sound and transparent. Therefore Koller has strongly emphasized without looking at those issues managers may not be able to end up with good decisions. In this case he suggests that application of DCF method need to be adjusted and assumptions to be made accurately. Because accuracy of the decision is relies on such assumptions. Surveys of capital budgeting practices in the UK and USA reveal a trend towards the increased use of more sophisticated investment appraisals requiring the application of DCF techniques. Several writers, however, have claimed that companies are under 2 investing because they misapply or misinterpret DCF techniques. Such claims have been made on the basis of observations in only a few companies, or anecdotal evidence, without any supporting statistical evidence. Reports on a recent survey conducted by the Drury C. & Tayles M. (1997) suggest that many UK firms are guilty of misapplying DCF techniques. On this survey they have tested the three areas where misapplication could be taken place. They are selection of investment appraisal techniques, treatment of Inflation and Uses of discount rate. In addition to that they have tested the major reason that is cited to explain why the financial appraisal often fails to justify investment in Advanced Manufacturing Technology’s (AMT). It is because those benefits which are difficult to quantify are either understated, or frequently omitted from the financial appraisal. Because of that UK organizations may be rejecting the profitable investment. On the other hand, when we are considering the appraisal of AMT project different researchers established diverse arguments. Kaplan (1986) argued that conventional DCF method to be used based on the financial data available to appraise the AMT projects. Meredith & Suresh (1986) also developed the new approach consist with flexibility, high level of risk and the synergy of Flexible Manufacturing Systems (FMS) when linked together with other systems. These three levels tested on different appraisal techniques and try to overcome the problems associate with Kaplan’s Model. But later Browmich & Bhimami (1991) developed the model in which quantify all the benefits either financial terms or score value terms. However DCF approach is still widely used investment appraisal techniques. It is prove according to the surveys carried out by Lawrance, Gary & Williams (1978) 65% and 56% respondent of Large US firms were applied IRR and NPV respectively and recent survey carried out by the Pike (1996) reported 75% and 81% UK firms are 3 applying NPV and IRR respectively. According to the study carried out by the McIntosh (1993) among major valuation firms in Australia and the Sangster (1993) among largest 500 Scottish companies they have revealed that more than 75% firms are currently practicing the DCF method.
Research Issue:
According to the literature survey we can see that there is an ongoing debate among the managers of all industries whether to use DCF analysis or any other method in capital investment evaluation process. However it was found that DCF analysis is the more accurate and flexible decision making technique that can be used. But as far as practical application is concern DCF models cannot be applied as it is. It has to be developed and to be made the necessary adjustments to minimize errors that can be occurred in decision making process. Therefore validity of the DCF analysis is susceptible. So that researcher undertakes research on following issue. Whether DCF analysis is validated by the Managers of Milk Food industry as an Investment Decision making Tool.
Objectives of the study:
To identify, whether DCF analysis is validated by the managers of milk food industry as an investment decision making tool.
Significance of the study :
Investments are the most critical aspect for the success of an organization. So that it has given the highest importance in financial management. It is because it’s impact upon the long term future of the business, the amount of scare resources utilized anddegree of irreversibility. Misguided decisions can endanger the survival of the business and cause difficulties in obtaining additional finance from more costly sources. On the other hand it showed that investment decision is at a high risk. Therefore investment must be carefully analyzed in a systematic and logical way. All of the projects will generate financial or non financial benefits to the organization. To evaluate the financial benefit pre determined appraisal techniques are developed and existed. But in case of appraising non financial benefits there is no specified method is developed. Therefore organizations evaluate the non financial benefits based on the judgments of the specialized persons and their experiences. When managers are evaluating the financial benefits of the generally accepted techniques such as Pay back, NPV or IRR most of the calculations based on the assumptions. Therefore validity and acceptability of such techniques is in doubt. According to the Sri Lankan context it is a collection of different industries like Transportation, Telecommunication, Garment, Milk food, Construction, Paddy etc. Considering the milk food industry it is more competitive and widely spread their activities all over the country. Therefore organizations which are currently running in milk food industry make frequent investments to keep their market by way of doing innovations. In addition to that major organizations which acquired majority of the market is foreign own companies. They make frequent investment according to the changes in technology, consumer preference all over the world. Therefore it is significant to study the decision making process of the milk food industry and there validity of the decision making techniques.
Flow of the study:
Introduction:
This chapter includes the background of the study, research issue, objective of the study, significant of the study, flow of the study and limitation of the study.
Literature Review This includes the literature review of the study.
Limitation of the study:
• Quantitative information is more confidential and more prices sensitive therefore companies are reluctant to give that information to outsiders • Milk food industry is comprised with large organizations as well as small scale organizations such as yogurt manufactures. Due to the insignificant capacity and unable to make more financial investment they are dismissed from the research.
Literature Review:
Capital budgeting define:
Drury (2000) stated, “ The theory of capital budgeting reconciles the goals of survival and profitability by assuming that management takes as its goal the maximization of the market value of the shareholders’ wealth via the maximization of the market value of ordinary share”. Capital budgeting decisions may be defined as “the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow benefits over a series of years”. (Pandy, 2005) According to the above definitions of capital budgeting, following features can be identified, I. Exchange current funds for future benefits II. Funds are invested in long term assets and III. Benefit will occur to the firm over a series of years. Therefore main objective of the capital budgeting decisions are to maximize the wealth of the shareholders by, • Determining which specific investment projects to be undertaken • Determining the total amount of capital expenditure which the firm should be obtained • Determining how this portfolio of projects should be financed. In capital budgeting process different investment appraisal techniques are used to evaluate the investments. They are mainly traditional and Discounting Factor (DCF) methods. In traditional method consist of Payback and Accounting Rate of Return (ARR) which don’t have the time value adjustment. But in DCF method Net Present Value (NPV) and Internal Rate of Return (IRR) are included and they are adjusting the time value of money to the cash flows. These techniques give different benefits and limitations in investment evaluation process, although as per the theoretical view DCF analysis may give more benefit to the organization. However successful completion of a project mainly depends on the selection criteria adopted while choosing the project in the initial phases itself and the choice of a project must be based on a sound financial assessment and not based on impression. DCF techniques are being widely used in both public and private sector. This is the method recommended for evaluating investment proposals. In this method, the incremental cost and benefits of proposals are discounted by a required rate of return in order to obtain the net present value of the proposal.
Discounted cashflow (DCF)
DCF focuses on the time value of money, Rs.1 is worth more today than Rs.1 in the future. The reason being that it could be invested and make a return (yes, even in times of low interest, so long as interest rates are positive). So that's the discounting methodology, DCF has two methods.
Net Present Value (NPV)
The annual cash flows are discounted and totaled and then the initial capital cost of the project is deducted. The excess or deficit is the NPV of the project, it goes without saying that for the project to be worthwhile the NPV must be positive and the higher the NPV the more attractive is the investment in the project.
Internal Rate of Return (IRR)
The IRR or yield of a project is the rate of return at which the present value of the net cash inflows equals the initial cost, which is the same as the discount rate which produces a NPV of zero. For an investment to be worthwhile the IRR must be greater than the cost of capital. Due to the following reasons, DCF method is identified as a best method for investment appraisal processes, • They give due weight to timing and size of cash flow • Thy take the whole life of the project in to irregular cash flows do not invalidate the result obtained. • Estimate of risk and uncertainty can be incorporated • Use of discounting methods may lead to move accurate estimating and • They rank projects correctly in order of profitability and give better criteria for acceptance or rejection of projects than other method. Because of that in theoretically said that DCF analysis is best method to evaluate the investment over its rivals. A survey carried out by the Arnold & Hatzopolous (2000) and Graham & Harvey (2000) to identify the practical usage of investment appraisal techniques among the large manufacturing firms of UK had revealed that NPV and IRR are less behind its rivals in practically. Therefore they have commented that there is a gap between usages of appraisal techniques in practically and theoretically. But according to the Koller (2006) have identified the errors which may occur frequently while application of DCF techniques. He also commented that DCF model should be economically sound and transparent to get the expected output. Economically sound means the company’s return and growth are consistent with the company’s positioning and the ample empirical records. Transparent means you understand the economic implications of the method and assumptions you choose. As per his comment most DCF models fail to meet the standards of economic soundness and transparency. Following are the frequent errors identified by Koller, • Forecast horizon that is too short. One of the most criticisms is that any forecast beyond a couple of years is suspect. • Uneconomic continuing value. The continuing value component of a DCF model captures the firm’s value for the time beyond the explicit forecast period which can theoretically extend in to perpetuity. • Cost of capital. You will rarely see a grate equity investor point to an ability to judge the cost of capital better than others as the source of meaningful edge. But you do see many DCF models debilitated by non sensible cost of capital estimates. • Mismatch between assumed investment and earnings growth. Companies invariably must invest in the business in order to grow over and extended period. Return on investment (ROI) determines how efficiently a company translates its investments into earnings growth. So that investor must treat the relationship between investment and growth carefully. • DCF models commonly underestimate the investment necessary to achieve an assumed growth rate. • Improper reflection of other liabilities. Most liabilities, including debt and many pension programs are relatively straightforward to determine and reflect in the model. Some other liabilities like employee stock option are trickier to capture. Not surprisingly most analysts do a very poor job capturing these liabilities in an economically sound way. • Discount to private market value. The discount to private market value model lacks sufficient transparency because it conflates the base and synergy cash flows. • Double counting. Models should not count a rupee of value more than once. Unwittingly, DCF models often double count the same source of value. • Scenarios. Probably the most often cited criticism of a DCF model is that small changes in assumptions can lead to large changes in the value. Because of such errors, they have commented that an investor must ensure the models are economically sound and transparent to apply DCF models to the real world. Drury and Tayles (1997) argued uses and limitations of DCF analysis in different view. They have done a survey on application of DCF method based on 886 UK manufacturing organizations. On that survey they have identified companies are under investing because of the misapplication and misinterpretation of DCF techniques. That survey showed smaller organizations place less emphasis on formal appraisal techniques and staff responsible for making capital investment decisions are likely to be involved in the invitation process. Hence they will have detailed “knowledge of the business” and intuitive managerial judgment. The survey findings also indicated that non-discounting methods continue to be used by both smaller and large organizations. Firms are guilty of rejecting worthwhile investment because of the improper treatment of inflation in the financial appraisal. Inflation affects both future cash flows and the cost of capital that is used to discount the cash flows. It must be noted also that inflation is likely to affect different components of cash flows in different ways. Inflation also affects the cost of capital because investors require higher monetary returns to compensate for inflation. The correct treatment of inflation requires that we compare like with like in the financial appraisal. Thus real cash flows should be discounted at a real discount rate or nominal rate. In order to ascertain how inflation was dealt with in financial appraisal they asked from the respondent to specify whether real or money discount rate used to discount the cash flows. In that case 49% of respondent were understating the IRR by using current or real cash flow estimates to compute the IRR and then comparing the resulting return with a normal discount rate. Results were almost similar to largest and smallest organizations. Therefore it is important to ensure that inflation is dealt with correctly in financial appraisals. Another misapplication of DCF analysis is uses of excessive discount rate uses for investment appraisal. During that period there was a debate on UK companies for using high discount rates to appraise investment and as a result these companies in danger of under investing. According to their survey, they have identified approximately 50% of respondents are using nominal and real discount rate more than 19%. It showed majority of respondents use rate significantly in excess of those calculated above for average risk projects. These findings show that many companies in UK were using excessively high discount rates. In case of Advanced Manufacturing Technological (AMT) investments, different researchers are having various ideas. Because AMT investments generate more benefits on financial and non financial terms as well. Benefits like quality improvement, manufacturing flexibility, higher level of customer service and delivery, shorter lead times and greater product innovations cannot be quantify are distorted by the DFC analysis. It means that investment in AMT projects are often fails because of non financial benefits which are difficult to quantify or either understated or frequently omitted. Kaplan (1986) argued that conventional DCF method should be used to evaluate investments based on the financial data available. He also stated that if the net results of the cash flows results in a negative NPV, then it becomes necessary to estimate how much the annual cash flows must increase before the investment does give a positive net present value. Kaplan goes on to argue that the management must then decide if the value of the intangible benefit will be greater than this figure. If the answer is yes, then he project would meet the criteria for acceptance. But Meredith & Suresh’s (1986) argument was financial appraisal methods used by industry to evaluate investments may be inappropriate on their own for today’s high technology business environment, since they fail to capture many of the strategical benefits from important AMT projects. Therefore he suggested three stages appraisal techniques. It can be identified as 1. Flexibility, 2. High level of risk and 3. Synergy of Flexible Manufacturing Systems. Flexibility can be identified by way of conventional investment appraisal techniques and at the second stage company must sue techniques such as value analysis, portfolio analysis and risk analysis. Final stage requires a more strategic justification. Bromwich & Bhimami (1991) had a different approach for the appraisal of AMT projects. In their approach, they attempted to quantify either financial terms or score values of benefits of investing in AMT. Still there is no specifically developed technique to appraise AMT projects. Different researchers have been developed different models for appraising AMT projects. Even though there are different models, different arguments still managers are compel to use DCF analysis for their investment decisions. According to the past survey carried out by Lawrence, Gary & Williams (1978) inquired about the capital budgeting techniques employed by large US firms and computation of the discount rate and cash flows. Of those responding firms indicating that a discount rate is applied. 65% of the respondents were applied IRR and 56% uses NPV method. Over 86% of the respondents use either IRR or NPV or both. Another survey carried out by Pike (1996) on capital budgeting practices of large UK companies between 1975 and 1992 reported a substantial increase in the usage of discounted cash flow. According to survey he has identified 75% and 81% UK firms are applying NPV and IRR respectively. In a recent study carried out by the McIntosh (1993) to ascertain whether or not DCF technique is used by property investors as an investment decision making tool among the major property investors in Australia. It was reported that 75% of the respondents always use DCF and 25% usually use DCF analysis in the valuation of properties over $25 million. The survey carried out by the Sangster (1993) among the 500 largest Scottish companies to ascertain currently used techniques for capital investment appraisal. His findings indicated that companies are using several appraisal methods together, and application of discounted cash flow techniques is becoming more sophisticated. Although the survey does not directly indicate the use of DCF techniques for valuing property investments, it does suggest that the DCF technique of appraising investment is an accepted and widely used method by investment appraisers Due to these research findings we can identify there is an ongoing debate among managers for using DCF analysis for their investment decisions. And there is an unfilled gap for the uses of DCF analysis.
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