Question

Analyze why, despite employing various investment appraisal techniques, large investment projects in big corporations may fail to deliver their estimated cash flows. Critically assess how a failed capital project may affect key stakeholders and shareholder value, and also shape the future strategy of investment capital.

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Answer 1

1. Payback Period Method:

The payback period is usually expressed in years, which it takes the cash inflows from a capital investment project to equal the cash outflows. The method recognizes the recovery of original capital invested in a project. At payback period the cash inflows from a project will be equal to the project’s cash outflows.

This method specifies the recovery time, by accumulation of the cash inflows (inclusive of depreciation) year by year until the cash inflows equal to the amount of the original investment. The length of time this process takes gives the ‘pay-back period’ for the project. In simple terms it can be defined as the number of years required to recover the cost of the investment.

In case of capital rationing situations, a company is compelled to invest in projects having shortest payback period. When deciding between two or more competing projects the usual decision is to accept the one with the shortest payback.

Payback is commonly used as a first screening method. It is a rough measure of liquidity and rate of profitability. This method is simple to understand and easy to apply and it is used as an initial screening technique. This method recognizes the recovery of the original capital invested in a project.

2. Accounting Rate of Return Method:

The accounting rate of return is also known as ‘return on investment’ or ‘return on capital employed’ method employing the normal accounting technique to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage of that capital investment.

The method does not take into consider­ation all the years involved in the life of the project. In this method, most often the following formula is applied to arrive at the accounting rate of return.3. Net Present Value Method:

The objective of the firm is to create wealth by using existing and future resources to produce goods and services. To create wealth, inflows must exceed the present value of all anticipated cash outflows. Net present value is obtained by discounting all cash outflows and inflows attributable to a capital investment project by a chosen percentage e.g., the entity’s weighted average cost of capital.

The method discounts the net cash flows from the investment by the minimum required rate of return, and deducts the initial investment to give the yield from the funds invested. If yield is positive the project is acceptable. If it is negative the project in unable to pay for itself and is thus unacceptable. The exercise involved in calculating the present value is known as ‘discounting and the factors by which we have multiplied the cash flows are known as the ‘discount factors’

4. Internal Rate of Return Method:

Internal rate of return (IRR) is a percentage discount rate used in capital investment appraisals which brings the cost of a project and its future cash inflows into equality. It is the rate of return which equates the present value of anticipated net cash flows with the initial outlay. The IRR is also defined as the rate at which the net present value is zero.

Profitability Index Method:

It is a method of assessing capital expenditure opportunities in the profitability index. The profitability index (PI) is the present value of an anticipated future cash inflows divided by the initial outlay.

The only difference between the net present value method and profitability index method is that when using the NPV technique the initial outlay is deducted from the present value of anticipated cash inflows, whereas with the profitability index approach the initial outlay is used as a divisor.

In general terms, a project is acceptable if its profitability index value is greater than 1. Clearly, a project offering a profitability index greater than 1 must also offer a net present value which is positive. When more than one project proposals are evaluated, for selection of one among them, the project with higher profitability index will be selected.

5. Discounted Payback Period Method:

In this method the cashflows involved in a project are discounted back to present value terms as discussed above. The cash inflows are then directly compared to the original investment in order to identify the period taken to payback the original investment in present values terms.

This method overcomes one of the main objections to the original payback method, in that it now fully allows for the timing of the cashflows, but it still does not take into account those cashflows which occur subsequent to the payback period and which may be substantial.

The method is a variation of payback period method, which can be used if DCF methods are employed. This is calculated in much the same way as the payback, except that the cashflows accumulated are the base year value cashflows which have been discounted at the discount rate used in the NPV method (i.e., the required return on investment).

Thus, in addition to the recovery of cash investment, the cost of financing the investment during the time that part of the investment remains unrecovered is also provided for. It thus, unlike the ordinary payback method, ensures the achievement of at least the minimum required return, as long as nothing untoward happens after the payback period.

6. Terminal Value Method:

Under this method it is assumed that each cashflow is reinvested in another project at a predetermined rate of interest. It is also assumed that each cash inflow is reinvested elsewhere immediately until the termination of the project. If the present value of the sum total of the compounded reinvested cashflows is greater than the present value of the outflows the proposed project is accepted otherwise not.