Investtnent Appraisal Techniques in British Enterprises

HuiHui ChenLongji Xue Cheng

This thesis will assess applications of various investment appraisal techniques in British enterprises. Investment evaluations are conducted to appraise the feasibility of projects, plans and investment portfolio as well as their potential values. From the perspective of business cases, the main purpose of investment evaluations is to gain rational definite values via investing. Excellent investment evaluation techniques are significant for British companies in dealing with increasingly complicated problems, especially British growing companies (Akalu 2001). Sangster (1993) found out that these enterprises were evaluating investment projects via multiple techniques. He compared investigations of the top 500 enterprises in Scotland and Although the best investment technique hasn' t been determined, enterprises shall adopt suitable investment techniques according to different backgrounds, resource endowments and time. This paper will discuss investment evaluation techniques including accounting rate of return method (hereinafter referred to as ARR), payback period method (hereinafter referred to as PPM), discounted cash flow (hereinafter referred to as DCF), net present value (hereinafter referred to as NPV) and internal rate of retum (hereinafter referred to as IRR).

To begin with, I would like to discuss two investment appraisal techniques that do not take time to value. The first one is Accounting Rate of Return (ARR), ARR refers to the average annual net income ratio of projects' initial investments. Besides, the investment plan with the higher accounting rate of return will be selected (Fisher and McGowan,1983). The advantage of ARR lies in its simple calculations of profitability and understandable conceptions. In addition, it is based on data from financial reports which can be easily obtained. Moreover, it takes all profits gained during projects' entire life cycles into consideration. Thus, this method demonstrates financial reports' changes after a project is accepted. Managers are aware of performance expectations via ARR which facilitates post-evaluations of projects (Akalu,2001). In the meantime, there is no doubt that ARR is not perfect. For example, instead of cash flows, it is based on paper profits. Hence, it ignores not only depreciation' s influences on cash flows but also influences of time distribution of net income on projects'economic values. Because of its inaccuracy, less and less commercial organizations applied this method (Drury& Tayles, 1997). Additionally, Chadwell(1996) discovered that 91% of British companies used ARR in evaluating investment projects. Furthermore, Lefley and Sarkis (1997) found that ARR was more preferable in small companies than in large enterprises.

The second one is Payback Period Method (PPM) is a static financial performance analysis method that compares the period of time required to recoup the funds expanded in an investment by calculating incomes, accrued depreciation amounts and the amortization of intangible assets under normal production and management to the payback period of the industry benchmark. Moreover, in terms of advantages, PPM with easy calculations is easy to understand. Nevertheless, PPM has certain limitations as well (Keown, Martin and Petty, 2013). Firstly, PPM weights cash flows of different periods equally. However, it doesn' t take time values of the capital into consideration. Secondly, it only pays attention to cash flows' contribution to investment benefits within the period. Nevertheless, it doesn' t think about its contributions to investment benefits after the period ends. Thirdly, standards of indexes of PPM are more subjective. Additionally, this method is applied by54% of British companies (Lefley, 1997). Furthermore, research shows that PPM is more frequently iised than any of the DCF technology (Sangster, 1993).

The next will to discuss the investment appraisal techniques is to consider the value of time. Firstly, Discounted Cash Flow (DCF) is applied to evaluate the attraction of investment opportunities. Besides, it is the current value discounted from cash flows of a certain year in the future. DCF, which was also referred to as the Rappaport Model, was first put forward by Alfred Rappaport at Northwestern University in America (Giles 2013). This method is used to determine the highest merger and acquisition value that is acceptable. Thus, incremental cash flows and discounted cash flows (or capital costs) resulting from the merger and acquisition shall be estimated. In other words, it refers to the lowest but acceptable rate of return of the new investment required by the market. DCF realized that tomorrow' s pound is more valuable than that of today because its opportunity cost is connected with current unpayable risks (Akalu, 2001).

Also, DCF can be divided into NPV (Net Present Value) and IRR (Internal Rate of Retum) (Keef & Roush, 2001). On the one hand, NPV discounts future cash deposit and withdrawal into the current cash according to the discount rate calculated from marginal cost of invested capital. On the other hand, IRR discounts potential cash flows created in duration into cash according to certain discount rates so as to achieve equality between cash incomes and the cost of investment. Furthermore, taking net cash flows into consideration, it integrates mobility with profitability. In terms of investment risks, the higher the risk is, the higher the rate of return would be (Akalu,2001). Additionally, NPV reflects the amount of corporate appreciation (or depreciation) resulting from investments. However, NPV has its limitations. For instance, firstly, it takes great efforts to calculate net present values; secondly, it is hard to measure net cash flows and discount rates; thirdly, it cannot mirror the actual income levels of investment projects directly from the dynamic perspective (Akalu, 2011). Moreover, it is difficult to determine whether the project is profitable with unequal investment volumes. Therefore, it cannot reflect the actual profitability of investment projects (Arya et al, 1998). Moreover, the calculation of net present values depends on the volume of capital costs which are decided by corporate financing cost.ln other words, the profitability of an investment project cannot be directly reflected by net present values. For example, high corporate financing costs may lower the net present value of a project with strong profitability. Therefore, NPV cannot reflect relative benefits of investment projects. In addition, NPV evaluates investment projects from the perspective of net eamings of investments. Since it is an index of absolute value, it is not able to represent relative benefits of investment projects.

The essence of the internal rate of return is a discount rate which reduces net present values of corporate investments to zero. Moreover, sharing certain similar features with DCF, it is always used to replace DCF in practice. Being free from influences of interest rates of the capital market, IRR is completely decided by corporate cash flows. Thus, it reflects inherent internal characteristics of enterprises. However, IRR can only tell whether the evaluated enterprises are worthy of investing. Therefore, it is not helpful for investors in deciding how much money should be invested (Akalu, 2001). A survey shows that 72% of British companies adopt IRR and large- scale companies use it more frequently (Akalu, 2001).

To sum up, although researchers have conducted numerous experiments, they failed in finding an accurate and reasonable method that is suitable for all different situations (Collins & Baker 2005). In spite of the fact that a small number of researchers believe that NPV is better than IRR, most of them hold the opinion that methods shall be combined in investment evaluations.

In conclusion, there is no comprehensive method that is suitable for all situations and cases. Therefore, the best solution is choosing different techniques and invesLment evaluation models according to specific cases. Through the assessment of different investment appraisal techniques, when applying investment appraisal techniques in the future, investors need to make more efforts in evaluating projects according to different elements and various risks. Only in this way can they lay a solid foundation for actual development and profit assessment in the future.

(Author unit:1.The university of Kent;2.ChongQing Normal University Foreign Trade and Business College ; 3.Jiaxing University)