…despite any shortcomings of particular techniques a company may wish to adopt, the importance of appraising projects before they are ever accepted cannot be over-emphasised. If this had been the norm rather than the exception, businesses collapse would not have been as rapid as we are witnessing today.
Usually, in a business environment, a lot of decision-making comes into play before money is invested in any project at all. Sometimes, the decisions taken reflect all considerations, both qualitative and quantitative.
Qualitative decisions are those that do not necessarily conform to measurement in terms of naira and kobo. Such decisions look critically at the economic climate, availability of personnel, the effect of government policy, the market environment in the usual demand and supply interplay, and others not easily quantifiable. Quantitative decisions, on the other hand, are those based on the amount of money that will be required to start, the returns expected from such operations, and the returns from other available projects, measured in terms of opportunity costs.
The sum total of quantitative and qualitative decisions finally culminates in embarking on a particular project, as against the other. Therefore, it behooves on decision-makers to ensure that they are satisfied with the line of action they finally take. This exercise is often regarded as project appraisal.
Project appraisal entails subjecting project opportunities to laid down criteria set by an organisation to select those that best satisfy such criteria. To this end, a ranking method is employed by which projects are graded in a descending order, with the best project coming first and others following in terms of quality. In the end, the best projects are selected subject, however, to the availability of funds, as in a capital rationing situation.
Briefly stated, capital rationing occurs in a situation whereby suitable investments exist but insufficient funds to carry them out. It could be a one-period capital rationing, not lasting for more than one accounting period or multi-period capital rationing that extends beyond one accounting period, and which may even occur intermittently.
Of course, It is not easy to determine which project best satisfies criteria until some analysis is carried out. As a result of the appreciation of this uneasiness, some techniques have evolved, which greatly assist in quantifying the financial effect of embarking on any project. These techniques will be briefly looked into in turn. The techniques that will be discussed are Accounting Rate of Return (ARR) or Return on Investment (ROI) or Return on Capital Employed (ROCE), payback period, and discounted cash flow techniques.
Accounting Rate of Return (ARR)
The accounting rate of return on investment or return on capital employed measures the accounting profit a particular project generates over its entire life. An average of this profit is found and compared with the initial sums invested; the percentage so derived will be to determine the profitability of such investment (project) or not.
The Accounting rate of return is usually calculated as follows:
(a) Average Accounting Return / Average Investment x 100
(b) Average Accounting return / Average Investment x 100
While Average investment return = Initial Investment + Residual value / 2
The residual value is the amount that will be recoupable at the completion of the project. It may, for instance, be the amount that machines used in the project will be sold as scrap at the completion of the project.
The accounting rate of return is easy to calculate and understand, even by a layperson. For instance, a company’s cost of capital is known; this is compared with ARR to determine profitability. In a situation where the cost of capital is higher than the ARR, that project is not profitable. For instance, a project with an APR of 10 per cent, as against a cost of capital of 12 per cent, points to unprofitability. The fact that should be noted here is that accounting profit does not include the cost of obtaining the funds.
Another advantage of using ARR is that information is readily available since it draws from the accounting records kept by the business. Even where estimates will be made, it is much easier to use the basic concept of price minus cost to arrive at a profit.
However, ARR has some shortcomings despite its simplicity. Although it considers projects throughout its entire life, ARR does not take into consideration the time value of money. Since future occurrence can hardly be predicted with certainty, coupled with rapid inflation time value of money becomes very relevant.
The expected profits to be earned in the future are mere projections which, perchance, may come to be. This is a limitation of forecasting. All the same, ARR provides an acid test in project appraisal.
The payback period is when a project will be required to recoup its initial outlay or investment, to be regarded as profitable. Using accounting profit and the returns or profit recorded in each year, is used to reduce the amount initially invested until such amount is completely recovered. For instance, a project that costs ₦100,000 to execute with profit in the year (1) one of ₦30,000, year two of ₦25,000, year three of ₦25,000, year four of ₦20,000, year five of ₦17,500, and year six of ₦15,000, will have four years as payback period.
But sometimes, the back period is maybe sometimes during the year. In such a situation, to actually determine the period will be as follows: For example, a project of ₦150,000 as the initial cost, with the following returns in years one to six, ₦40,000, ₦45,000, ₦47,000 ₦43,500, ₦37,500 will be calculated thus:
|Initial Investment||₦||Balance: ₦|
|Year 1 profit||40,000||110,000|
|Year 2 profit||45,000||65,000|
|Year 3 profit||47,000||18,000|
|Year 4 profit||43,500||25,500|
The payback period = three years + 18,000 / 43,500 X 12 = three years, five months.
The payback period is also straightforward to calculate and understand in that it does not require many complications. It does not require severe technicalities and, as such, can be easily used by anybody. When more than one project is considered, the project with the shorter payback period is the most profitable.
Another advantage of this technique is that it cushions the effect of uncertainty with future estimates, as projects with too long a payback period may not be considered.
There is, however, the need to have a standard timeframe that an organisation will regard as its average payback period. This is a challenging thing to decide.
It is also factual that cash flows are connected with the type of operations involved in, and hence ranking projects of different nature may be misleading. A poultry farmer will generate more early income than a plantation farmer and comparing them at the initial stage may be unjust.
Like everything human with shortcomings, the payback period, even at that, provides some valuable guidelines in project appraisal.
Discounted Cash Flow Techniques
These are techniques that take into consideration the time value of money. Projects utilising this technique are appraised, discounting the income generated at the company’s cost of capital rate. Primary methods under the technique are Net Present Value and Internal Rate of Return.
The Net Present Value (NPV) measures what a unit of naira today will be worth at a future date. The sum total of income generated will then be deducted from the amount initially invested to give the Net Present Value.
A positive NPV means that the project is profitable and hence should be accepted. In contrast, a negative NPV, on the other hand, points to an unprofitable project that should be rejected. However, a zero NPV means that the project is at the break-even point and as such, acceptance or rejection will depend on the decision maker’s attitude.
Internal Rate of Return (IRR) is used to determine the rate at which a project will be at zero point, i.e., at a break-even point, and any such projects that have a higher return are regarded as profitable
The most significant advantage of discounted cash flow techniques is that it takes into consideration the time and value of money. It also considers cash flow throughout the entire life of the project.
Between NPV and IRR, there can be some conflicts. However, results provided by NPV are more reliable as IRR itself uses trial and error techniques.
In conclusion, despite any shortcomings of particular techniques a company may wish to adopt, the importance of appraising projects before they are ever accepted cannot be over-emphasised. If this had been the norm rather than the exception, businesses collapse would not have been as rapid as we are witnessing today.
Bolutife Oluwadele, a chartered accountant and a public policy and administration scholar, writes from Canada. He is the author of Thoughts of A Village Boy andcan be reached through: email@example.com
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