Individual Assignment: The Methods of Evaluating Proposed Investment Projects

Part A

Managers often face a problem of choosing among several mutually exclusive projects proposed for the company’s future development, expansion, replacement of fixed assets, modernisation, or other purposes. In order to make the choice, managers apply various appraisal techniques based either on projected profitability of alternatives or their future cash flow patterns. This part of the paper will compare two methods of evaluating proposed investment projects: the first one devoted to profitability criteria (accounting rate of return) and the second one implying time value of money (a combination of net present value NPV and simple and discounted payback tools, i.e. the Cash Payback Method). Further, the paper will review them in more detail with relevant examples and assess which of the ways better suit for the management’s decision-making process.

Determination of the accounting rate of return is considered to be one of the fastest and easiest ways to evaluate a project that is the main advantage of this technique. Basically, one needs to compose the company’s income statements assuming implementation of each project separately or in a combination (if they are not mutually exclusive) and implement the following formula to projected financial results:

ARR = (P – D) / (I + S) / 2;

where ARR is the accounting rate of return, P is projected profit of a company (obtained from application of the evaluated project), D is depreciation of the project, I refers to initial investment into the project, and S is possible residual value of the project’s assets after they are fully depreciated or the project is completed (Hill 2008).

In order to illustrate implementation of the ARR method, one can assume that the company’s management needs to choose between two mutually exclusive projects with equal initial investment of USD 1,000. Project 1 will provide annual profits of USD 300 over the next five years and end up with zero residual value. The project’s depreciation will amount to USD 1,000 / 5 years = USD 200. Project 2 is supposed to generate annual profits of USD 400 and be completed in three years with residual value of USD 70. Here, the depreciation equals to USD (1,000 – 70) / 3 years = USD 310. Accounting rates of return for these alternatives are computed as follows:

ARR (Project 1) = (USD 300 – USD 200) / (USD 1,000 – USD 0) / 2 = 20.00 %;

ARR (Project 2) = (USD 400 – USD 310) / (USD 1,000 – USD 70) / 2 = 19.35 %.

Thus, one can note that both projects have virtually the same accounting rates of return. However, if the company is able to finance only one of them or projects exclude each other by their nature, then ARR criteria propose to choose project 1 and reject project 2. Besides, ARR of both projects need to be compared to some specified rate of return generally required by the management. For instance, if the company usually generates 25% on its other projects, then both of the alternatives should be rejected, whereas if the standard acquired returns are above 20%, then any of the projects is acceptable for the management. Nonetheless, it is recommended to conduct further analysis of both projects for the following reasons: project 1 will be realised over a longer period of time that makes future projected profits less certain than those of project 2; and the method does not incorporate evaluation of cash flows from the projects that might differ from the accrued profits significantly. In fact, accrual basis of used accounting profits for the ARR method is referred to as its main drawback, while it provides a large space for management judgements in application of accounting policies.

A much more comprehensive and complex analysis can be performed using discounted cash flows of the projects. This method allows evaluating the actual cash position (or some derivative of it) that can be provided by the project’s implementation. Discounting refers to the process of obtaining current values of future money movements. While a company always has a choice of simply putting money today on a deposit account and obtaining at least interest in the future, time plays an important role for assessment of the project’s cash flows. Therefore, a range of decision makers employ such tools of discounted cash flow analysis as net present value and payback period techniques.

Net present value method requires calculation of the sum of all discounted net cash flows from the project and subtracting the initial investment amount from it. There are several points of special consideration when the company’s management intends to apply this technique. First, they need to compute future cash in- and outflows very accurately so that not to include non-cash items into the sums. Second, enormous attention should be paid to the choice of the discounting rate. Usually, companies choose weighted average cost of capital (WACC) that is the average rate a company pays for financing its business in form of external debt (e.g. interest on bank loans) or equity capital (e.g. dividends or other pay-outs to investors) (Brigham & Ehrhardt 2011). Other types of discounting rates might include market bank interest rates, yield on company’s shares, or any other budgeted rate of return chosen by the management in consistency with risk levels related to the evaluated alternatives (Arshad 2012). Besides, it is important to use the same rate for discounting cash flows of all alternative projects.

Using the same example as for the ARR method, one can assume that project 1 provides net cash inflows of only USD 75 over the first two years and USD 450 over the past three years, while project 2 has the same cash pattern as its net profits, i.e. it generates USD 400 over all three years plus additional USD 70 at the end of year 3 (after the sale of its assets for their residual value). Both projects are discounted using the company’s chosen rate of return equal to 12%. It is to remember that initial investment for the projects is USD 1,000. Hence, the following calculations for the alternatives are given below:

Project 1.

Discounted cash flows for years 1 and 2 = USD 75 / (1 + 12 %) ^ 1 + USD 75 / (1 + 12 %) ^ 2 = USD 126.75;

Discounted cash flows for years 3 to 5 = USD 450 / (1 + 12 %) ^ 3 + USD 450 / (1 + 12 %) ^ 4 + USD 450 / (1 + 12 %) ^ 5 = USD 861.63;

NPV (Project 1) = USD 126.75 + USD 861.63 – USD 1,000 = - USD 11.62.

Project 2.

Discounted cash flows for years 1 to 3 = USD 400 / (1 + 12 %) ^ 1 + USD 400 / (1 + 12 %) ^ 2 + (USD 400 + USD 70) / (1 + 12 %) ^ 3 = USD 1,010.56.

NPV (Project 2) = USD 1,010.56 – USD 1,000 = + USD 10.56.

Thus, there has been obtained negative net present value for project 1 and positive value for project 2. The NPV rule requires to reject alternatives with negative NPV values and accept those with the positive ones (Ross, Westerfield & Jordan 2010). Hence, using the NPV criteria, there are opposite results to the ARR method as it is necessary to refuse now from project 1 and give a chance to project 2. Although this seems a bit ridiculous as project 1 generates in total USD 1,500 over 5 years when project 2 provides only USD 1,200 in the next 3 years, there is a strong logic behind such decision. Cash inflows from the first project are minor in years 1 and 2 when they are much more certain and predictable and are consequently more worthy for the company. At the same time, project 2 generates equal cash inflows over its life, including the very first year of its implementation. This provides more certainty and value to the project in terms of time.

What is more, obtained inference can be supported by analysis of simple and discounted payback periods of the two projects. This technique implies calculation of the number of years needed to return the initial investment to a company. Simple or cash payback method involves not discounted cash flows of the projects. Thus, for project 1 one can see that the initial investment of USD 1,000 will be recovered by year 1 (USD 75) + year 2 (USD 75) + year 3 (USD 450) + some portion of year 4 (USD 450). After years 1 to 3, there is a need to cover remaining USD 1,000 – USD 75 – USD 75 – USD 450 = USD 400. Consequently, the portion of year 4 equals to USD 400 / USD 450 = 0.89. Hence, the project will be “paid back” in 3.89 years or 3 years 10 months and 20 days. Analogously, the payback period for project 2 will be determined as follows: initial investment of USD 1,000 minus year 1 (USD 400) minus year 2 (USD 400) minus some portion of year 3 (USD 470). In year 3, the initial investment will be recovered in: (USD 1,000 – USD 400 * 2) / USD 470 = 0.43 years. Consequently, the payback period of project 2 is 2.43 years or 2 years 5 months and 3 days, which is much shorter than for project 1 and, thus, more preferable for the company.

To conclude, it is essential to underline that both NPV and cash payback methods support the choice of project 2 based on actual cash flows and time value of money the company will receive from the alternatives. It can also be noted that the use of discounted payback period that is calculated based on discounted cash flows is unnecessary in this case as project 1 generates negative NPV and, thus, will not be paid back with discounted cash flows. Discounted cash flow technique is a more accurate tool for determination of the best choice between several proposed projects when compared to the accounting rate of return, while the latter considers only accounting profit on accrual basis that can be easily manipulated with the help of accounting and credit policies of the company. Still, it is better to implement both techniques in the analysis as the NPV method does not take into account profitability of the projects when compared to the investors’ expected returns.

Part B

Fama (1991) concluded that “security prices fully reflect all available information”. This statement completely redefined understanding of the capital market behaviour. Since then, a wide range of articles and theories have been published that either confirm or criticise the Fama’s view. However, none of them has fully approved or rejected the hypothesis of efficient markets. At the same time, actual behaviour of securities markets provides a strong support for this theory as the markets develop and fewer opportunities are left available for speculations and generation of abnormal returns.

Efficiency of capital markets is now one of the most popular assumptions used by financial specialists in both theoretical and practical implications. The theory implies that prices of securities traded on capital markets immediately and fully incorporate all available information and change respectively (Ross, Westerfield & Jordan 2010). In fact, this notion relies on the hypothesis that asset prices on the stock market change unexpectedly or follow a random walk and their movements are not interrelated or there is no or very low autocorrelation among the prices. Besides, such nature should ensure that it is impossible to make abnormal returns in the securities market as none of the assets are over- or under-priced.

Supporters of the efficient market hypothesis prove its strength by the existence of a high level of competition in capital markets. They believe that a wide range of trading specialists operating in the market continually analyse all available information every moment in time and react to any news immediately by changing the assets’ prices. This automatically affects the whole market and, thus, prices of securities tend to always incorporate the latest information.

Still, even followers of the theory of efficient stock markets recognise that there are three forms of efficiency: weak form, semi-strong form, and strong form. This occurs due to different levels of development of stock exchanges around the globe. Weak form efficiency assumes that current stock prices are affected by their historical behaviour. Thus, everyone in the market is able to predict securities quotes based on relevant previous prices and, therefore, there is no or little space for excess returns of individual traders. Semi-strong form of efficient markets assumes that only information made public is reflected by current prices immediately. Most securities markets now are believed to have semi-strong form as the quotes react very fast to any important news. However, it also often happens that prices of securities either have a delayed reaction (i.e. it takes up to several hours or days till a quote changes) or overreact to the news in the first few hours or days due to circumspection of investors. Strong form efficiency is the most disputable one in the modern society as it implies that prices of securities immediately reflect both public and internal information available. Of course, new requirements to financial statements and other data that are made public have obligatorily reduced the gap between insiders and outside traders significantly. However, one should still recognise that, despite a wide range of ethical codes and external regulatory norms, there is always some portion of internal information used by insiders to trade more successfully in the market.

An important issue is that the efficient market hypothesis relies on several assumptions, which can be easily criticised by practitioners. According to Esch et al. (2005), these assumptions include:

• Rational behaviour of traders and other economic agents in the financial market. This means that traders buy and sell in accordance with their level of risk aversion to maximise their expected utility of wealth and, thus, do not obtain excessive returns based on the accepted risk. Besides, this implies that economic agents employ all available information and act purely in accordance with constructed financial models of projected stock movements. The assumption can be easily criticised by the fact that all people are human and cannot act purely rationally by nature. There is always space for some irrationality in behaviour of traders as well. Besides, large market players might and have the ability to artificially misprice some stock for a certain period of time to attain their own goals. This would seem irrational and, thus, unexpected in the market for most investors appear to be too reasonable to be speculators.
• Availability of all information to everyone in the capital market simultaneously. It is expected that everyone will react in accordance with released information immediately. It has become much easier to provide information simultaneously to all market players with the development of the Internet technologies. Still, there remains a good portion of internal information made available only for insiders or provided to them earlier than to outside investors. Moreover, the human nature of prudent investors makes market players overreact to bad news and delay reaction after learning the good ones. This leads to an inadequate and postponed reaction even once information is made public for everyone.
• The information has zero cost for investors. The assumption can easily be broken by the existence of insider information and readiness of outsiders to pay sometimes enormous amounts for it. Moreover, even public information is not always accepted free of charge. There is a wide range of online databases and analytical reviews that require a fee for registration, while hard and soft copies of journals and magazines containing important data on companies are also not provided for free.
• Zero transaction costs and zero taxes in the capital market. Transaction costs in the securities market relate to fees and charges required by stock exchanges for registration, as well as by brokers for conducting trading operations. While these fees are minor when compared to the volume of everyday trading, they still exist and, thus, have to be at least covered by investors’ returns. Moreover, trading profits are subject to income taxes in all countries that have rather high rates in some places. Thud, for now it is impossible to assume zero costs in the capital market, which makes them less than perfectly efficient everywhere.
• Perfect liquidity of the capital market. This assumption can be easily observed in practice on large world stock exchanges where financial assets are traded freely. Nonetheless, there exist some restrictions even in developed capital markets. First of all, there are large market players such as banks, funds, and insurance companies that hold significant interest in most notable companies and do not trade them every day. Moreover, liquidity of the real estate market is naturally not very high. Finally, there are over-the-counter markets that are still not highly liquid when compared to organised stock exchanges.

In general, the theory of market efficiency is a strong and useful hypothesis in projecting capital market movements. In spite of existing criticism, this theory works in practice better as stock markets develop. Modern financial specialists also complement this hypothesis with issues from behavioural finance, which makes the theory more practicable in action (Tapiero 2004). Psychological studies have created valuable models for financing and investment decisions. This has significantly extended understanding of the notion of rational behaviour of investors and provided explanation for a deferred response on available information in the capital market.

However, it is necessary to recognise that in practice market efficiency cannot be attained in full due to insider trading activities and information asymmetry. There will always be some portion of non-zero returns accessed by the most proficient traders and lucky insider investors. Moreover, the latest financial crisis of 2008 has demonstrated considerable inefficiency of the capital market when it comes to innovative financial instruments and speculative bubbles.