Project Appraisal Techniques

Topics: Net present value, Internal rate of return, Time value of money Pages: 7 (2564 words) Published: March 12, 2011
Project appraisal techniques are used to evaluate possible investment opportunities and to determine which of these opportunities will generate the best return to the firm’s shareholders. Therefore, it is vital for the firm if they wish to continue receiving funds from shareholders to employ the best techniques available when analysing which investment opportunities will give the best return. There are two types of project appraisal techniques: non-discounted cash flows and discounted cash flows. The Net Present Value and internal rate of return, examples of discounted cash flows, are in use in many large corporations and regarded as more effective than the traditional techniques of payback and accounting rate of return. In this paper, I will examine the use of the Net Present Value, and the provisions it makes for specific cases, such as unequal lives and mutually exclusive projects. Then I will conclude with the technique that has been proved the best for investment appraisal through the analysis and comparison of project appraisal techniques.

The Net Present Value (NPV) method is used by 75% of firms when deciding on investment projects. The reasons for its wide use is that firstly, the NPV rule takes into account the time value of money, meaning that it recognises that a pound today is worth more than a pound tomorrow as the pound today can be invested to start earning interest immediately. Secondly, NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital. And the final reason for its preference is because the present values are all measured in today’s pounds they have the property of additivity. This property is important as it helps managers to not be misled into accepting a low NPV project just because it is packaged with a high NPV project (Brealey and Myers 116-19). Other reasons for this widely used technique by managers are that it facilitates the managers’ work since the NPV calculation includes many of the aspects which must be evaluated by managers separately if they were to use the other investment appraisal methods. Also, the NPV rule reflects the marginal return on the investment equal to the rate of interest on equivalent financial investments in the capital market allowing managers a facilitated comparison. Although the Net Present Value provides many advantages some extensions were made in order to include the special cases of unequal lives and mutually exclusive projects. Unequal lives

The Net Present Value method is extended in the circumstance of unequal lives which is often referred to as the `horizon’ problem (Solomon) . This problem arises when alternative investment projects have different lives, which has been the subject of much dispute. Unequal lives do not arise in independent projects, but can arise for mutually exclusive projects; but even in these cases it is unsure whether it is appropriate to extend the analysis to a common life. And it has been disputed that the extension should only be done if there is a high probability that the projects will actually be repeated at the end of their initial lives (Brigham and Houston 424-26).

The first solution proposed was the replacement chain approach. Those who are in favour of this method often argue that the cash flows of a project are realized earlier than those of another project so this gives the firm extra time to reinvest the money. This argument is not valid because a firm can always raise money at a specified rate, independent, of the project it wishes to execute. However there are three exceptions to this rule (Hirschleifer): when the investments are closely related to the project, when the projects use the same physical resource, and where replication is obvious. Calculating mutually exclusive projects with different lives can be very complex. For example, if one project has a 5 year life versus one with a 20 year life, it would require a replacement chain analysis over twenty...

Cited: Brealey, Richard A. and Steward C. Myers. Principles of Corporate Finance. McGrawHill-Irwin, 2009.
Brigham, Eugene F. and Joel Houston. Fundamentals of Financial Management. Cengage Learning, 2007.
Dorfman, R. “The Meaning of Itnernal Rates of Return.” Journal of Finance (1981).
Drury, Colin. Management and Cost Accounting. Cengage Learning, 2008.
Hirschleifer, Jack. “On Theory of Optimal Investment Decision.” Journal of pOlitical Economy (August 1958).
Lumby, Steve and Chris Jones. Corporate Finance: thoery and practice. Cengage Learning, 2003.
Pike, Richard and Bill Neale. Corporate Finaance and Investment: decisions and strategies. Prentice Hall, 2008.
Solomon, Erza. “The Arithmetic of Capital Budgetting Decisions.” Journal of Business (April 1956).
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