Question Dear Sir,
I m pursuing MBA from IGNOU. It will really be helpful if you could kindly reply the question below:
critically analyse the various methods used for evaluating investment proposals?
Answer VIDYA,
HERE IS SOME USEFUL MATERIAL.
REGARDS
LEO LINGHAM
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Evaluation Methods or Techniques Used.
The evaluation or techniques used are the simple measures consisting of Payback Period and the Return on Funds employed [ROFE] and the time adjusted, measures consisting of the Internal Rate of Return [IRR], Net Present Value [NPV] and Present Value Index [PVI].
Evaluation Methods Proven Effective .
The time adjusted measures were efficient, however the companies also relied on the simple measures. Based on the type of budget and magnitude of expenditure, decisions were made using the cited measures.
1.Payback Period
The advantages were:
Simple to calculate
Universally understood indicator of liquidity and risk; the sooner an investment is recovered, the shorter the period of uncertainty regarding its worth.
The disadvantages were:
Fails to consider project profitability or economic efficiency since it stops analysis with recovery of investment.
Fails to consider the time value of money.
2.Return on Funds Employed (ROFE)
The advantages were:
Simple to calculate
Places emphasis on profitability, rather than liquidity.
The disadvantages are:
Essentially an averaging technique
Fails to consider the time value of money.
3.Internal Rate of Return (IRR)
The advantages were:
It is conceptually superior to Payback Period and ROFE methods
Does not ignore any periods in the project life or any cash flows
Takes into account the time value of money
Yields a percentage that management can examine and make judgment about when cost of capital is not known with confidence.
Favors early cash flows over late ones.
The disadvantages were:
Requires an estimate of the organization's cost of capital, or at least a range of values in which it is likely to be found
Is much more difficult to apply without a computer than payback period or ROFE and when cash flows are non uniform, much more difficult to apply than the net present value method.
Does not distinguish between projects of different size and/or different economic lives.
Often yields multiple, thus ambiguous results when there is more than one sign change in the cash flows.
Implicitly assumes that cash flows may be reinvested at a return equal to IRR.
4.Net Present Value (NPV)
The advantages were:
Is conceptually superior to Payback Period and ROFE
Does not ignore any periods in the project life nor any cash flows
Takes into account the time value of funds
Is easier to apply than the IRR since it involves evaluating a polynomial rather than finding a root
Favors early cash flows than late ones.
The disadvantages were:
Requires that the organization has an estimate of its cost of capital
Is more difficult to apply than payback and ROFE, and thus less suitable for use by lower levels in the organization without proper training in its application
Gives a distorted comparison between projects of unequal size and/or unequal economic lives, unless modified by conversion to uniform annual equivalent and converted to profitability index.
5.Present Value Index (PVI)
The advantages were:
Provides ready comparability between investment proposals of different magnitudes
Provides a ranking or prioritization of projects.
The disadvantages are:
Expresses only relative profitability
Requires knowledge of the firm's cost of capital.
The present methods of evaluation ranked in the order of efficiency are:
1.Net Present Value (NPV)
2.Internal Rate of Return (IRR)
3.Return on Funds Employed (ROFE) and Payback Period
4.Present Value Index (PVI)
5.Others i.e. Economic Value Added (EVA), Cost Benefit Analysis (CBA), and Free CashFlow Shareholder Value (FCF SV)
The specific objective of selecting the most suitable method given specific capital investment proposals, was likewise achieved. Since all the measures were used simultaneously on all capital projects it was deemed that the measures were all suitable, except on projects involving land acquisitions, and emergency items.
