Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management.
Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organizations?
According to Atrill and McLaney (2013a), investment decisions (ID) are typically concerned with significant amounts of resources and cannot be called back. ID is a costly and risky business, which is why back-of-the-envelope calculation or intuition are inadequate approaches to it.
Nowadays, there are different methods of making an ID. Atrill and McLaney (2013) focus on four approaches of investment appraisal which can and tend to be used by any business type. The accounting rate of return (ARR) represents the future profit from the ID divided by the investment and expressed as the percentage of the latter. The minimum ARR is set by the analyst. The payback period (PP) method considers the time that a project takes and requires that it does not exceed a certain limit. These two methods are popular and easy to use but have numerous limitations (for example, arbitrary point of comparison) and do not take into account shareholder’s wealth.
The net present value (NPV) method demands that an ID has a positive NPV that is calculated from the net cash flows, which are discounted to determine their present value. The internal rate of return (IRR) method is based on finding IRR: the rate, at which the cash flows of a project have zero NPV. Better projects have greater IRR. These two methods are considered superior, but IRR still does not relate to shareholders’ wealth. NPV is regarded as the best option: it considers all the relevant information.
Atrill and McLaney (2013) do not enumerate all the existing approaches. For example, Costa and Paixão (2010) describe the scenario method and create a model that attempts to predict the possible outcomes by suggesting that several variables can influence them. While this approach allows making more informed ID, it is more difficult to carry out. Also, Carmichael (2011) offers a new method based on the Markov model that can be used to define the probability of events. It has a number of limitations and assumes that the future depends only on the present state of an event. Admitting this, Carmichael (2011) suggests combining approaches, complementing them to make their limitations less significant for the process of decision-making. Atrill and McLaney (2013) also point out that businesses tend to use several methods for one ID. This comprehensive approach may be not favored by every business, but it appears that ID should depend on the investment option more than on the type of organization. For a crucial decision, the comprehensive approach may be most suitable.
The specific methods of an investment appraisal should be used by an organization to fit its needs and the requirements of a particular ID. I suppose that no business type should abstain from using an appropriate ID method. Small enterprises may operate scantier amounts of resources, but large losses are likely to be more dangerous for them. On the other hand, the bigger the enterprise, the more is at stake. Therefore, it seems illogical to make uninformed IDs, especially since there exists a variety of investment appraisal methods including the emerging ones and those that have not been mentioned here.
Atrill, P & McLaney, E 2013, Accounting and finance for non-specialists, 8th edn, Pearson Learning Solutions, New York.
Atrill, P & McLaney, E 2013a, Accounting and finance for non-Specialists PowerPoints on the Web: Chapter 10.
Carmichael, DG 2011, ‘An Alternative Approach to Capital Investment Appraisal’, Engineering Economist, vol. 56, no. 2, pp. 123-139.
Costa, A & Paixão, JM, 2010, ‘An approximate solution approach for a scenario-based capital budgeting model’, Computational Management Science, vol. 7, no. 3, pp. 337-353.