Tuesday, October 19, 2010

(229)---CUT-OFF RATE

Cut-off Rate

In the implementation of a sophisticated project evaluation system, the use of a minimum required rate of return is necessary. The required rate of return or the opportunity cost of capital should be based on the riskiness of cash flows of the investment proposal; it is compensation to investors for bearing the risk in supplying capital to finance investment proposals.

Not all companies in Asian countries specify the minimum acceptable rate of return. Some of them compute the weighted average cost of capital (WACC) as discount rate. Unfortunately, all companies do not follow correct methodology of calculating the weighted average cost of capital (WACC). Almost all companies use the book value weights.

Business executives in Asian countries are becoming increasingly aware of the importance of the cost of capital, but they perhaps lack clarity about its computation. Arbitrary judgment of management also seems to play a role in the assessment of the cost of capital. The fallacious tendency of equating borrowing rate with minimum required rate of return also persists on the case of some companies. In USA, a little more than 50% companies have been found using weighted average cost of capital (WACC) as cut-off rate. In UK, only a very small percentage of firms were found attempting any calculation of the cost of capital. As in USA and UK, companies in Asian countries have a tendency to equate the minimum rate with interest rate or cost of specific source of finance. The phenomenon of depending on management judgment for the assessment of the cost of capital is prevalent as much in USA and UK as in Asian countries.

Monday, October 18, 2010


Methods of Project Evaluation

As regards the use of evaluation methods, most companies use payback criterion. In addition to payback and or other methods, companies also use internal rate of return (IRR) and net present value (NPV) methods. A few companies use accounting rate of return (ARR) method. Internal rate of return (IRR) is the second most popular technique.

The major reason for payback to be more popular than the discounted cash flow method techniques is the executives’ lack of familiarity with discounted cash flow techniques. Other factors are lack of technical people and sometimes unwillingness of top management to use the discounted cash flow techniques. One large manufacturing and marketing organization, for example, thinks that conditions of its business are such that the discounted cash flow techniques are not needed. By business conditions the company perhaps means its marketing nature, and its products being in seller’s markets. Another company feels that replacement projects are very frequent in the company, and therefore, it is not necessary to use the discounted cash flow techniques for such projects. Both these companies have fallacious approaches towards investment analysis. They should subject all capital expenditures to formal evaluation.

The practice of companies in Asian countries regards the use of evaluation criteria is similar to that in USA. Almost four-fifths of US firms use either the internal rate of return or net present value models, but only about one-fifth use such discounting techniques without using the payback period or average rate of return methods. The tendency of US firms to use native techniques as supplementary tools has also been reported in recent studies. However, firms in USA have come to depend increasingly on the discounted cash flow techniques, particularly internal rate of return. The British companies use both discounted cash flow techniques and return on capital, sometimes in combination sometimes solely, in their investment evaluation; the use of payback is widespread. In recent years the use of discounted cash flow methods has increased in UK, and net present value (NPV) is more popular than internal rate of return (IRR). However, this increase has not reduced the importance of traditional methods such as payback and return on investment. Payback continuous to be employed by almost all companies

One significant difference between practice in Asian countries and USA is that payback is used in Asian countries as a “primary” method and IRR/NPV as a “secondary” method, while it is just reverse in USA. Asian countries managers feel that payback is a convenient method of communicating on investment’s desirability, and it best protects the recovery of capital-a secure commodity in the developing countries.

Tuesday, October 12, 2010


Project Evaluation

The evaluation of projects should be performed by a group of experts who have no axe to grind. For example, the production people may generally interested in having the most modern type of equipments and increased production even if productivity is expected to be low and goods cannot be sold. This attitude can bias their estimates of cash flows of the proposed projects. Similarly, marketing executives may be too optimistic about the sales prospects of goods manufactures and overestimate the benefits of a proposed new product. It is, therefore, necessary to ensure that projects are scrutinized by an impartial group and that objectivity is maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of investment evaluation. The criterion selected should a true measure of the investments profitability (in terms of cash flows), and it should lead to the net increase in the companies wealth (that is, its benefits should exceed its cost adjusted for time value and risk). It should also be seen that the evaluation criteria do not discriminate between the investment proposals. They should be capable of ranking projects correctly in terms of profitability. The net present value method is theoretically most desirable criterion as it is a true measure of profitability; it generally ranks projects correctly and is consistent with the wealth maximization criterion. In practice, however, managers’ choice may be governed by other practical considerations also.

A formal financial evaluation of proposed capital expenditures has become a common practice among companies. A number of companies have a formal financial evaluation of almost three froths of their investment projects. Most companies subject more than 50% of the projects to some kind of formal evaluation. However, projects, such as replacement or worn-out equipment, welfare and statutorily required projects below certain limits, small value items like office equipment or furniture, replacement of assets of immediate requirements, etc., are not often formally evaluated.

Saturday, October 9, 2010


Developing Cash Flow Estimates

Estimation of cash flows is a difficult task because the future is uncertain. Operating managers with the help of finance executives should develop cash flow estimates. The risk associated with cash flows should also be properly handled and should be taken into account in the decision making process. Estimation of cash flows requires collection and analysis of all qualitative and quantitative data, both financial and non-financial in nature. Large companies would generally have a management information system providing such data.

Executives in practice do not always have clarity about estimating cash flows. A large number of companies do not include additional working capital while estimating the investment project cash flows. A number of companies also mix up financial flows with operating flows. Although companies claim to estimate cash flows on incremental basis, some of them make no adjustment for sale proceeds of existing assets while computing the project’s initial cost. The prevalence of such conceptual confusion has been observed even in the developing countries. For example, in the seventies, a number of UK companies were treating depreciation as cash flows.

In the past, most Indian companies chose an arbitrary period of 5 or 10 years for forecasting cash flows. This was so because companies in India largely depend on government owned financial institutions for financing their projects, and these institutions required 5 to 10 years forecasts of the project cash flows.

Tuesday, October 5, 2010


Identification of Investment Opportunities

Investment opportunities have to be identified or created; they do not occur automatically. Investment proposals of various types may originate at different levels within a firm. Most proposals of various types may originate at different levels within a firm. Most proposals, in the nature of cost reduction or replacement or process or product improvements take place at plant level. The contribution of top management in generating investment ideas is generally confined to expansion or diversification projects. The proposals may originate systematically or haphazardly in a firm. The proposal for adding new product may estimate from the marketing department or from the plant manager who thinks be a better way of utilizing idle capacity. Suggestions for replacing an old machine or improving the production techniques may arise at the factory level. In view of the fact that enough investment proposals should be generated to employ the firm’s funds fully well and efficiency, a systematic procedure for generating proposals may be evolved by a firm.

In a number of companies, the investment ideas are generated at the plant level. The contribution of the broad in idea generation is relatively insignificant. However, some companies depend on the board for certain investment ideas, particularly those that are strategic in nature. Other companies depend on research carters for investment ideas.

Companies use a variety of methods used are:
  • Management sponsored studies for project identification
  • Formal suggestion schemes
  • Consulting advice
Most companies use a combination of methods. The offer of financial incentives for generating investment idea is not a popular practice. Other efforts employed by companies in searching investment ideas are:
  • Review of researches done in the country or abroad,
  • Conducting market surveys,
  • Deputing executives to international trade fairs for identifying new products and technology.
Once the investment proposals have been identified, they are be submitted for scrutiny. Many companies specify the time for submitting the proposals for scrutiny.

Saturday, October 2, 2010


Capital Investment Planning and Control

At least five phases of capital expenditure planning and control can be identified:
  • Identification or origination of investment opportunities
  • Development of forecasts of benefits and costs
  • Evaluation of the net benefits
  • Authorization for progressing and spending capital expenditure
  • Control of capital projects
The available literature puts the maximum emphasizes on the evaluation phase. Two reasons may be attributed to this bias. First, this phase is easily amenable to a structured, quantitative analysis. Second, it is considered to be the most important phase by academicians. Practitioners, on the other hand, consider other phases to be more important.

The capital investment planning and control phases are discussed are our future postings.