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.

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