Finance 567; Assignment 2 by Sanjeev Sabhlok; 24.5.

93

INVESTMENT APPRAISAL DECISION

1. INTRODUCTION

The investment decision is perhaps the most important

financial decision for a firm, as indicated by Brealey and
Myers' Third Law: "There's more value to be gained by good
investment decisions than by good financing decisions
(Brealey,1988:451)". The investment decision, also called
capital budgeting decision, is a decision of how much not
to consume now so that more can be consumed in the future.
This could be done either by lending or by producing, with
the expectation of getting returns at least equal to the
market's rate of return.

Now, for the sake of theoretical tractability, it is

assumed for most of this paper that capital markets are
perfect and complete and that there are no imperfections,
including taxes. In such a situation, there would be no
reason for any project to give a positive net return. In a
perfectly competitive market, where all opportunities have
been duly exploited, there would exist no potential for
returns higher than the market rate of return. Only when a
firm is competitive in a particular area for some
particular reason will it be possible to have a project
with net positive returns. Thus positive NPVs come from
specific competitiveness. It is assumed in the rest of the
discussion that the firm does have a competitive edge which
could lead to returns higher than the market rate of
return. We shall also consider the financing and dividend
decisions as given. Further, in perfect capital markets,
the Fisher separation principle allows the consumption and
investment decisions to be considered independently so that
the decision criterion for shareholders would be to
"maximise the present value of lifetime consumption"
(Copeland,1983: 18). As we are aware, in reality there
could be other interests operating, and agency costs to be
incurred. Hence "a best technique for rating investment
projects is heavily dependent on the decision maker's
objective" (Bogue and Roll,1974:601). But in this paper, we
assume that agency costs are absent (Copeland,1983:20).

How much to invest today, is referred to as the

capital widening decision and how long to invest it for is
the capital deepening decision (Martin,1988:111). There are
three types of investment decisions: (i) the usual
investment decision, or the allocation of capital to
 investment proposals, (ii) the decision to reallocate
capital, when an existing asset no longer justifies
continued commitment of capital, and (iii) acquisitions and
mergers, which are similar to other investment decisions in
many ways.
2. THE DECISION CRITERIA

Selecting the correct technique for investment

purposes is very important. "The use of an improper capital
budgeting technique will result in aggregate errors which
stock-holders will not be able to eliminate" (Bogue and
Roll, 1974). The decision criterion for capital budgeting
purposes should take into account all cash flows; these
cash flows should be discounted at the opportunity cost of
funds; the technique should be capable of selecting from a
set of mutually exclusive projects; and finally, the value-
additivity principle should hold (Copeland,1983:26).

2a) Traditional techniques: Sophisticated, or discounted

cash flow (DCF) techniques, take into account the time
value of money. These are the net present value (NPV),
internal rate of return (IRR) and profitability index (PI)
or benefit-cost ratio. The MIRR (modified internal rate of
return) is also used (Brigham,1990:282). There are also
numerous unsophisticated techniques, chief among these
being the payback method, including discounted payback, and
the average rate of return (ARR) on book value. While we do
not deliberate on the unsophisticated techniques here, and
while it will shortly be seen that the NPV is the "best"
technique, it would not do to outright reject the use of
other techniques. "The different measures provide different
types of information to decision makers, and since it is so
easy to generate the values for the measures, all should be
considered in the decision process. For any specific
decision, more weight might be given to one measure than
another, but it would be foolish to ignore the information
inherent in any of the methods" (Brigham,1990: 289).

The correct sophisticated (DCF) technique: Initially, the

IRR was the method recommended to firms by theorists such
as Dean (1951). But in the mid- and late 1950s, it was
conclusively shown by Savage (1955) and Hirshleifer (1958)
that NPV is the superior technique and that the IRR rule
often breaks down. The IRR rule gives rise to the following
problems:

a) Change in sign of cash flows (lending or borrowing):

If a project offers positive cash flows (borrowing)
 followed by negative flows (lending), then the IRR
rule breaks down (Brealey,1988:80).
b) More than one change in sign of cash flows (multiple
roots, or rates of return): If there is more than one
change in the sign of the cash flows, the project may
have several IRRs, or no IRR at all (e.g. the oil-well
pump problem). It must be mentioned here that the MIRR
has overcome the multiple IRR problem (Brigham,1990:
283).
c) Mutually exclusive projects: The IRR rule often gives
the wrong ranking of mutually exclusive projects which
differ in economic life or in the scale of investment.
d) Term structure of interest rates: The IRR rule
requires a comparison of the project's IRR with the
opportunity cost of capital. But often the short run
and long run opportunity costs differ. It then becomes
difficult to determine a yardstick for evaluating IRR.
e) Reinvestment at the IRR (implicit reinvestment rate
assumption). It is assumed that the time value of
money is the IRR, i.e., investors can reinvest their
money at the IRR for each project. But reinvestment
should be considered only at the opportunity cost of
capital. Hence this assumption under the IRR rule
defies logic (Copeland,1983:32).
f) Combinations of mutually exclusive and independent
projects: The IRR rule violates the value additivity
principle when combinations of mutually exclusive and
independent projects are taken (Copeland,1983:32).

In view of the above, NPV is treated as the correct

decision criterion for DCF analysis in this paper.

2b) Strategic analysis: Many projects may give rise to

real options, and require a strategic analysis. The DCF
techniques are inaccurate in capturing the range of
possibilities in such cases. For example, businesses with
substantial growth opportunities or intangible assets have
options on their investments (Myers,1984:135).

3. CASH FLOWS

Two variables determine the NPV: the expected future

cash flows and the expected opportunity cost. At the heart
of the NPV are the cash flows. If these are biased, then
the NPV rule will fail (Brealey,1988:88). A cash flow is
simply the difference between cash received and cash paid
out. We are interested here in the after-tax cash flows for
an all-equity firm, but the principles hold true even for a
firm using leverage (Weston,1989:104).
 3A Certain cash flows: Let the cash flows be known with
certainty and assume that these flows are perpetual, i.e.,
there is no growth (Copeland,1983:37). Then the relevant
(certain) cash flows are given by

CF = (_R-_VC-_FCC)(1-Óc) + Óc(_dep) - _I,

where, CF stands for cash flows for capital budgeting,

_R represents revenues, _VC is variable costs of
operations, _FCC is fixed cash costs, Óc is the
corporate tax rate, _dep is depreciation, and _I is
the investment.

It is to be noted that all additional, associated,

cash flows that follow from project acceptance have to be
included (incremental cash flows). Allocated accounting
overheads are included if they result from an actual
increase caused due to the project. Sunk costs are ignored.

3B Uncertain cash flows: In the case of uncertainty about

future cash flows, the same formula as above applies. But
what we get are forecasts of cash flows (usually the
expected cash flows). Very often, the forecast errors are
quite large (Brigham,1990:298). The way out is to ensure
that all persons involved in forecasting use a common and
consistent set of macroeconomic and other assumptions. Data
on probability distributions of the estimates, and their
standard errors is essential. Fortunately, most of the
forecast errors are random (unbiased) and can be expected
to cancel out. On the other hand, some studies have shown
that cash flow forecasts are not unbiased, but are commonly
over-optimistic (Brigham,1990:316). This consistent upward
estimation of forecasts has to be tackled carefully. One
way being adopted by firms is to keep track of the
historically determined over-estimates, if any, made by
different managers, and to include this information in
their future forecasts. The second method is to ask from
where do the positive net present values come from? What is
the competitive advantage of the firm in that project?
Additional points required to be considered are:

i) The cross-sectional relationships between cash flows.

ii) Correlations of cash flows over time: if the cash
flows of year t are dependent on cash flows for year
t-1, then the variance of the project cash flows
becomes larger and the project riskier.
ii) Links between today's investments and tomorrow's
opportunities have to be worked out. Tomorrow's
 opportunities often represent an option, and require
separate analysis.

From the forecasts we get either of:

a) Expected cash flows, or E(CF): In this case, risk is

taken into account by adjusting the discount rate
(risk-adjusted return, or RADR).
b) Certainty equivalent cash flows or, CE(CF): In this
case, risk is absorbed into the cash flows. It was
shown by Rubinstein (1973), using the CAPM, that if
is the market price of risk, i.e.,

= E(Rm) - Rf
VAR(Rm)

where E(Rm) is the expected market rate of

return, Rf is the market's risk-free rate of
return, and VAR(Rm) is the variance of Rm.
then, the CE(CF), or certainty equivalent cash flow is:

CE(CF) = E(CF) - COV(CF,Rm)

where COV(CF,Rm) is the covariance of the cash

flow with the market rate of return (Copeland,
1983:196).

Both versions of the cash flow lead to equivalent

results in the one-period case (Copeland,1983:195). But in
the multiperiod case, Robichek and Myers (1966) showed that
the CE technique is superior to the E(CR) and RADR
technique. According to them, risk and time are logically
distinct variables. The CE approach takes account of them
separately, but the RADR approach lumps them together. The
only problem is that "there is no practical way to estimate
a risky cash flow's certainty equivalent. Each individual
would have his or her own estimate, and these could vary
significantly." (Brigham,1990:368). Therefore the CE method
is not commonly used. We must note that if we use the CE
method then the risk-free rate is used to determine the NPV.

4. DISCOUNT RATE

The cost of capital depends on the use to which it is

put (Brealey,1988:173). Therefore, the required rate of
return on a project will depend on the riskiness of its
cash flows.
4A. CERTAIN CASH FLOWS: The following analysis holds when
either the cash flows are known with certainty, or we have
CE(CF). In these cases there is no further riskiness of
cash flows and Rf is used to discount these cash flows. But
we must take note of the following theoretical aspects.

4A.1 Two period case:

a) Lending and borrowing rates are the same (equal to r):

Let an individual have an endowment of (y0,y1) of
incomes at the beginning and end of the period, and a
series of utility curves U. Then, if only production
is an opportunity to him, then he will consume an
amount C0 which is exactly equal to the amount he
produces in the first period, P0, and invest y0-C0,
such that the marginal rate of substitution of his
consumption is exactly equal to the marginal rate of
transformation of his production opportunity set. If
borrowing and lending is allowed (capital markets
exist), then it can be shown that the individual can
increase present consumption C0 and thus increase his
utility, by borrowing down the market line at the
interest rate r (Copeland, 1983: 11). "A very
practical example is building a house and then
borrowing on it through a mortgage so as to replenish
current consumption income" (Hirshleifer,1958). The
important thing in this process is that MRS = MRT = -
(1+r), where r is the lending/ borrowing rate. This
holds true for all investors. This process was
demonstrated by Hirshleifer (1958). The Fisher
separation theorem arises from this: if capital
markets are perfect and complete, then all individuals
will reach the same decision for wealth maximisation
with reference to the market rate of return. In
practice, it is assumed that the risk-free market rate
of return, Rf, can sufficiently represent r.

(b) Borrowing rate greater than lending rate: When the

capital markets are not perfect (there are transaction
costs) , then borrowing and lending rates will differ.
In this case the solution becomes more complicated,
with three zones being created. Hirshleifer showed
that in Zone I, the borrowing rate is the relevant
rate, in Zone III the lending rate is relevant, and in
Zone II, a rate somewhere between these two rates is
relevant. The Fisher theorem breaks down in such a
 case, and the subjective preferences of individuals
enter back into the picture. Thus, the complications
introduced by transaction costs are difficult to
quantify. Rf is used in this case too, as a convenient
proxy, but we must remember that it may not be the
correct discount rate, and the subjective utility
functions of shareholders have to be considered too
(if that is possible).

4A.2 Multiperiod case: Hirshleifer (1958) also showed that

essentially it is possible to generalise the principles of
investment analysis of a two-period case to the multiperiod
case, with the market line becoming a hyperplane, and the
indifference curves becoming indifference shells.

4B. UNCERTAIN CASH FLOWS: The determination of RADR is

necessary when we use the mean cash flows E(CF). The effect
of risk on the required rate of return (RRR) has to be
considered. A project can have three kinds of risk: stand-
alone risk, within-firm (corporate) risk, and market risk
(Brigham,1990:341). An investor is usually interested only
in the market (systematic) risk, which is the relative risk
of the project with reference to the market, since
unsystematic risk can be diversified away by the investors
on the capital market. But when liquidation costs exist,
then unsystematic, corporate, or total risk, is also
relevant to the shareholders - since diversification can
prevent the possibility of bankruptcy (Brigham,1990:376).

The WACC (weighted average cost of capital) is a

useful starting point for estimating the appropriate
discount rate. But the problem is that WACC considers the
risk of the firm's existing projects, and not specifically
that of the project under consideration. The WACC has to be
adjusted for risk by considering the project's risk
category in relation to the divisional/ company risk
structure. Unfortunately, this is a subjective adjustment,
and not theoretically sound. The correct way would be to
determine the project's systematic risk or ßproj, and then
apply the CAPM to determine the RRR. Theoretically, it
would be possible to do even better, by applying the APM.
We look into these two methods below. We also touch upon
the APV technique.

4B.1 Arbitrage pricing model, or theory (APM/APT): In the

APT, formulated in 1976 by Ross, the assumption made is
that the RRR on any security is a linear function of the
movement of a set of fundamental factors, which are common
to all securities. The return R on an asset would be given
by the following equation, when three factors are
considered:

R = E(R) + ß1F1 + ßGNPFGNP + ßrFr + _

where F1, FGNP and Fr represent systematic risk

because these factors affect many securities. The term
_ is considered unsystematic risk because it is unique
to each individual security (Ross,1990:311).

The k-factor model would read as:

Ri = E(Ri) + bi1F1 + ... + bikFk + _i

where Ri is the random rate of return on the ith

asset, E(Ri) is the expected rate of return on the ith
asset, bik is the sensitivity of the ith asset's
return to the kth factor, Fk is the mean zero kth
factor common to the returns of all assets under
consideration, and _i is a random zero mean noise term
for the ith asset (Copeland,1983:211).

The APT allows the consideration of a large number of

fundamental factors which is not possible in the CAPM
(Ross, 1990:453). Chen, Roll and Ross (1983) find
industrial production, inflation, interest rate term
structure, and the spread between low and high grade bonds
to be important economic variables (Bower,1986). The
predictive power of APM has been found to be superior to
the CAPM in all tests. However, there is disagreement on
the variables involved, and there are many complications in
applying the APM. Therefore the APM is not commonly used
for determining RADR.

4B.2 Capital asset pricing model, or CAPM: In case the

market rate of return is considered to be the only relevant
factor, then the APT leads us to the CAPM, which can then
be considered as a special case of the APM. According to
the CAPM, sensitivity to a single market index does as
good a job as any multi-factor model since the different
sensitivities of the asset to the collection of economic
forces "net out."

4B.2.1 Single period case:

4B.2.1.1 All-equity case: In this case, the project as
well as the firm are financed entirely by equity. The CAPM
assumes perfect capital markets, well-diversified investors
and homogeneous expectations and therefore works well under
a "single period uncertainty" case, as shown by Rubinstein
(1973). The CAPM requires the project to earn at least the
rate of return required by the market on projects of
equivalent risk (Weston,1989:437). Rubinstein considered
that the new asset already exists and is valued in the
market (Martin,1988: 292). He then showed that the RADR is
given by:

E(Rproj) = Rf + [E(Rm) - Rf]ßproj.

where, Rproj is the RADR on the project, and ß proj is

the project's beta (Weston,1989:441).

Projects with greater systematic risk will have

greater betas, and their RADR will be higher. Here, we see
that Rf and Rm are generally known, but the problem is the
determination of ßproj, which we now look into, below.

a) When the project has the same risk as the company's

existing assets, then the company's beta of assets is
required. It is determined by regressing an accounting
measure of return for the company (such as the return
on assets) on an economy-wide index of returns (such
as the average return on assets for non-financial
corporations). There are complications associated with
this approach, which we do not touch upon here.

b) When the project has different risk to that of the

company then it is the asset beta of the project that
counts. Since product markets do not have active
secondary markets, finding ßproj from historical
information is not usually feasible (Rao,1992:366).
The techniques used therefore are (Brigham,1990:363):

i) In the pure play method, existing firms producing

a single product similar to the project under
consideration are sought out. The betas of these firms
are determined through regression analysis, and can
then be used as a proxy for ßproj.

ii) When such single-product, publicly traded firms

suitable for the pure play approach are not available,
then accounting beta method is used. Here a suitable
 proxy is chosen, such as the division of another firm,
or a privately held firm which matches the project,
and a time series regression of that division's
earning power is run against the average earning power
of a large sample of stocks (Brigham,1990:364). We
note that accounting betas are not as good as market
betas.

4B.2.1.1.2 When the firm has leverage: If the firm as well

as the project include debt financing, then as a company
increases its degree of debt financing, the investors
require an additional financial risk premium. The RADR is
then adjusted under the CAPM by the Hamada (1969) formula
in case the classical tax system applies. Here the RADR,
keL (the cost of equity to a leveraged firm) is the sum of
risk-free rate, business risk premium and financial risk
premium.

keL = Rf + (Rm - Rf)ßU + (Rm - Rf)ßL

where ßL is the beta of the levered firm and ßU is the

beta of the unlevered firm. But we know that

ßL = ßU [1+(B/S)(1-T) (Hamada formula)

where B is the market value of debt, S is the value of

shares of the levered firm, and T is the corporate tax
rate. Therefore,

keL = Rf + (Rm - Rf)ßU + (Rm - Rf)ßU (1-T)(B/S)

In Australia, where the dividend imputation system

prevails, if there is no earnings retention and no
preferential treatment of capital gains, and if a
comprehensive measure of income is used, then the CAPM
takes the form which would apply if there were no taxes
(Van Horne,1990: 257):

keL = Rf + (Rm - Rf)ßU + (Rm - Rf)ßU. B/S

or keL = Rf + (Rm - Rf)ßU (1+B/S)

4B.2.1.1.3 Liquidation costs (Total risk to the firm):

Projects financed with debt could at times cause an impact
on the total risk to the firm (corporate risk), by bringing
about the possibility of bankruptcy. The diversification
aspects of a proposed investment are relevant to its
evaluation in such a case (Van Horne,1990:243). A project
which has a diversification effect would have a lower RADR,
at least from the point of view of the shareholders/
debtholders and perhaps the management. This
diversification effect could be verified by correlating the
project's cashflows/NPV with the rest of the firm's
projects.

4B.2.2 Multiple period case: We know that the CAPM

relates to a single period only; but investment analysis
almost always considers more than one year/ period. Many
problems arise when the CAPM is extended to more than one
period. The future Rf, Rm, and even ßproj vary over time.
Some projects are safer in youth than in old age, others
are riskier. In particular, the extension of CAPM is safer
when ßproj remains constant over time, than if it changes
significantly. In the latter instance, it would be
necessary to apply different betas (and consequently,
different RADRs) over different future periods.
Unfortunately, there is no practical method to estimate
these changes, and the errors in estimates can increase
over time. Hence when the CAPM is extended to the
multiperiod case, we must realise that its power declines
over time (Rao,1992:373).

In fact, Bogue and Roll (1974) showed that multiperiod

capital budgeting is simply not possible if there are
imperfect markets for physical capital. They also required
the consideration, not only of the systematic risk in the
usual CAPM sense, but also of the risk of fluctuations in
the risk-free rate and the covariation risk of the
intermediate value of the project (Copeland,1983:363). Fama
(1977) reexamined Bogue and Roll's critique and found that
certain uncertainties allowed by Bogue and Roll are
inadmissible in the stationary CAPM context, which assumes
the portfolio opportunity set to be nonstochastic.
Therefore the only admissible form of uncertainty is in the
expected cash flows at time t, assessed at time Ó<t. The
RADR in each future time period cannot be uncertain if the
assumptions of the CAPM hold. He therefore showed that
given its strong assumptions, the CAPM does allow extension
to the multiperiod (Copeland,1983:363). Finally,
Constantinides (1980) has been able to show the multiperiod
extension of CAPM to be valid under a less restrictive set
of assumptions (Copeland,1983:364). But he noted that
application of the CAPM becomes very complex in such a
case. The only exception is a case in which the effect of
the nonstationarity in the model's parameters through time
is of little practical significance (Martin,1988:312).

In brief, we note that there are considerable

difficulties involved in extending CAPM to the multiperiod
case. Inspite of this, it is still used as a useful
approximation.

4B.3 Adjusted NPV approach (APV): Myers has proposed an

alternative adjustment process in case of a levered firm.
Here, the project's "base-value" is estimated by
considering it to be an all-equity mini-firm. To this is
added the NPV of the side-effects caused by project
acceptance. This is fundamentally a generalisation of the
WACC rule. Here,

n n
APV = ð OCFt + ð kd BT
t=0 (1+keL)t t=0 (1+kd)t

where OCFt is the after-tax operating cash flow in

period t, kd is the cost of debt financing.

Projects which have a positive APV are considered as

having an adjusted cost of capital r*. This r* can be
approximated by the MM or the Miles and Ezzell formulae
(Brealey,1988:449). However, the adjusted cost of capital
is not commonly used to determine the RADR for a project.

5. NPV UNDER CERTAINTY

Having determined the its cash flows and discount

rate, the next step for the firm is to determine the NPV.
The usual approach is valid for one or more independent
projects, where the manager can choose to undertake any or
all of them (Copeland,1983:26). Here, projects with
positive NPVs are accepted; or if necessary, those with the
highest NPVs are selected. But for interacting projects,
additional issues have to be borne in mind. Contingent
projects are those which have to be carried out together or
not at all. These include mutually inclusive projects,
where the acceptability of one project is contingent on the
prior acceptance of another. Mutually exclusive projects
are also contingent projects, where, from a set of
projects, only one project can be chosen. Here, the NPV
rule requires acceptance of the one which gives the higher
positive NPV, no matter what the initial investment. Some
other cases are briefly discussed below:

i. Optimal investment term for a project, or its

duration: In this problem, the object is to determine
the optimal life of the project, e.g., when to harvest
trees. In this case we have to replicate the project
at constant scale to infinity, then set the derivative
of NPV to zero to maximise it, and solve for time t.
Some projects need to be replicated with proportionate
growth in scale (Martin,1988: 139).
ii. Projects with different lives: Here, there could be
two machines with identical capacity but different
lives. If the projects have the same risk, then the
annual equivalent cost (AEC), or the value of renting
the machines, is worked out. The machine with lower
cost would be preferred (Copeland,1983:47). However,
if the projects have different risks, then this is not
appropriate, and we compute instead the NPV of an
infinite stream of constant scale replications. The
NPVs are then compared and the project with greater
NPV is accepted.
iii. Projects of different scale: In this case the Present
Value Index (PVI) can be used (accept all whose PVI>1).
iv. Capital constraints/ rationing: There is some debate
on this point, since it is felt that there is no real
capital constraint in the real world. Internal (soft)
constraints are more likely than external (hard) ones.
If there is a one-period capital constraint, then the
PVI can be used. For multiple period capital
constraints, two types of programming techniques are
applicable: linear programming in case the projects
are divisible, and integer programming in case they
are not (Weingartner,1963,1977). However, these
techniques fail when uncertainty is introduced.
v. Replacement problem: Here the question is whether to
continue with a machine or to replace it now. The
existing machine would have maintenance costs, but
would yield revenues and a salvage value. In such a
case the AEC of the new machine has to be worked out
and a comparison made with the cost of the old
machine.
vi. Excess capacity costs: The spare capacity created by a
project has to be charged to whosoever uses it, in
order to value it properly (Brealey,1988:109).
vii. Fluctuating load requirements: In case of more than
one machine being required to meet fluctuating load
requirements, it is possible that the NPV of replacing
 one or a few machines may be greater than replacing
all of them (Brealey,1988: 110).
viii.Treatment of inflation: Here, both the cash flows and
the opportunity cost of capital have to include (or
exclude) expectations of inflation. The problem is of
course the estimation of the future inflation rate.
Usually, the term structure of interest rates is
considered, as it is felt to reflect expected
inflation. Account must be also taken of the differing
effects of inflation on various inflows/outflows.

6. NPV UNDER UNCERTAINTY

In case E(CF) and the RADR as derived using the CAPM

are used, then, the present value of an expected cash flow
E(CF) will be given by:

E(PV) = E(CF) _
1+ {Rf + [E(Rm) - Rf)]ßproj}

Subtracting the initial outlay I from PV, we get the

E(NPV)= E(PV) - I. But E(NPV) can be deceptive. Therefore
it is always worthwhile doing some more study into the
viability of the project.

i) Sensitivity analysis: Here we consider the major

variables determining a project's success and estimate
how far the NPV would be altered by taking a very
optimistic or a very pessimistic view of each of these
variables, one at a time.
ii) Scenario analysis: In this the effect on the project
of a few combinations of variables is examined.
iii) Monte Carlo simulation: For large projects, it is
worthwhile to look at all possible combinations of
variables. In this technique, a model of the project
is determined. The probability distributions of each
of the determinants of cash flow are then specified.
The computer then gives random values to these
variables and determines different cash flows, and the
NPVs. This gives rise to a frequency distribution of
returns.

The above analysis will give a more complete picture

of the variability of the NPV, and depending on the risk-
aversion of shareholders, a better decision can be taken.

7. PRACTICAL ISSUES WITH DCF TECHNIQUES:

7.i Capital budgeting techniques used by firms: In a study
in the USA, Gitman and Forrester (1977:68) found that the
most popular investment appraisal decision rule is the IRR
(53.6%), followed by ARR (25%). The use of the NPV has been
increasing over the years, from 9.8% in the Gitman study
(1977), to 68% in the Pike (1988) study carried out in UK.
Pike found that:

a) Almost 2/3rd of the sample prepare a capital budget

which looks beyond two years.
b) 84% of the firms have investment manuals.
c) Capital budgeting is not regarded as a specialist
function and only 26% of the firms employ personnel
for capital budgeting.
d) 71% of the firms review and set hurdle rates for their
projects.
e) 86% of the firms carry out formal risk analysis.
f) Firms seem to use a basket of techniques to decide on
a project. They use the payback method in 92% of the
cases, IRR in 75% of the cases and NPV in 68% of the
cases. Many of the firms use computer models for their
analysis.
h) It was also found that DCF methods have proved their
worth to firms, inspite of their many unavoidable
shortcomings.

7.ii DCF and the decline of American fortunes: M.E.Porter

(1992) has criticised the DCF system of evaluation of
projects as being a possible cause of the relative decline
of American business in comparison to Japan. He feels that
DCF methods have led US capital and financial markets
toward a short-term gain orientation. Impatient investors
force business managers to maximise short-term earnings
rather than in long-term growth. However, Bernstein (1992)
shows that investors are not only patient but pay a premium
for stocks of research-oriented companies. The cause of the
decline of the US lies elsewhere and not in DCF techniques/
financial markets. One tends to agree with Bernstein.

8. MERGERS AND ACQUISITIONS (M&A):

M&A also constitute an investment decision. The

difference is that in M&A, prices are subject to
bargaining, and it is difficult to measure incremental cash
flows accurately (Van Horne,1990:219). For M&A activity to
be beneficial, there must first be an economic gain. For
this to happen, the two firms must be worth more together
than apart (synergy). Gain = PVAB - (PVA + PVB) where PVAB
is the present value of the merged firm, and PVA and PVB
are respectively the pre-merger values of the firms A and
B. In addition, the costs have to be worked out. One should
go ahead only when the gains exceed the costs. When the
acquisition is financed by cash, Cost = cash - PVB, and
when it is financed by equity, the cost = PVAB - PVB. There
are different models which take account of efficiency,
information costs, agency problems, market power, tax
deductability, etc., in mergers and acquisitions. Analysis
of M&A activity is therefore an independent topic itself
and will not be considered here further.

9. STRATEGIC REAL OPTIONS ANALYSIS

Under some uncertain situations, investment projects

could have options embedded in them: e.g., flexible
technologies and research and development projects. These
are called "real" options, to distinguish them from
financial options such as traded puts and calls. Real
options last longer and are more complex than financial
ones. They are distinguished by the time-series links
between/within projects. Many of these also take the
"American" form, whereby they can be exercised before the
expiration date. Such a project's NPV can be quite
different from one that has no such options embedded in it.
Very often the embedded option can tip capital investment
decisions one way or the other (Brealey,1988:495). Some of
the common real options are (adapted from Kulatika, 1993):

i) Investment timing: A positive-NPV project is

equivalent to an in-the-money call option. We would
obviously like to exercise this option at the best
time. Thus all projects have the option of being taken
up now, or later. A lease for offshore exploration for
oil could be more profitable in the future when oil
prices rise (Myers, 1984).
ii) There is always an option to make follow-on investment
if the immediate investment project succeeds (Brealey,
1988:495).
iii) Abandonment value: If a project fails, it is not
necessary to continue with it. Instead, if there are
active secondary markets for tangible second-hand
goods, then the project can be sold at higher than
salvage value. We must keep in mind that intangibles
have usually a lower value than tangibles. The second-
hand market gives the owner a put option (Myers,1984).
iv) Shutdown option: The option to shutdown could exist in
some cases during low price periods.
v) Growth option: Sometimes a current investment could
facilitate future investment opportunities. In such a
case the current project would have a larger NPV than
it would otherwise have had (Brealey,1988:469).
vi) Designed-in option: This could include the option to
switch to cheaper inputs, to switch to a different
outputs and to include future expansion requirements.

vii) Research and Development projects: The value of R&D is

almost all option; so also is the value of other
intangible assets.
viii)Takeovers/acquisitions: A firm could sometimes be
acquired at premium, at a negative NPV, for purely
strategic reasons, for opening up investment
opportunities in the future.

This area was a part of financial strategy till

recently and not amenable to quantitative analysis. But
now, a mixture of DCF and option valuation models are
capable of forging the missing link between finance theory
and strategic planning.

Valuation of real options: Banz and Miller (1978) have

shown a method of valuing such options. First, the problem
is set up in a time state preference framework. Second, the
Black and Scholes (1973) option pricing model is used to
calculate the prices of the identified state contingent
claims identified (Martin,1988:510). One problem is that
many of these options are of the American type and the B-S
model has limitations when dealing with these. Further, the
absence of a secondary market for the underlying asset
places serious limitations on the value of real options.
However, the mere recognition of real options opens up
areas for quantitative analysis not available earlier.

10. CONCLUSION

The manager of a firm has to recognise that projects

of different types, and meeting different assumptions,
require different approaches to investment analysis.
Whereas the DCF techniques and the CAPM have serve fairly
well in most cases, it is important to recognise that many
projects have real options, and recognising this would
reduce the chance of rejecting good projects. Mergers and
acquisitions also require a special analysis. But we must
remember that inspite of the theoretical advance made in
asset pricing under uncertainty, there are limitations
imposed by the very nature of uncertainty in the analysis,
and subjective judgement has ultimately to be applied, once
all available data is compiled. To that extent, investment
appraisal takes on the features of an art, rather than a
science.

But as Pike (1988) has found out, sophisticated

techniques have come to stay inspite of these limitations,
and are making a positive contribution in improving
investment decisions.

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