PROPOSAL
This project work is design to look into capital project evaluation as an aid to managerial decision in modern day’s businesses.
Ordinarily, no business wishes to invest money in a project unless the return or profit is considered to be sufficient. In trying to assess the return from any capital project, many techniques are used in evaluating the profitability of such project in order to assist management in taking decision on whether to embark on such project or not.
This evaluation system is characterized by a lot of inadequacies in modern day business. Abandoned and clear indication of poor evaluation system. Many companies are also faced with the problem of selecting the right techniques to be used and others will not want to engage the services of an expert for such an exercise. Considering the fact they capital project required huge such of money and will last for more than one year. The researcher was inspired to establish the techniques available (and the associated problems in capital project evaluation currently being neglected in modern day business so as to ensure project returns from such project.
CHAPTER ONE
INTRODUCTION
1.1 PREAMBLE
Capital project monitoring and evaluation is a part of capital budgeting and investment decisions. It is a decision normally taken by management as to whether the return of a project is adequate in the height of the inherent risk. I M PANDEY (P.69) suggest that the evaluation of project should be performed by a group of exert, which has no motive to fulfill. in 1975 (FOULKS LYNCH) opine that management will need to formulate a long term investment program with the aim of ensuring controlled growth of the business and in so doing major areas for investment will be determined a new product, choosing between alternative machines.
Project evaluation involves two steps
(i) Estimation of benefit and cost and
(ii) selection of an appropriate criterion to judge the desirability of the project
In the view of KOLEDADE AND PETER (P.226) “whatever form investment takes, it has several common characteristics” one of which is that it represent expenditure now, or in the near future, in exchange for benefit to be enjoyed in a more distant future period during which the asset is used.
According to G.OLABODE (page 43) management must often choose between different projects perhaps because they are mutually exclusive or there is a temporary shortage of fund. In addition management requires a consistent and comparing capital investments.
In general, no business wishes to invest money in a project unless the return or profit is sufficient.
This research deal with various technique available (and the associated problems) to assist management in selecting the most suitable capital project.
1.2 STATEMENT OF RESEARCH PROBLEM
Capital project monitoring and evaluation in modern day business is characterized by a lot of inadequacies. The researcher has there fore taken the time to highlight some of the easily identifiable ones like
(i) What is the right project when faced with mutually exclusive project?
(ii) What is the right technique to use in capital project evaluation?
(iii) What are the consequences of applying wrong interest rate in project evaluation?
(iv) Is it necessary to embark on project without considering the uncertainty and the risk attached t pots return?
In Nigeria today there are lots of abandoned capital project that are considered unprofitable.
1.3 STATEMENT OF RESEARCH HYPOTHESIS
Effective and efficient capital project monitoring and evaluation enhance profitability and liquidity of a modern day business.
The researcher has formulated the following hypothesis for testing.
(1). Ho: The selections of capital project depend on the evaluation techniques used in appraising the project.
(2). Hi: The selection process of capital project does not depend on the evaluation techniques used in appraising the project.
(3) Ho: The presence of trained management staff and project analysts determines the type of evaluation techniques to be used in appraising capital project in business organization.
(4) Hi: The presence of trained management staff and project analyst does not determines the type of evaluation techniques to be used in appraising capital project in business organization.
(5) Hi: The returns of capital project are affected by the uncertainty and risk attached in estimating their cash flow to be used in appraising them.
(6) Hi: The returns of capital project are not affected by the uncertainty and risk attached in estimating their cash flow to be used in appraising them.
OBJECTIVE OF THE STUDY
The purpose of this research is to establish the techniques and the associated problems in capital project monitoring and evaluation.
This is to ensure proper return from such projects. In the same vein, it highlights the constraints inhibiting the efficient evaluation of capital project in modern day business. It is therefore to ascertain.
(i) The interest rate used in appraising capital projects. Whether the right project is selected when faced with mutually exclusive Project.
(ii) The qualification and experience of staff engaged in capital project evaluation. The extent to which the effect of taxation is recognized in project appraising or appraisers and the extent to which uncertainty and the risk attached to capital are considered.
1.4 significant of the study
this research work is aimed at helping the modern day business in Nigeria to.
i. Use effective capital project monitory and evaluation techniques in appraising their capital so as to ensure proper returns from such project.
ii. Avoid tying down lump sum of money on project that are not profitable thereby starving the organization of funds that could have been better invested in other profitable ventures.
iii. Helping the management in taking effective decision when there are several alterative investment.
iv. Help the management in calculation in the correct interest rate to be used in project appraisal.
v. Contribute to the development of knowledge and solve the difficulties students normally encounter on the topic.
1.6 SCOPE OF THE STUDY
Owing to the importance of project evaluation in profit making organization, it attracts great affection of the financial managers in modern days business. This research is therefore based on capital project monitoring and evaluation in modern day business.
1.7 LIMITATION OF THE STUDY
This research will be limited to the capital project evaluation of Flourmills of Nigeria Plc. Apapa Lagos. It is believed that the capital project evaluation techniques employed by this company on appraising capital project reflect a true view of what obtains in other companies.
The reasons for restricting the research to the above company is due mainly to time and financial constraint.
Other limiting factor experienced during the conduct of this research is the right schedules of the respondents.
1.8 HISTORICAL BACKGROUND OF FLOURMILLS OF NIGERIA PLC APAPA LAGOS.
Flourmill of Nigeria Plc was established in 1960 and started fill operation in 1962. It is situated along Dockyard road Apapa Lagos. The board of customs and excise of Nigeria for the production of flour, semolina, whole wheat and macaroni license the company. It has exercise factory registration number 1699 and incorporated number 2343. The grains grinding capacity of the mill then was 650 tons per day.
Flourmill of Nigeria Plc leads the industry before 1983, the company was rated the second largest mill in the world with a daily grinding capacity of 2,400 tons of grains.
In 1983 an expansion program was embark upon to increase the grinding capacity to 3,400 tons thereby making it the largest in the world.
The staff strength of flourmill of Nigeria Plc. In 1985 totaled 2,837 made up of 2447 junior staff and only 33 were expatriates and the majority of them were employed on the technical side of the company, half of the staff strength were retrenched in 1986 following the barn on importation of wheat imposed by the federal government.
Flourmill of Nigeria Plc has associated and wholly owned subsidiary companies which include.
i. Nigeria Mill Calabar
ii. Manduguri Flour Mill, Manduguri
iii. Golden Penny Flour
iv. Burnham Cement
v. Nigeria bag manufacturing company Lagos
vi. Northern Nigeria Flour mill Kano
vii. Golden fertilizer company Ltd.
viii. Southern star shipping company Ltd Apapa.
ix. Southern star shipping company incorporated in New York.
The group turn over during the year went up to #30.9 billion from #23.7 billion, an increase of about 30% which the group profit before fax, dropped by 139 to #677.1 million from #775.2 million. But there was a decline in-group profit after fax from #602.9 million to #390.8million a decrease of about 35%. This is attributed to the Nigeria bag manufacturing company limited which posed a lose of 806 million before tax.
REFERENCES
Four Mill of Nigeria Plc 200/200: Annual report and account pages 5 pages 4.5 respectively
Foulks Lyneh 1975: The home study tutor capital project evaluation C.P.E.N
Kolende Oshisaini and peter n dean 1985: financial management in the Nigeria public sector. Pitman publishing incorporation Page 226.
Pandey I.M. 1984: Financial Management Vain Education Book A division of vitas publishing house. P.V.T. page 69.
Olabode Akinola G. 1985: corporate financial management page 43.
CHAPTER TWO
LITERATURE REVIEW
2.1 DEFINITION OF CAPITAL PROJECT MONITORING AND EVALUATION IN MODERN DAY BUSINESS
Capital project monitoring and evaluation involves two steps:
a. Estimation of benefit and costs, the benefit and cost must be measured in terms of cash flow and.
b. Selection of appropriate criterion to judge the desirability of the projects.
In the view of I.M Pandey (1985 pg. 65) “capital budgeting may be defined as the firm decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefit over a number of years.
It has also been said that “the profitability of a firm is primarily a function of its ability to generate projects or investment that provide retune greater than the cost of fund used” G Olabode Akinmola (1988 pg 43).
Investment on capital project has also been seen as “representing expenditure now, or in the near future, in exchange for benefit to be enjoyed in a move distant future period during which the asset is used. The cost of the asset must be justified in terms of the benefit which will accrue from its future use” Kolade Oshisami and Peter. N. Dean (1985 pg 226).
In the opinion of T. Lucky (1988 pg 409) investment decision are long run decision where consumption and investment alternatives are balance overtime in the hope that investment will generate extra returns in the future.
Having critically reviewed previous work on this topic, the researcher came up with the opinion that capital project evaluation as part of investment and capital budgeting decision involves the method used in appraising project in order to determine their profitability and their ability of justifying the huge sum of fund invested in them.
If is also a decision normally taken by management as to whether the return of a project is adequate in the light of the risk to undertake it.
2.2 CAPITAL PROJECT MONITORING AND EVALUATION TECHNIQUES
Because of the utmost importance of the capital budgeting decision a sound appraise method should be adopted to measure the Economics worth of each investment project. The investment evaluation criterion to be used should at least posses the following characteristics.
a. It should provide a means of distinguishing between acceptable and unacceptable projects.
b. It should provide a ranking of projects in order of their desirability.
c. It should solve the problem of choosing among alternative projects.
d. It should be a criterion which is applicable to any conservable investment project.
e. It should recognize the tact that bigger benefit are preferable to smaller ones and early benefit are preferable to latter benefit I.M. Pandey pg 70.
There are a number of investment criteria in use. The researcher has decided to discuss the most widely accepted criteria. These techniques can be grouped into the following two categories.
1. Traditional criteria
i. Pay back period
ii. Accounting rate of return
2. Discounting cash flow (D.C.F) method
i. Net present value
ii. Internal rate of return
iii. Profitability index or benefit-cost ratio.
It should be realized that different firm-large or small, may use different techniques. However, to avoid confusion, the same method or methods should be used uniformly for every project throughout the firm. Though these appraisal techniques will help management in making decision objectively, the management must still exercise their common sense and adjustment in making the decision.
2.2.1 PAYBACK PERIOD
This can be defined as the time it takes to recover the initial cost outlay expended on a project.
Payback can also be defined as “the period, usually expressed in years for the projects net cash flow to recomp the original investment” T. Lucky (1988 p. 411).
If the project generates constant annual cash in flow, the payback period can be computed dividing cash outlay by the annual inflow. That is:
Payback period = cash outlay (investment) = C
Annual cash inflow A
ACCEPTANCE RULE UNDER PAYBACK
The payback period can be used as an accept-or-reject criterion as well as a method of ranking project. As an accept or-reject criterion, if the payback calculated for a project is less than the maximum payback set up to the management, it should be accepted, it gives highest ranking to the project which has shortest payback period and lowest ranking to the project with highest payback period. Thus, if the firm wants to choose amongst two mutually exclusive projects, project with shorter payback period will be selected
2.2.2 ACCOUNTING RATE OF RETURN (A.R.R)
“This method attempts to quantity the profit expected to be derived from the investment project. Under consideration in accordance with conventional accounting procedures, and expresses the profit forecast as a percentage of the capital expenditure involved” G. Olabode pg 44.
A.R.R = Average Annual Accounting Profit
Average investment
Where:
Accounting profit is the profit after taxes and average investment would be equal to the original investment plus salvage value (if any) divided by two. Alternatively Average investment can be found out be dividing the total of the investment book values after depreciation by the life of the project.
other method of calculating A.R.R include
- Total rate of return as a percentage of the capital outlay.
- Average annual rate of return as a percentage of the capital outlay
- Average net annual rate of return as a percentage of the capital outlay on both fixed asset and working capital.
ACCEPTANCE RULE UNDER A.R.R
As an accept all or reject criterion, this method will accept all those project whose A.R.R is higher than the minimum rate establish management and reject those project which have A.R.R less than the minimum rate. This method would rank a project as number one if it has highest A.R.R and lowest rank would be assigned to the project with lowest A.R.R
2.2.3 ADVANTAGES AND DISADVANTAGES OF TRADITIONAL METHOD
The traditional method is generally simple and easy to understand. It could serve as a simple initial screen in project appraisal. On the other hand, the traditional method ignores the time value of money. In the case of payback period, it rarely consider the scrap value of projects and cannot distinguish between project having the same payback period. For ARR, the arithmetic mean averaging is used, no weight is given for fluctuations (e.g. long-term build-up to late high profit). A.R.R also makes use of conventional accounting profit that is not consistent with the objective of maximizing the shareholders wealth.
2.2..4 DISCOUNTED CASH FLOW (D.C.F)
A major criticism of both payback and return on capital or accounting rate of return method is that they ignore the timing of each flow and treat money received in future.
The main discounted cash flow methods are net present value and internal rate of return. As third method, the cost-benefit ratio or profitability index, is a variation of the net present value method.
2.2.5 NET PRESENT VALUE (N.P.V) METHOD
The calculation of the net present value (N.P.V) of a project involves discounting all the cash flow of a project to their present values and summing the result. If A0 is the initial cash outlay of a project and A1, A2, A3 the net cash receipt 1 year, 2 year and 3 years hence respectively, the present value of a project is counted by an annual interest rate is
NPV = A0 + A1 + A2 + A3
(1+1) (1+1)2 (1+1)3
Illustration 2.1
A project has initial cost of #2,500 and generate in year end cash flow of #900, #800, #700, #600, #500 in year one through year five. The required rate of return is 10%.
The N.P.V of the project can be calculated as
Year
|
#
|
Discounting factor (10%)
|
Discounting value (#)
|
1
|
900
|
0.909
|
818
|
2
|
800
|
0.826
|
616
|
3
|
700
|
0.751
|
526
|
4
|
600
|
0.683
|
410
|
5
|
500
|
0.621
|
311
|
Gross present value 2726
Less initial cash outlay 2,500
NPV 226
ACCEPTANCE RULE
For an independent project, the NPV is expected to be positive for the project to be accepted. If the NPV is zero the analyst is in difference and need to consider other factors.
Where there are alternative ways of accounting the same result (mutually exclusive investments), choose the investment with the highest N.P.V provided it is positive.
(A) ADVANTAGES
- The greatest strength of NPV is that it considers the timing of the cash flow by discounting all the returns back to the year zero i.e bringing the returns generated at different time value to the same level.
- It is consistent with the objective of maximizing the wealth of the owners.
- It considers the cash flow generated through out the life of the investment.
(B) DISADVANTAGES
- It is to easy determine the discounting rate i.e the firms cost of capital.
- It is a bit difficult to use in that it involves cumbersome calculations.
- Where there are mutually exclusive projects and also limitations of funds, NPV may give sub-optimal decision especially where the project to be analyses are having different life span and different initial cash outlay.
INTERPRETATION OF NPV
- The position NPV an unrealized capital firms and is an immediate increase in the firms wealth if the project is accepted.
- It represents the amount, which the firm is willing to buy or sell the opportunity of making investment.
- The position NPV represent the amount the firm could raise at the required rate of interest, in addition to the initial cash outlay to distribution immediately to its shareholders and by the end of the project life to have paid off all the capital plus interest on it.
THE INTERNAL RATE OF RETURN (I.R.R) OR YIELD
“The internal rate of return can be defined as that rate which equals the represent value of cash inflow with the present value of cash outflows of a project”. Alternatively, it may be defined simple as the rate of return, which makes the net present value of a project to be zero. It is called internal rate because it depends solely on the outlay and proceed associated with the investment and not any rate determined outside the investment I.M Pandey pg 78 (1988).
The diagram below shows a graph of the net present value of a normal project (cash outflow followed by several cash receipts) plotted against the rate of interest used to calculate that NPV.
Table 2.1
NPV |
IRR Rate of interest
The point r, where the line derived cuts the horizontal axis is the I.R.R because at this rate of interest NPV equals zero. There are two methods of calculating the internal rate of return.
a. Trial and error-by trying various rate of discount until one is found which gives an NPV close to zero.
b. Advance mathematical methods for solving equations, computer programmes are available which do the calculations using both methods. If A0 is the initial cash outlay of a project and A1 A2 and A3 the net cash receipts 1 year, 2 years and 3 year respectively the internal rate of return is:
0 = A0+ A1 + A2 + A3
(1+)(1+1)2 (1+1)3
ACCEPTANCE RULE UNDER IRR
For independent project, a hurdle rate will be give. The hardly rate must be equal to the firms cost of capital.
If the calculated I.R.R is greater than the firms cost of capital the project will be accepted. If the given firms cost of capital, the project will be rejected. If the two are equal, the investment analyst is indifferent i.e. he can either reject or accept for mutually exclusive project, the project with the highest I.R.R will be accepted.
ADVANTAGES
- Like the N.P.V methods the I.R.R take the mine value of money into consideration.
- Unlike the payback method, it considers all the cash flows occurring, over the entire life of the project.
- Since the I.R.R is stated in percentage terms it has an added advantage of being a type of measure that is generally familiar to many managers. This makes it easy to use when explaining desirability of individual projects.
DISADVANTAGES
- The I.R.R is probably more tedious to use compared with other method of project evaluation.
- Respected calculation may be needed when cash flows are not in annuity form.
- It may also fail to indicate a correct choice between mutually exclusive projects under certain conditions.
- The I.R.R may sometimes give multiple rates.
INTERPRETATION OF I.R.R
The I.R.R may be interpreted as the highest rate of interest a firms would be ready to pay on the fund borrowed to finance the project without being financially worse off by separating the loam-principal and accured interest interest-out of cash generated by the project.
Thus, the IRR may be referred to as the “breakeven” rate of borrowing from the bank.
2.2.6 PROFITABILITY INDEX (P.1)
Profitability index is the ratio of NPV to initial cash outlay i.e
NPV
Initial outlay
(1) Acceptance Rule
For the first definition of p1 i.e
NPV
10
IF p1>0, accept
If p1 = 0, indifference
If p1<0, Reject
For the second definition i.e
NPV
10
IF p1>0, accept
If p1 = 0, indifference
If p1<0, Reject
For mutually exclusive project using p1 will be misleading because of reasons that will be discussed under conflicting decision arising between the I.R.R and N.P.V technique
2.3 PROBLEM OF INVESTMENT APPRAISAL
Selection of an appropriate criterion to judge the desirability of a project must be done after considering the associated problems involved in project evaluation.
The research has reviewed the work of other and was able to come out with some problems, which are discussed here as follows.
2.3.1 NET PRESENT VALUE OR INTERNAL TRATE OF RETURN
The question of which of the two main technique is preferable may be asked in a situation where the decision is purely whether to accept or reject a particular projects, both techniques lead to the same conclusion i.e A project which show a position N.P.V when the criterion discount rate is used will also show a I.R.R greater than the criterion rate. This is illustrated below.
|
Table 2.2
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 | |||||||||||||||||
|
|
|
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| |||||||||||||||||
| |||||||||||||||||
The diagram above shows the relationship between NPV and discounting rate. The diagram show that the NPV and discounting rate are inversely related from the diagram it is apparent that if the cost of capital of a project is less than 10% the project will have a positive NPV and as such the project will be accepted. If the cost of capital of the project is above 10% e.g 12% the NPV will be negative. For this type of project, the decision will be to reject.
If the IRR is calculated at 10% as above and the cost of capital is 12%, the project is rejected given that the cost of capital is 8% the project will still be accepted.
To this extent, we can assume that NPV and IRR techniques will lead o consistent decision.
In priority ranking situation, however or when choosing between mutually exclusive project, the techniques may lead to conflicting conclusions.
The reason for conflicting decision can be summarized as follows.
a. Difference in size of mutually exclusive projects.
b. Difference in life span.
c. Difference in timing of cost flows.
1. cash difference in size
If the two projects under consideration are of difference size, the cash inflow will also differ in size. Using NPV and IRR will lead ot conflicting decision.
ILLUSTRATION 2.4
Two projects C and D involve initial cash outflow of #100,000 respectively project C return a cash inflow of #120,000 in the first year, if in two cases, the required rate of return is 10% show which of the two project is under the NPV and IRR rules.
SOLUTION
Year
|
Cash flow
|
DF at 10%
| ||
Project
|
Project
|
Project
|
Project
| |
C
|
D
|
C
|
D
| |
0
|
(100)
|
(100,000)
|
1,000(1000)
|
(100,000)
|
1
|
1.500
|
120,000
|
0.9091363
|
109080
|
NPV 364
|
9080
|
Thus, quite clearly under the NPV rules project D is the one preferred. Since this is a one period cash inflow, we can use algebra to solve for each IRR instead of the trial and error method normally used.
Thus for project C we have
1000 = 1500
1 + r
Cross-multiplying, we have
1000 (1 + r) = 1500
Solving we have
1000 + 1000r = 15000
1000r = 1500 – 1000
1000r = 1500 – 1000
1000r = 500
r = 500
1000
= 0.5
=50%
Thus, the IRR of project C = 50% in the case of project D
We have
100,000 = 1500
1+r
100,000(1+r) = 120,000
100,000 + 100,000r = 120,000
100,000r + 20,000
r = 20,000
100,000
=0.2 or 20%
The IRR of project D on the other hand is 20%. This means under the IRR decision rule project C is better
(iii) CASE OF DIFFERENCE IN LIFE SPAN
Where the project are of equal size but differing life span, NPV and IRR may also give conflicting result.
ILLUSTRATION 2.5
Two project E and F each require an initial cash outflow of #10,000 = project E generate a one period cash inflow of #12,000, at the end of year one, while project F generate a one year period Cash inflow of #20,120 at the end of year 5. Assuming a 10 percent required rate of return, show, which is the better project under the two criteria.
SOLUTION
Year
|
Cash flow
|
DF at 10%
|
PV
| |
Project E
|
Project F
|
Project
|
Project
| |
0
|
(10000)
|
(100,000)
|
1(10,000)
|
(100,000)
|
1
|
12000
|
-
|
0.90910908
|
-
|
2
|
-
|
-
|
0.826
|
-
|
3
|
-
|
-
|
0.751
|
-
|
4
|
-
|
-
|
0683-
|
-
|
5
|
-
|
20,120
|
0.621-
|
12495
|
NPV
|
908
|
2495
|
Thus, under NPV decision rule, project F is the better project
IRR of project E
10,000 = 12,000 1+r
10,000 (1+r) = 12,000
10,000r = 10000R = 12,000 – 10,000
10,000r = 2000
R = 2000
1000
= 0.2 or 20%
Hence IRR of project E is 20%
IRR of project F
10000 = 20120
(1+R)5
10000 (1+R)5
10000 (1+r)5 = 201210
10000
(1+r)5 = 20120
10000
(1+r)5 = 20120
1+r =
r = 1.15 – 1
=0.15 or 15%
Hence IRR of project F = 15% Under IRR evaluation, project E is the better project.
(iii) CASE OF DIFFERENCE IN CASH FLOW
Both NPV and IRR is based on the fundamental assumption of reinvestment of principal i.e te cash flow generated on the project can be reinvested until the explication of the life of the project..
The fundamental difference of this assumption between these two techniques are that the NPV assumes a reinvestment rate equal to the cost of capital while the IRR rule assumes a re-investment rate equal to IRR.
Because of the difference in the re-investment rate assumed by the two techniques, a conflicting decision will be arrived at when the cash flow pattern of the two project are difference.
ILLUSTRATION
A company wishes to evaluate two project A and B, which are mutually exclusive. The company cost of capital is 8% and cash outflow and cash inflows of each project are as follows.
YEAR
|
PROJECT AS CASH FLOW
|
PROJECT BS CASH FLOW
|
0
|
(#2,500)
|
(#3000)
|
1
|
(2000)
|
(#5000)
|
2
|
(#1000)
|
(#1000)
|
3
|
(#500)
|
(#3000)
|
Show which project is better under the NPV rule and IRR rule
SOLUTION
Calculations in the normal way would reveal the following results.
N.P.V at 8% IRR
Project A 606 24.86%
Project B 702 17.495%
From the above, while N.P.V chooses project B IRR chooses project A.
(ii) RECONCILIATION OF THE CONFLICT BETWEEN N.P.V AND IRR
The 3 examples give under the 3 sources of conflicting decision indicate that using N.P.V and I.R.R to evaluate two projects that are mutually exclusive will lead to conflicting decision.
This conflicting decision is better resolved by separately evaluate the incremental cash flow between the two projects. Using the result obtained under cash of different in size of projects, we have
PROJECT
C
|
D
| |
NPV
|
364
|
9080
|
IRR
|
50%
|
20%
|
Using the NPV, project D will be accepted while IRR suggest that project C will be accepted.
This conflict can better be resolved be leveling up the two projects and finding the incremental.
Cash flow, which should be separately evaluated as if the incremental cash flow is another project.
If the NPV of the incremental cash flow is positive or the IRR above the required cost of capital, the bigger project should be accepted.
Year
|
Project C
|
Project D
|
D
|
Project C
|
0
|
(1000)
|
(100,000)
|
(99000)
| |
1500
|
120000
|
11,500
|
Year
|
CF
|
DEF
|
DV
|
0
|
99000
|
1
|
99000
|
118,500
|
0.909
|
107717
| |
NPV
|
8717
|
Accept project D
IRR = 118500
99000 1+R
99000 (1+R) = 118,500
99000+99000R = 118,500
9900 = 118,500 – 99000
99000 = 19500
R = 19500
99000
= 0.19 or 197%
Since R > 10% accept project D
INTERPRETATION
The interpretation of this that project D will offer what ever project C can offer and at the same time offer something better with its incremental cash flow.
This therefore suggests that project D should be accepted. From the above analysis, it can be said that where there is d conflict between NPV and IRR, NPV supersedes. This is because the NPV uses the company’s cost of capital. IRR uses the rate that is equal to IRR.
However many authors have appreciated the difficulties of choosing the appropriate selection criteria for investment with different characteristics.
2.3.2 CASH FLOW AND THE EFFECT OF TAXATION
In selecting relevant costs to be included in the computations of capital investment appraisal, the accountant must include only those items which involves an inflow or outflow of cash in the future, thus past expenditure or apportionment of fixed expenditure are to be avoided. However, the impact of taxation must be allowed for and when saving are articulated by obtaining large capital allowances in the early years of an investment the company must be covered regardless of the method of appraisal used and it will in addition be necessary to defined precisely when the cash flow occur i.e the cash flow profile. The timing of cash flow is virtually that the project may be evaluated by means of technique which consider the time value of money.
In evaluating a specific project, the fax adjustment may be made without regard to the total fax payable on the totality of the business operation. But where the business has a heavy lose to carry forward for fax purposes, it may be necessary to consider the effect of fax lose on the phasing of the fax flows.
2.3.3 THE INTEREST RATE USED DISCOUNTING
In discounting cash flow method, an interest rate is used either
a. to calculate the net present value or
b. To act as a standard against which is discounting is the company’s cost of capital. The long term capital of an enterprise falls into three categories normally…
Equity, preference share, and debenture, each of these three categories has different cost. The cost depends on the risk pretrial of each of them. Consequently, it is generally agreed that the discount rate (cut-off or criterion rate) should represent the weighted average cost of capital (W.A.C.C) to be obtained flow all the various sources over the period covered be the capital investment plan.
The calculation of future cost of capital is fraught with problems of analysis and estimation.
2.3.4 ALLOWANCE FOR INFLATION
It is generally agreed that inflation should be allowed for in the fore-cost of the cash flow arising from the project. Different constituents of the cash flow may be subject to different rate of inflation for example, in considering a labour cost may be subject of government interference and therefore will inflate at a lower rate than say important raw materials. Calculating of future cost of capital automatically consider the effect of inflation in the discounting rate. Estimates of expected of existence and extent of inflation would invariable condition rate of return and growth rates.
2.3.5 THE PROBLEM OF UNCERTAINTY
Sometime a distinction is made between risk and uncertainty. Risk is associated with those situations in which the probability distribution of the returns on a given project can be estimated. Uncertainty is associated with those situations in which insufficient evidence is available even to estimate a probability distribution Weston and Brigham’s pg. 251.
In formal terms “the risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project’ I.M Pamdey page 132.
As noted earlier, an element of uncertainty applies to the various fore-cash used in calculating the profitability of investment project. An attempt to compensate for uncertainty is sometimes made by using
a. Risk adjusted discounted rate
b. Certainty equivalent to co-efficient rate
A. RISK ADJUSTED DISCOUNTED RATE
This method involves the use of discounting rate that provide for the risk of uncertainty that be inherent in those element ot be used for decision making, the technique is based on the assumption that the more uncertain the return in the future the greater risk and the greater the premium required. That is, if the time preference for money is be recognized by discounting estimated future cash flows at some risk-free rate to their present value, when to allow for the riskiness of those future cash flow a risk premium rate may be added to risk-free discount rate. Such a composite discount rate will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investor’s attitude towards risk. The risk adjusted discount rate method can be formally expressed as follows
rx + =1 +B
where rx = Risk adjusted discount rate
1 = Risk free rate
B = Risk premium
The sense behind the use of risk-adjusted discount rate is to conservatively reduce the NPV of a risk project to make it less attractive.
ADVANTAGES
a. It is simple and can be easily understood
b. It has a great deal of intuitive appeal for risk adverse businessmen.
c. It incorporate an attitude (risk aversion) towards uncertainty
DISADVANTAGES
This approach, however, suffers from the following limitations
a. It does not make any risk adjustment in the numerator for cash flow that are forecast over the future.
b. There is no easy way of deriving a risk-adjusted discount rate
c. It is based on the assumption that investors are risk adverse without considering risk seekers.
B. THE USE OF CERTAINTY EQUIVALENT COEFFICIENT FACTOR
A common procedure for dealing with risk in capital budgeting is to reduce the forecasts each flow to some conservative level. For example, if an investor according for his best estimate expects a cash flow of #60,000 next year, he will apply an intuitive correction factor and may work #49,000 to be safe side.
The uncertainty equivalent approach may be defined as xt At
Where
At = the forecast of cash flow without risk adjustment
xt = the risk – adjustment factor or the certainty – equivalent coefficient.
The certainty – equivalent can be determined as a relationship between the certain cash flow and the risky cash flows.
That is
xt = At = certain cash flow
A
Risky cash flow
Risky cash flow
I.M Pandey P 135
For example, if one expected a risk cash flow of #80,000 in period t and consider a certain cash flow of #60,000
#80,000
One of the advantages of this method is that it explicitly recognized risk. A forecaster can however intentionally inflate it.
The project will still be accepted if after applying this method, it still shows positive N.P.V
2.3.6 PORTFOLIO THEORY
The basic concepts of portfolio theory were specifically developed for ordinary shares by Harry Markowitz and were first presented in his article portfolio selection, Journal of finance No. 1 (march 1952) pg 7791.
The logical extension of portfolio theory to capital budgeting call for considering firms as having portfolio of tangible assets.
In the view of Folk Lynch, in formulating a capital investment programme, a company is likely to consider a number of projects, which may be related to each other in more or less significant degree. Thus, it is the aggregate risk attaching to the entire accepted project that is to paramount importance rather than the risk of a project.
Considering isolation, management may therefore place a higher value on a project which will provide a good return as a result of other project not achieving expectations.
To illustrate, a steel company may decided to diversity into house building materials. It is known that when the economy is booming, the demand for steel is high and the return from steel mill is large house building, on the other hand tends to be counter-cyclical when the economy as a whole is in a recession. The demand for construction materials is high. Because of these divergent cyclical patterns, a divergent from with investment in both steel and construction could expect to have a move stable pattern of revenue than would a firm engaged exclusively in either steel or house building.
In other words, the deviation of the return on the portfolio of assets ‘r’ may be less than the sum of the deviations of the return from the individual assets.
2.3.7 CAPITAL RATIONING
In previous notes, it was concluded that under condition of certainty, if a firm could borrow at a given rate of interest it should accept independent investment when they produce a positive net present value of a given rat. The approaches assume an unlimited supply of capital so that the company would undertake all projects producing net present value.
Foulk Lynch pg 19
In many practical situations, however, the supply of capital will limited either.
a. Internally: when management arbitrary limits to total amount to be invested because of constraint on other resources or through a desire to prevent uncontrolled growth.
b. Externally: When all feasible sources of finance have been exhausted.
In theory, a company should be able to borrow extral capital provide that a sufficiently high interest rate was offered but in practice, the financial institution will restrict the amount they are prepared to lead. The cost of obtaining capital from other less conventional sources is likely to be prohibitively high.
Thus, in a capital rationing situation the number of acceptable project may exceed the amount of capital available and management is faced with the problem of selecting the optimum investment plan to maximize the utilization of funds. As was previously discussed, neither the N.P.V nor IRR provides a conclusive basis for determining priority project but the present value (profitability) index may be helpful to indicate ranking
REFERENCE
Buharia A.La 1984: Straight to the point/can polytechnic public Finance Unilorin Press Page 233-236.
Foulks Lynchi 1975: The home study tutor capital project evaluation C.P.E.N
Koleade Oshisami, and Peter N. Dean: Financial Management in Nigeria Public Sectors pg 226.
mereet A.J. and Skyes A. 1988: The Finance and analysis of capital Project 2nd Ed. Longman New York.
Squir L. And Van Dertar M.G. 1975: Economic analysis of project World Bank John Hopkins pg 41
Weston J.F and Brigham E.F 1981: Managerial Finance 5th edition. New York MC Grew Hill.
Chapter Three
research methodology
3.1 RESEARCH DESIGN
The research design is the “red print” of research that enables the investigator to come up with solution to the problem of study. It is a logical model of verification that guides the investigator in the various stages of the research.
3.2 POPULATION
Arthur H. Hall (1988) in his book defined the term population as all the items, which come with in the scope of an investigation of human or otherwise.
Population here refers to those workers of flow mill of Nigeria Plc. the researcher intends together the relevant information from through the questionnaire and interviews.
It is offer not possible and practicable to carry out a complete interview investigation of the whole. Population under a study due to factors such as lost and time. It therefore becomes necessary to select a sample from the whole population that will adequately represent the characteristics of the entire population.
Therefore, based on available resources, the appropriate sample size is put at eight (80).
This figure was arrived at through employing the rule-of thumb. Since the sample for a study of this nature could be selected either by calculated or rule of thumbs or both. Infact this was the view held by Zaltman and Burger when they stated in the book that.
There are two basic ways of making the sample size decision. One is by the rule-of thumb and the other calculated method. the rule-of thumb measure is widely used.
3.3 DATA COLLECTION
Have selected a sample size as stated above, data was collected from this sample both primary and secondary data were collected for research. The sources of primary data were questionnaire and oral interview based on the contents of the questionnaire. The interview was held that senior staff considered knowledgeable in capital project evaluation. The secondary data were collected from the organization’s annual reports and accounts business journals and magazine and textbooks.
3.4 QUESTIONNAIRE DESIGN
A.S Hornby defined a questionnaire as a list of printed questions to be answered by a group of people to get fact or formation, or for a survey.
For the purpose of this study, only set of questionnaire was design and administered giver the evaluation. It became imperative that the nature of the questionnaire should coven this range.
Again for case of administration and analysis, the questions were structured in the form that it is comprehensible and less time consuming, as senior staff are usually busy.
The questions include were based on the expectations that the answers will be significant for testing the first and second hypothesis.
3.4 QUESTIONNAIRE ASSUMPTIONS
The questionnaire for the purpose of this study was based on the following assumptions.
i. That the respondents have knowledge of capital project evaluation and its importance in modern day business.
ii. That respondent will voluntarily and honestly ensure the survey question with out any resistance.
iii. That most factual objective responses to the survey question would be provided by each respondent.
iv. That there are no extraneous factors to distort the originality of the intermission.
2.5 INTERVIEWS
Interviews was held with some staff considered to be knowledgeable in capital project evaluation in modern day business majority of those interviewed where fore flow mills of Nigeria Plc Apapa.
3.6 DISTRIBUTIONS AND COLLECTION OF QUESTIONNAIRES
A total of eight (80) questionnaire were saved to the staff concerned. Those question were administered by the researcher and they were accompanied with a cover letter in order to get the respondent more interested and involved in the study. A sample of the questionnaire could be found in the appendices.
Respondent wee given the time with in which to complete the questionnaire and to return them to the researcher.
3.7 RELIABILITY OF DATA
Reliability means the extent to which the researcher can confidently depend on the answer given by the respondent in the questionnaire. That is how dependable are the information given in the questionnaire by the respondent.
Four methods have been generally indentified by estimating the reliability of the information given in the question.
REFERENCES
Authur Alli H. 1988: An introduction to Statistics. London, the Macmillan press Ltd pg 103.
Harper Inboyd 1977: Marketing research text and cases 4th edition Homewood Illinois Richard/Iroin Incorporation pg 34.
Hornby A.S 1974: Oxford advance learners dictionary of Current equality Great Britain Oxford University Press pg 688
Ofanson E.J. 2002: Corporate/Business Finance. Lagos Imprint Service Nigeria.
CHAPTER FOUR
ANALYSIS PRESENTATION AND INTERPRETATION ON DATA
4.1 INTRODUCTION
Data analysis and presentation is a vital aspect of research work. It is designed to give an analysis and presentation of data collected during the field survey. This will help to given clear and concise information about the data such that any one who pickup a research work will not find it difficult to comprehend.
The analysis to be made in this chapter will be based in the data collected from the primary and secondary sources referred to in chapter three.
The first, second and third hypothesis were based on the responses received from the questionnaire.
4.2 DATA PRESENTATION AND ANALYSIS
This section contains the responses from the respondent from the completed questionnaires. It is important to examine the characteristic feature of each item on the questionnaire.
Consequently, the pieces of information have been structured in tabular form for easy understanding.
Below are tables computed form responses to each of the question contained in the questionnaire. Explanations are also given to these tables. The first part of questions (1-7) deals with demography of respondent.
1. Age: The table below gives details about the age distributions of the respondents,
TABLE 4.2 AGE DISTRIBUTIONS OF RESPONDENTS
Age (years)
|
No. of Respondents
|
Percentage
|
15-20
|
4
|
5
|
21-29
|
20
|
25
|
30-39
|
46
|
57.5
|
40 and above
|
10
|
12.5
|
Total
|
80
|
100
|
The above table shows that bulk of the respondent are in the age bracket of 30-39 that if 57.5% while only while only four of them belong to the age of 15-20 that is 5%
2. Marital Status: The table below gives the marital status of the distribution
Table 4.3
Marital Status
|
No. of Respondents
|
Percentage
|
Married
|
55
|
69
|
Single
|
22
|
23
|
Divorced
|
3
|
3
|
10
|
12.5
| |
Total
|
80
|
100
|
The table of distribution above shows that most of the respondents (69%) are married while only just 3% of them are divorced others are single.
3. Sex: The table below gives the sex distributions
Table 4.4
Sex
|
No. of Respondents
|
Percentage
|
Male
|
60
|
75
|
Female
|
20
|
25
|
Total
|
80
|
100
|
The majority of the respondents are male staffs they represent 75%.
4. EDUCATIONAL QUALIFICATION
Table 4.5
Qualification
|
No. of Respondents
|
Percentage
|
Primary, secondary leaving certificate
|
Nil
|
-
|
General certificates of EDU. O.L
|
4
|
5
|
General certificates of EDU. AL
|
16
|
20
|
N.C.E, O.N.D
|
30
|
38
|
BSC, HND, or equivalent
|
28
|
35
|
Prof. Qua. (ACA,ACIBNIM)
|
2
|
2
|
Total
|
80
|
100
|
Table 4.5 shows that 35% of the respondents are holders B.Sc and HND also 2% of the respondents possessed professional qualification, on the whole, those who posses B.Sc, HND and Professional qualification sum up to 37%. This means that the responses received will be high quality.
5. YEARS OF SERVICE
Table 4.6
Years
|
No. of Respondents
|
Percentage
|
1-5years
|
24
|
30
|
6 and above
|
56
|
70
|
Total
|
80
|
100
|
Table 4.6 depicts that 75% of the respondent have staged more than five years. This category of staffs will be more experience in capital project evaluation. Meanwhile, the rest 30% have staged between one to five years.
6. STAFF CATEGORY
Table 4.7
Category
|
No. of Respondents
|
Percentage
|
Senior staff
|
68
|
85
|
Junior staff
|
12
|
15
|
Total
|
80
|
100
|
The distribution shows that majority of the respondent (85%) are Senior staff while just few (15) are junior staff. Considering the nature and scope of the research, the senior staffs are more useful.
7. Department
Table 4.8
Department
|
No. of Respondents
|
Percentage
|
Accounts
|
28
|
35
|
Finance
|
32
|
40
|
Foreign exchange
|
8
|
10
|
Production
|
8
|
10
|
Personnel
|
4
|
5
|
Total
|
80
|
100
|
The total numbers of respondents from the above table who are the account departments sum up to 28 representing 3% of the endive respondents while those from the finance department totaled 32, which represents 40% of the whole respondents. Those forms the foreign exchange department are 8 which represent 10% of the whole respondents. These three department summed up to 85% this figure is significant because these three department are intact the target study of the research.
Question 8-18: Deals with the subject matter of the study. It provides the base for the testing of the hypothesis. They are the academic questions and this directly liked the main focus of the study
Question 8:
Table 4.9: Distribution of respondents on whether capital project selection is independent of the evaluation technique use in appraising the.
Responses
|
No. of Respondents
|
Percentage
|
Yes
|
12
|
15
|
No
|
63
|
85
|
I don’t know
|
Nil
|
Nil
|
Total
|
80
|
100
|
The table below shows that 15% of the respondent were of the views that capital project is independent of the evaluation technique used while the rest 85% disagree with this.
Question 9:
Table 4.10: Distribution of respondents on the interest rate in capital evaluation
Responses
|
No. of Respondents
|
Percentage
|
The company cost of capital
|
44
|
55
|
Any rate suggested by director
|
32
|
40
|
None of the above
|
4
|
5
|
Total
|
80
|
100
|
Table 4.10 shows that 55% of the respondents agreed that the company cost of capital is used in capital project evaluation while 40% believed that the rate used is suggested by the director the remaining 5% have no answers to the question.
Question 10:
Table 4.11: Distribution of respondents on whether taxation effects on capital project evaluation is recognized.
Question 11:
Table 4.12: Distribution of respondents on whether the presence of trained management staffs and project analysis determine the type of technique in appraisal.
Responses
|
No. of Respondents
|
Percentage
|
Yes
|
72
|
90
|
No
|
8
|
10
|
I don’t know
|
-
|
-
|
Total
|
80
|
100
|
Table 4.12 shows that majority (90%) of the respondent believed that the presence of trained management staff and project analysis determines the evaluation technique used in appraising capital projects. The other 10% have opposing view.
Question 12
Table 4.13: Distribution of respondents on who is responsible for capital project evaluation in the company
Responses
|
No. of Respondents
|
Percentage
|
Financial director
|
16
|
20
|
Personnel manager
|
15
|
18
|
Managing director
|
12
|
15
|
Budget director
|
10
|
13
|
All of the above
|
27
|
34
|
Total
|
80
|
100
|
Table 4.13 shows that 34% are of the opinion that financial director, personnel manager, managing director and budget director are responsible in evaluation capital projects while 20% and 18% respectively agreed that financial and personnel director is responsible.
Question 13:
Table 4.14: Distribution of respondent on whether the returns of capital projects are affected by uncertainly and risk attached in estimating the cash flow used in appraising them.
Responses
|
No. of Respondents
|
Percentage
|
Yes
|
68
|
85
|
No
|
8
|
10
|
I don’t know
|
4
|
5
|
Total
|
80
|
100
|
85% of the respondents shows that returns of capital projects are affected by uncertainly and risk attached in estimating the cash flow used in appraising then while 10% does not all 5% are ignorant.
QUESTION 14
Table 4.15: Distribution of respondent’s factors affecting the selection of mutually exclusive project.
Responses
|
No. of Respondents
|
Percentage
|
The technique used
|
4
|
5
|
Fund available
|
16
|
20
|
All of the above
|
60
|
75
|
None of the above
|
-
|
-
|
Total
|
80
|
100
|
Table 4.15 above 60% of the respondents are of the opinion that both the technique use and the fund available affects the selection of mutually exclusive projects, 20% favors availability of fund while 50% favors technique used.
QUESTION 15
Table 4.16: Distribution of respondent on whether inflationary effects are taken care of in project evaluation or appraisal.
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