Applied Studies in Agribusiness and Commerce A P STR AC T

Agroinform Publishing House, Budapest

SCIENTIFIC SUMMARIES

Key aspects of investment analysis

Andrs Nbrdi and Lszl Szllsi
Faculty of Agricultural Economics and Rural Development, University of Debrecen
Abstract: This paper reviewed principally accepted methods applied to investment analysis. To describe every aspect of investment analysis
fully would require far more space than available here, so we highlight only of few of its aspects.
This study collects several well-known bibliographies, contrasts them with each other and provides explanations for having done so. There
are many questions about which authors and companies agree, including about how to apply certain methods, but on others there is
disagreement.
Four dynamic methods (Net Present Value, Internal Rate of Return, Profitability Index, and Discounted Payback Period) are demonstrated
from the viewpoint of application. Moreover, this study clarifies several sensitive questions, such as handling income taxes, inflation and
uncertainty. Other examined issues are only mentioned at the end of this paper, and we will publish on these more thoroughly at a later date.

Keywords: net present value, internal rate of return, profitability index, payback period

Introduction
The capital investment analysis procedure is of primary
importance in investment control. Once the investment has
been made, it is largely a sunk cost and should not influence
future decisions. The manager wants to obtain the maximum
long-run cash flow from capital investments and to add
further capital investments only when they will provide a net
return in excess of the companys cost of providing the
investment (Anthony et al., 1992).
Most proposals require significant amounts of new
capital. Techniques for analyzing such proposals are
described in many studies.
Different methods are used to analyse each type of
investment because of differences in timing the expenses and
their associated returns (Kay Edwards, 1994).
In general, the most frequently used technique for large
corporations is Internal Rate of Return (IRR) or Net Present
Value (NPV) (Ross et al., 2005), (Graham Harvey, 2001).
According to Helfert (2001), the net present value (NPV)
measure has become the most commonly used indicator in
corporate economic and valuation analysis, and it is accepted as
the preferred measure in the widest range of analytical processes.
An important point is that these techniques are in fact
used in only about half of the situations in which,
conceptually, they are applicable. There are several reasons
for not using present value techniques in analyzing all
proposals (Anthony Dearden Govindarajan, 1992).
There is no feasible alternative to adopting the
proposal. The necessity to comply with legislation is
an example.
The rationale for the proposal is something other than
increased profitability. The need to improve employee
morale or company image, or perhaps to meet safety
regulations are good examples.

Companies usually have rules and procedures for the

submission of capital expenditure proposals. These rules
specify the approval requirements for proposals of various
magnitudes and also contain guidelines for preparing
proposals and general criteria for their approval (Anthony et
al., 1992). Nevertheless, we have to say that in Hungary; only
a few larger and developed companies have a working
system for making investment decisions. Moreover, several
firms do not use dynamic techniques, and in Hungary this
statement is cumulatively true.

Discussion
When organizations evaluate the financial feasibility of
investment decisions, the time value of money is an essential
consideration. This is particularly true when a project
involves cash flow patterns which extend over a number of
years. This is called a discounted cash flow method.
(Budnick, 1988) In order to discount all cash flows, an
interest rate must be assumed for the intervening period.
Frequently, this interest rate is an assumed minimum desired
rate of return on investments. Sometimes this is a reflection
of the known rate of return, which can be earned on
alternative investments (e.g., bonds or money market
founds). (Budnick, 1988) According to Helfert (2001), this
rate is commonly based on a companys weighted average
cost of capital, which embodies the return expectations of
capital structure. From an economic standpoint, it should be
the rate of return an inventor normally enjoys from
investments of similar nature and risk. In effect, this standard
represents an opportunity rate of return. In a corporate
setting, the choice of a discount rate is complicated both by
the variety of investment possibilities and by the types of
financing.

54
The Net Present Value (NPV) method
The Net Present Value (NPV) of an investment is the
present value of the expected cash flows, less the cost of the
investment (Ross et al., 2005).
Cash inflows are treated as positive cash flows and cash
outflows, including the initial investment as negative cash
flows. If the NPV of all cash flows is positive at the assumed
minimum rate of return, the actual rate of return from the
project exceeds the minimum desired rate of return. On the
contrary, if the NPV for all cash flows is negative, the actual
rate of return from the project is less than the minimum
desired rate of return (Budnick, 1988). While the NPV Rule
has many advantages that have been explored in the
literature, it also has numerous limitations. For example, the
NPV Rule does not answer all our questions about the
economic attractiveness of capital outlays. One of these is
that the size of the NPV is affected by the size of the
investment (Helfert, 2001), (Warren, 1982). The more central
problem is that the concept of a NPV is awkward for a
layman to understand. Most farmers have good ideas of what
is meant by return on capital, but few will have a grasp of
the implications of net present value. It is just that NPV is not
a convenient yardstick. Ideally, we need an investment
appraisal technique which will incorporate the discounting
principle and yet give a percentage rate of return on capital,
and such a technique is the IRR method (Warren, 1982).
Although this analysis allows one to determine whether a
project satisfies the minimum desired rate of return criterion,
it does not provide a measure of the exact rate of return.
Methods for computing the actual rate of return are simple
extensions of NPV technique (Budnick, 1988).
In the following, we present the most popular alternatives
to NPV. When it is all said and done, they are not the NPV
rule; for those of us in finance, it makes them decidedly
second-rate. (Ross et al., 2005)
The Internal Rate of Return (IRR) Rule
IRR is also called the marginal efficiency of capital or
yield on the investment. (Kay Edwards, 1994)
Naturally, the result of a given project will vary with
changes in the economic life and the pattern of cash flows. In
fact, the IRR is found by letting it become a variable that is
dependent on cash flows and economic life. In the case of
NPV and PI, we have employed specified return standard to
discount the investments cash flows. For the IRR, we switch
the problem around to find the one discount rate that makes
cash inflows and outflows exactly equal (Helfert, 2001). It is
the discount factor that sets NPV to zero.
Once the IRR has been calculated, it can be compared
with the cost of capital (Warren, 1982). Accept the project if
the IRR exceeds the required return.
Unlike the NPV method, IRR can be used to rank
investments which have different initial costs and lives (Kay
Edwards, 1994). Select alternative with the highest IRR.
As a ranking device for investments, the IRR is not
without problem (Brealey et al., 2006), (Fnagyet et al.,

Andrs Nbrdi and Lszl Szllsi

2003), (Helfert, 2001), (Katits, 2002), (Lee et al., 1980),
(Ross et al., 2005), (Warren, 1982).
It does not distinguish between investing and
borrowing.
IRR may not exist or there may be multiple IRR,
mainly not typical investments.
Problems with mutually exclusive investments.
The rate of return does not reflect the size of a project,
it is the Scale problem.
The timing problem. The NPV and IRR methods give
conflicting ranking for projects.
Assumption concerning the reinvestment rate
NPV versus IRR
Hardacer et al (2004) support the widespread recommendation by economists that NPV is the most appropriate
investment criterion. When comparing investments with
different time horizons, the corresponding recommendation is
to use equivalent annuity as the choice criterion. This is
simply the NPV averaged over the life of investment. In
practice, the recommendation in favour of NPV is often not
followed. Instead, the internal rate of return (IRR) is widely
used in preference to NPV, mainly on grounds of ease if
interpretation this advantage is highlighted by Ross
Westerfield Jaffe (2005) also , especially for comparing
investments of different scale. Hardacer et al (2004)
mentioned also that the two criteria will not always rank
alternative investments in the same order.
In general, NPV (ideally supported by the PI) is
preferable on grounds of consistency, with IRR having
values of convenience and ease of communication. (Warren,
1982) Ills (2002) emphasizes the disadvantages of NPV
method and prefers IRR method. In deciding whether to use
the IRR or the NPV method, it should be recognized that in
most cases both give the same accepting or rejecting
decision for a single project. The NPV method tends to be
somewhat easier in terms of the computational procedures
required. The IRR method has the advantage of expressing
the result as a compound rate of return, which makes it
easier to compare the project under consideration with
financial instruments and other investment opportunities. In
many cases where two or more projects must be ranked, it
will be helpful to use both methods and draw a diagram of
the results (Lee et al., 1980).
The Profitability Index (PI) method
In situations where a limited amount of capital is being
allocated among several independent projects, it is
sometimes helpful to rank them on the basis of the
Profitability Index (Lee et al., 1980), (Brealey et al., 2006).
After calculating the NPV of a series of projects, we might be
faced with a choice that involves several alternative
investments of different sizes. This choice is based on the
same inputs, but differs in format, focusing on the relative
size of the project (Helfert, 2001). There is no understanding

Key aspects of investment analysis

concerning the matter of PI. Contrary to other authors,
according to Brealey et al. (2006), PI is NPV divided invested
costs. It gives different explanation to this indicator. It has
problems with mutually exclusive investments (Ross et al.,
2005).
The Discounted Payback Period (DPP) Rule
The payback period of a project shows us the time it takes
the project to pay back its initial investment, taking the
time value of money account. This value is the number of
years it takes before the cumulative forecasted cash flow
equals the initial outlay. The payback rule says: only accept
projects that payback in the desired time frame. This
method is flawed, primarily because it ignores the timing of
cash flow within the Payback Period, and the present value of
payments after the payback period (Brealey et al., 2006),
(Ross et al., 2005). It is a break-even condition in value
creation. It is achieved at the specific point in time when the
cumulative positive present value of cash benefits equals the
cumulative negative present value of all the cash outlays
(Helfert, 2001).
Handling income taxes
According to most authors, investments are better
analysed using after-tax net cash flows; therefore all values
should be on an after-tax basis in a practical application of
methods. Whenever after-tax net cash flows are used, it is
important that an after-tax discount rate also be used (Kay
Edwards, 1994), (Lee et al., 1980).
Although some companies evaluate projects on a
before-tax basis, most find that the best analysis is on aftertax basis (Budnick, 1988). There are two things that must
be considered when calculating after-tax cash flow:
investment credit and depreciation. The interest of the
credit increases cash outflows, so it reduces taxable
income. Depreciation is not included in calculating net cash
flows because it is a non-cash expense. However,
depreciation is a tax-deductible expense which reduces
taxable income and therefore income taxes (Kay
Edwards, 1994), (Lee et al., 1980).
Helfert (2001) not only emphasises the importance of
depreciation as a tax shield effect in investment analysis, but
considers accelerated depreciation possibilities and effects
for return of investments as well. On the contrary, Ills
(2002) emphasises the methodological problems of using
after-tax cash flows; therefore, she puts before-tax cash flows
forward.
Handling inflation
The most common error in investment appraisal is the
calculation of the rate of return in real terms, i.e. not building
inflation into cash flow or profit estimates, testing against a
cost of capital (discount rate) expressed in nominal terms.
The result is the rejection of many projects which would in
fact have been worthwhile (Warren, 1982).

55
When accounting for inflation in capital budgeting, we
should maintain consistency between cash flows and
discount rate (Ross et al., 2005), (Kay Edwards, 1994),
(Warren, 1982), (Brealey et al., 2006), (Helfert, 2001). Thus,
if no inflation is built into the basic calculation, the result
should be compared with the cost of capital in real terms. In
other words, if no inflation is calculated in cash flows,
discount rate in real terms should be used, and conversely, if
inflation is calculated in cash flows, discount rate in nominal
terms should be used.
In many ways, this is the simplest solution to the inflation
problem, as long as it can be assumed that the values of all
inputs and outputs will rise in price at the same constant rate
over the project life, and discounted by the nominal rate. In
this way, we can take that situation into account also when
costs are likely to rise faster than the prices of outputs. It is a
common story in agriculture (Warren, 1982).
Handling risk and uncertainty
In most cases, the initial outlay can be estimated with
reasonable accuracy. Estimates of the other cash flows are
nearly always subject to some degree of uncertainty. It must
be expressed consistently in developing the investment
analysis (Helfert, 2001), (Lee et al., 1980).
Given the uncertainty that may exist about the future, it is
often useful to make a sensitivity analysis, which asks a
number What if questions. Such quesitons can be
characterized thus: What changes in x will result from a
given change in the level of y?, where x is a measure of
profit, cash flow, capital or NPV and y is one of the
components in that measure, such as input price, input
volume, output prise, output volume, interest rate, and so on.
This analysis involves changing one or more values in the net
present value equation (called model) and the recalculation
of not only the NPV, but other indicators as well (Helfert,
2001), (Kay Edwards, 1994), (Warren, 1982).
The analysis will give an impression of the risk of the
investment but, perhaps more importantly, it will also
show the elements for which the balance is most sensitive.
On the other hand, it is a technique which allows the
manager to examine the likely effects of his worst, best,
and most likely assumptions (pessimistic, expected, and
optimistic cases) concerning the outcome of a project
(Warren, 1982).
The problem with sensitivity analysis is that the
underlying variables are likely to be interrelated, and we can
not consider them properly.
There are other techniques to handle uncertainty (Brealey
et al., 2006), (Ross et al., 2005), see them shortly below.
Scenario Analysis: Project analysis giving a particular
combination of assumptions. It allows managers to look at
different but consistent combinations of variables.
Simulation Analysis: Estimation of the probabilities of
different possible outcomes. Monte Carlo Simulation is a
tool for considering all possible combinations.
Break Even Analysis: Analysis of the level of any
variable at which the company breaks even. Point at which

56

Andrs Nbrdi and Lszl Szllsi

the NPV=0 is the break even point. It is calculated on a net

present value basis, gives managers minimum targets.
Decision Trees: Allow us to graphically represent the
alternatives available for us in each period and the likely
consequences of our actions.

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Further questions in connection with investment analysis

Hardacer, J. B., Hurnie, R. B. M., Anderson, J. R., Lien, G.

(2004): Coping with Risk in Agriculture. Second Edition, CABI
Publishing, 234244. p.

Step for the analysis of investment, estimation of cash

flows
Handling investment financed by credits or other capital
Comparing investment with unequal lives

Graham Harvey (2001): The Theory and Practice of Finance:

Evidence from the Field. Journal of Financial Economics 61,
187243. p.

Helfert, E. R. (2001): Financial Analysis: Tools and Techniques,

A Guide for Managers, McGraw-Hill, 221296. p.
Ills, M. (2002): Vezeti gazdasgtan. Bvtett msodik kiads,
Kossuth Kiad, 85175. p.

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