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Evaluation of the Application of Capital Investment Appraisal Techniques by Corporate Organizations in Nigeria
Sylvester Feyi Akinbuli (BSC, MSC, LLB, BL. AMNIM, FCA, ACTI) Distance Learnning Institute, University of Lagos, Akoka, Lagos E-mail: sfakinbuli@yahoo.com Tel: +2348033311383, +2347025715145 Abstract Every organization, whether private or public, invests in capital projects. The decision to invest and choice of the right investment out of so many available investments is often problematic to managers. The study is an attempt to evaluate the methods of appraising Capital projects generally and in particular to examine the application of these methods in industries including government agencies in Nigeria. The methodology used is a survey of sixty companies incorporated under the Companies and Allied Matters Act (1990). The elements of the survey were selected randomly; one hundred and twenty copies of purposely designed questionnaires were distributed. A total of one hundred and twenty questionnaires were administered using simple random sampling technique. The analysis of the responses showed that there has been improvement in the application of capital appraisal techniques in Nigerian industries. Also the responses further showed that some Nigerian industries and mostly government agencies do not use or apply appraisal techniques but rely on rule of the thumb and guesswork as to the viability of the project .The study recommends that every organization should adopt policies that every capital project should be adequately appraised before embarking on them. Also, organizations should engage in extensive training of their staff in the area of capital appraisal.
Keywords: Capital Investment Appraisal Technique; Corporate Governance; Government Ministries and Agencies; Discounting Cash Flow; Payback Period; Post Audit.
Introduction
The main purpose of the existence of corporate organization is the actualization of its corporate objectives. Corporate objectives in this sense may include: - Maximization of profit through investments, Maximization of sales, Survival of the firm, satisfactory level of profits, obtaining the largest share of the market and Satisfying social needs. The two most important goals appear to be profitability and survival of the firm. The critical problem faced by managers is availability of myriad of investment opportunities. The big question is: which of the investment opportunities should the manager select. He has to make a decision. One of the most important decisions that an investor/ manager takes is the selection of the best investment that will aid the actualization of his organization corporate objectives. This decision is important because once made, the organization has to live with the decision for many years to come. Once capital investment is made, it is difficult to reverse, for instance, if a plant is built, the company is
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committed to a course of action that is not easy to reverse. The study of capital investment appraisal techniques therefore becomes very relevant in todays business environment. There are various appraisal techniques that could be adopted. Lucy (2003) classifies them as follows: The traditional method which consist of - Accounting Rate of Return (ARR) and Payback method (PBP). The Discounted Cash Flow (DCF) Techniques which consist of Net Present Value (NPV) and Internal Rate of Rate of Return (IRR). The purpose of this study is to exhaustively examine each of the appraisal technique and consider whether Nigerian companies do apply the techniques, and if so, to what extent.
Responsibility
Taking investment decision is primarily that of the management. Lucy (2003) opined that investment decision making is invariably a top management exercise. This is because of the scale and long term nature of the consequences of such decisions. The accountants task is to gather the essential data from various sources, consider the financing and taxation implications, analyze the data using one or more appraisal techniques and present the decision maker with the results of the exercise so that the decision maker may make more informed and hopefully better decision, Drury (2000).
Literature Review
Van-Horne (1990) described capital investment as a situation when firms make a current cash outlay for the benefit to be realized in the future. In other words, it involves a decision to spend money now on a project with the expectation of reaping or recovering such money back from the project at some future date. Drury (2000) opined that investment decisions are long-run decision where consumption and investment alternatives are balanced over time in the hope that investment now will generate extra returns in the future. There are many similarities between short-run and long-run decision making, for example, the choice between alternatives, the need to consider future costs and revenues and the importance of incremental changes in costs and revenues but there are additional requirement for investment decisions that, because of time scale involved, the time value of the money invested must be considered. Klammer (1970) studied 369 large scale USA firms between 1959 and 1970 to determine which method was being used for capital project appraisal. The author lumped together the various methods of the Discounting Cash Flow Technique and classified them as the sophisticated technique. The rest, he called the Primary evaluation method. In Klammer survey, he observed that the popularity and adoption of discounted cash flow techniques had raised from 19% in 1959 to 57% in 1970 also the firms that use the rule of the thumb had fallen from 13% to5% in 1970. Falusi (1983) selected 60 manufacturing firms out of which 45 were listed on the Nigerian stock exchange to determine the extent to which firms in Nigeria adopted the discounted cash flow techniques since the traditional methods (non discounted cash flow techniques) are widely assumed to be in use. The study showed that 40 of the 45 quoted companies made use of Net Present Value method while the pay back method were used by the remaining quoted companies as well as the non-quoted companies.
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The time scale over which the benefits will be received is relatively long so that any wrong decision made over an investment, the investor has to live with it for a long period. The whole nature of the business and its direction, and the rate of progress are ultimately governed by its overall investment programme. Capital investment involves waiting for the recoupment of expenditure which could have been invested elsewhere. Therefore there is opportunity cost. Once the expenditure is incurred, it cannot be recouped quickly and the capital (fund) is tied up for several years. The investment will earn streams of profit or returns over the period of anticipated years. The component parts of capital investment budgeting has been summarized by Dean (1953) as follows: A creative search for investment opportunities. Long-range plans and projections of the companys future development. A short-range budget of supply of funds and demanded capital. A correct yardstick of economic worth of individual projects. Standard for screening investment proposals that are geared to the companys economic circumstances. Expenditure controls of outlays for facilities by comparison of authorization and expenditure. Candid and economically realistic post completion audits of project earnings. Investment analysis of facilities that is suitable for disposal. Forms and procedures to insure smooth working of the system.
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5. Measure payoffs 6. Select investment 7. Obtain authorization and implements 8. Review capital investment
No
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Applying Accounting Rate of Return in appraising these projects will give the following results: Accounting Rate of Return =
Projects Average Profit ARR =
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The appraisal in the above calculation shows that projects A, B, & C have a return on capital of 24%, 51% and 8% respectively. Based on Accounting Rate of Return decision rule, project B will be selected because it has the highest rate of return on capital. Besides, management needs to compare the ARR of project B against the standard of benchmark to determine the ultimate viability in financial terms.
Payback Method
Lucey, (2003) defined Payback as the period, usually expressed in years which it takes for the projects net cash inflows to recoup the original investment. The usual decision rule is to accept the project with the shortest payback period. Drury (2000) defined Pay back as the length of time that is required for a stream of cash proceed from an investment to recover the original cash outlay required by the investment. If the stream of flow from the investment is constant each year, the payback period can be calculated by dividing the total initial cash outlay by the amount of the expected annual cash proceeds. For example, an investor is to appraise the following two projects using payback appraising technique:
Year Cash Flow N -1500 +600 +500 +400 _ _ _ Project 1 Cum Cash flow N -1500 -900 -400 NIL Cash flow N -1500 +300 +500 +400 +300 +300 +300 Project 2 Cum Cash flow N -1500 -1200 -700 -300 NIL +300 +600
0 1 2 3 4 5 6
The appraisal in the above table shows that project 1 payback its capital outlay in 3years while project 2 pay back in 4 years. Based on payback decision rule, project 1 will be selected. The Pay Back period of an investment with constant cash flow is calculated as: Initial Outlay Constant Cash inflow For instance, a project with initial capital outlay of N100, 000 which have a constant cash inflow of N20, 000 will have a payback period of N100, 000 = 5years. 20,000
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indicates that the firm should be indifferent to whether the project is accepted or rejected. To calculate NPV of a project, the following appraisal formula should be used: FV3 FV1 FV2 FVn NPV = + + + Io 2 3 1 + K (1 + K) (1 + K) (1 + K) n Where: Io = represent the investment outlay, FV = represent the future values received in years 1 to n, K = represent the cost of capital. As an illustration, a company T&K Plc. is evaluating projects A and B with initial capital outlay of one million Naira. The projects have the following cash inflows:
Projects Year1 Year 2 Year 3 A N 300000 1,000,000 400000 B N 600000 600000 600000
Cost of capital is 10%. To calculate the NPV require the substitution into the formula as follows NPV for project A is 300,000 1.10 1,000,000 (1.10)2 400,000 1,000,000 (1.10)3 = + 399,700
The net present value calculated for project A is positive with +N399, 700, therefore, it is acceptable, if and only if, it is equal or higher than the benchmark or standard. The NPV for project B is also positive using discount factor of 2.487x N600,000 =1492200 N1,000,000 = N492,200. Comparing the NPV of project A which is N399, 700 with that of project B which is N492, 200. Project B NPV is higher and should be selected.
Note: that the discount factors in the present values table are based on 1 received in n years time calculated according to the present value formula For example, 1 received in year 1, 2 and 3 when the interest rate is 10% is calculated as follows:
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FV3 FV1 FV2 FVn + + + 2 3 1 + K (1 + K) (1 + K) (1 + K) n Where: Io = represent the investment outlay, FV = represent the future values received in years 1 to n, K = represent the cost of capital. For example A company is trying to decide whether to buy a machine for N80, 000 which will save costs of N20, 000 per annum for 5years and which will have a resale value of N10,000 at the end of year 5. What would the IRR of the project be? The IRR is calculated as follows Io =
Try 9% Year 0 1-5 5 Cash flow (80,000) 20,000 10,000 PV factor at 9% 1.0 3.890 .650 PV of cash flow (80,000) 77800 6,500 Net Present Value 4,300
Try 12% Year 0 1-5 5 Cash flow (80,000) 20,000 10,000 PV factor at 9% 1.0 3.605 0.567 PV of cash flow (80,000) 72,100 5,670 Net Present Value (2230)
The real rate of return is therefore greater than 9% (NPV = +4,300) but less than 12% (NPV = 2230) By interpolation one can apply this formula: P IRR = A + ( x (B A )) P+N Where A is the (lower) rate of return with a positive NPV B is the higher rate of return with negative NPV P is the amount of the positive NPV N is the amount of the negative NPV 4300 In this example, the IRR is 9 + ( x (12 9))% 4300 + 2230 = 10.98%, approximately 11% The above calculation shows that the IRR is approximately 11%. The IRR decision rule is that if the IRR is greater than the opportunity cost of capital, then, the investment will yield positive NPV which makes it profitable and acceptable. The cost of capital in this case is 9% hence the project is acceptable.
Post audit
A post audit or a post-completion audit is a review of the cash inflows and outflows from a project after it has reached the end of its life, or at least some years after it has begun. As far as possible, the actual cash flows should be measured and compared with the estimates. The manager responsible for the project should be asked to explain any significant variances. Post audit checking cannot reverse the decision to make the capital expenditure, because the expenditure will already have taken place. However, it does have a certain control value. If a manager asks for and gets approval for a capital project and he knows that in due course of time the project will be subject to a post audit, he will be more likely to pay attention to the benefit and the running costs than if no post audit were threatened.
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In other words, the threat of the post audit will motivate managers to work to achieve the promised benefits from the project. If the post audit takes place before the project life ends and if it is found that the benefits have been less than expected because of management inefficiency and earn greater benefits over the remaining life of the project. It can help to identify managers who have been good performers and those who have been poor performers. A post audit might identify weakness in the forecasting and estimating techniques used to evaluate projects and so should help to improve the discipline and quality of forecasting for future investment decisions A post audit might reveal areas where improvements can be made in methods so as to achieve better results in general from capital investments.
Nigerian Experience
Investment in capital project in Nigeria cuts across the public and private sectors, capital investment world over should be carefully appraised in other to arrive at accurate decision for maximization of profit. The focus of this paper is to find out whether Nigerian investors do appraise their investment before they embark on them and if they do, to find out the method used, the extent of usage and effect on profitability.
Methodology
In order to give empirical support to this paper concerning application of capital appraisal techniques in Nigeria, a survey of sixty companies incorporated under the Companies and Allied Matters Act (1990) was conducted. The main issue in this survey is the assessment of application of capital appraisal in Nigeria .The companies selected were classified into four groups namely The Manufacturing Industries Construction, Engineering and Mining Industries Merchandise Industries, and Government Ministries and Agencies The elements of the survey were selected randomly, one hundred and twenty copies of purposely designed questionnaires were distributed .The draft questionnaires were perused by three experts in the field of accounting including two fellow members of the Institute of Chartered Accountants of Nigeria and a University lecturer with a Doctoral degree in research to enhance its reliability and validity . The criticism from them were noted and incorporated in the final copies. The respondents were believed to posses enough accounting knowledge in the processes and valuation of capital projects using appropriate techniques. Simple tables, percentages and ratio were used in the analysis.
Research Questions
Do Nigerian organizations including government establishments apply capital project appraisal techniques before embarking on capital projects? What is the effect of non- application of capital appraisal techniques on project before embarking on capital project? To what extent do Nigerian companies apply capital appraisal techniques on projects?
Data Analysis
The analysis of the data was made in the tables below and their results were equally discussed.
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A total of one hundred and twenty questionnaires were administered. One hundred and fourteen representing ninety five percent of the questionnaire was completed and returned out of which ten questionnaire representing about half percent were wrongly completed and was discarded as unusable. The questionnaire significantly covered all the sectors studied. This sectorial representation was depicted in table 1 below:
Table 1: Analysis of questionnaire distribution.
No. of Respondents 25 28 27 25 105 % of respondents to total Response 24 26 26 24 100
Category/Group of Organization No. Q/Administered Studied Manufacturing industries 30 Construction, engineering and 30 mining industries Merchandise industries, 30 Government Ministries and Agencies 30 Total 120 Source: Researchers Survey Findings 2011
Table 2:
Classification of Respondents
A 25 Manufacturing industries B 28 Construction, engineering and mining industries C 27 Merchandise industries, D 25 Government Ministries and Agencies Source: Researchers Survey Findings 201
100
28
Nil
100
Nil
100
07
20
26
74
100
20
20
80
100
The above table shows that about 92% of the Manufacturing sector and 95% of the companies engaged in the Construction and Engineering organizations have knowledge of capital project appraisal techniques while 74% of the Merchandise organizations and 80% of Government Ministries and Agencies are not aware of capital appraisal techniques.
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Discussion of Results
Table 3:
S/ N Questions
Did your organization use capital Appraisal Techniques to appraise its capital projects? Did your organization use NPV techniques to appraise capital project? Did your organization use IRR techniques to appraise capital project? Did your organization use ARR techniques to appraise capital? Project Did your organization use Pay Back techniques to appraise capital project? Did your organization make use of rule of the thumb or guess work to appraise project before execution? In your opinion, will the use of capital appraisal technique on capital project affect the profit of your organization ?
10
07
25
14
56
28
15
54
27
05
19
25
03
12
25
09
36
28
08
29
27
04
15
25
00
00
25
03
12
28
04
14
27
07
26
25
00
00
25
00
00
28
04
14
27
05
19
25
05
20
25
00
00
28
00
00
27
15
56
25
23
92
25
20
80
28
21
75
27
14
52
25
22
88
Table 3 above shows that majority of the manufacturing organization and companies that engaged in Construction, Engineering and Mining industries apply Capital Project Appraisal Techniques. In the Manufacturing sector, 56% apply NPV, 36% uses IRR and the rest uses traditional methods while in the Construction organizations 54% uses NPV,29% uses IRR and the rest apply
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traditional method. Only 19% of Merchandise companies and 12% of Government Ministries and Agencies apply NPV techniques while 15% of Merchandise companies use IRR and the Government Ministries and Agencies do not use IRR at all instead about 88% of them apply rule of the thumb.
Table 4: Effect of Application of Capital Appraisal Techniques.
No of Respo in MFG 15 % of Response No of Respo in CONST % of Response No of Respo in MERC % of Response No of Respo in GOVT % of Response
Options
Efficient Operation of 60 the organization. Inefficient Operation of 6 24 the Organization It has no effect 4 16 Total 25 100 Source: Researchers Survey Findings 2010
20 5 3 28
71 18 11 100
17 6 4 27
63 22 15 100
20 03 02 25
80 12 08 100
Table 4 above show that about 80% of the total respondents believed that the applications of Appraisal Techniques on capital projects before execution will enhance the actualization of corporate objectives through significant increase in the profitability of the organizations.
Table 5: Effect of Non - Application of Capital Appraisal Techniques.
No of Respo in MFG % of Response No of Respo in CONST % of Response No of Respo in MERC % of Response No of Respo in GOVT % of Response
Options
Increase in the Growth of the organization. Failure of the Organization It has no effect on the Organization
2 20 3
8 80 12
03 22 02 27
11 82 07 100
0 25 2 27
0 93 07 100
0 18 07 25
0 72 28 100
Average of 82% of the total respondents is of the opinion that non application of Capital Appraisal Techniques on projects before execution can lead to inefficiency of operation and subsequently to failure or liquidation of the organization while about 14% believed that non application of capital appraisal techniques will have no effect on the performance of the project.
Table 6: Why did some organizations failed to change from non-project appraisal procedure to the application of capital project appraisal procedure?
No of Respo in MFG 9 6 10 % of Response No of Respo in CONST % of Response No of Respo in MERC % of Response No of Respo in GOVT % of Response
Options
Fear of cost 36 Lack of staff support. 24 Lack of adequate 40 knowledge of the Outcome of utilization of appraisal techniques Total 25 100 Source: Researchers Survey Findings 2010
15 03 10
54 10 36
0 25 2
0 93 07
10 03 12
40 12 48
28
100
27
100
Average of 32.5% of the total respondents is of the opinion that fear of cost, 34.75% lack of staff support and 32.75% believed that lack of adequate knowledge of outcome of application was
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responsible for organization unwilling to change from the existing policies of non appraisal technique to the application of capital appraisal techniques on projects
Above figure revealed that some organizations use the combination of one or more of the techniques simultaneously. The study further revealed: 1. that most government organizations and merchandize organizations do not apply capital project appraisal technique. 2. Application of capital appraisal technique can lead to efficiency, effectiveness , increase in corporate profitability and actualization of corporate objectives. 3. that non-application of capital appraisal technique may be due to the fact of fear of implementation cost or lack of adequate knowledge of the outcome after its utilization. 4. That change in the existing policy of non application of capital appraisal to effective and properly implemented policies can reposition the organization for better. 5. The study revealed that there has been great improvement in the application of capital appraisal technique when compared with the study conducted by Klammer in 1970 and that of Falusi 1983, even though both study failed to analyse the application of each technique by various organisation and government ministries and agencies were not included.
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6. The study revealed that most companies in Nigeria do appraise their capital investment by using capital appraisal techniques such as NPV, IRR, ARR, and PBP techniques. 7. The study further revealed that some organization including government ministries and agencies still embark on capital investment without using any appraisal technique instead they apply rule of the thumb or guess work in appraising their project
Recommendations
1. Organizations both in public and private sector should ensure that there are strong policies that make it mandatory to evaluate all capital project before embarking on them; 2. Government should ensure that they recruite skilled personnel that have adequate knowledge on capital project evaluation; 3. Government should train and retrain the existing staff in area of capital project evaluation techniques; 4. Nigerian Tertiary Institutions, Institute of Chartered Accountants of Nigeria and other financial institutions still have much to do in terms of educating investors, business and government organization through workshops and seminars.
Reference
[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] [17] Adepoju, A. (2002) Capital Investment Appraisal Techniques: The Way Forward, ICAN Students Journal, Institute of Chartered Accountant of Nigeria, Lagos Nigeria. BPP Publishing Ltd, (1987), Financial Management, Dacosta Print & Finishing Company, Salusbury, London, W2 IJA . Brown, J.L and Howard, L.R (1982) Managerial Accounting and Finance, Macdonald& Evans Ltd Estover, Plymouth PL6 7PZ. Pp678-752 Colin Drury (2000) Management and Cost Accounting, 5th edition, Thomson Learning London. Dean, J. (1953) Controls for Capital Expenditure Financial Management, Series No. 105, American Management Association. Garrison, R.H. and Noreen, E .W. (2003) Managerial Accounting, 10th Edition, Mc Graw-Hill Irwin Van- Horne, J.C. (1990) Financial Management and Policy, 6th Edition, Englewood Cliffs, N . J, Prentice Hall. International Inc. Klammer, T (1972) Empirical Evidence of the adoption of sophisticated Capital Budgeting Techniques, The journal of Business, October edition. Lucey, T. (2003) Management Accounting, 5th edition, Continuum, London. Major, E. (1995) Fundamentals of Project Appraisal, Lagos, Masan Nig. Co. Publishers. Pandey, I. M. (1979) Financial Management, New Delhi, Vikas Publishing House.