B) Investment Project Appraisal

P.M.: How can an investment project be evaluated?

Con.: There are different techniques. Most common today are UNIDO techniques based on payback period, net discounted cash flow and internal rate of return.

P.M.: What criteria should be used in our case? What do they imply?

Con.: Let's start with the payback period, which is the number of years required to recover the investment needed for the project.

F.M.: Experience has shown that the payback method does not provide reliable information about the project's contribution to the market value of a company. Besides, it disregards time value of money. It's common knowledge that the value of our Rouble today is more than its value to be received after some time.

Con.: Yes, the sum of money to be received in future is less valuable than it is today.

P.M.: What can you say about the other criteria?

Con.: In the opinion of a number of scientists, net discounted cash flow appraisal, based on cash flow discounted at a certain discount rate, is a more effective technique. Net discounted cash flow gives a wider picture of investment results.

P.M.: From my experience, I, for one, think that this technique is more reliable because it takes into consideration all benefits and costs occurring during the entire life of the project.

Con.: Net discounted cash flow is a difference between the cash flow over the project life expressed in terms of its present value and investments in the project.

P.M.: I see. How can the third criterion be determined, I mean the internal rate of return? Does this method have any advantages over the others?

Con: The IRR method also considers the time value of money by discounting the cash streams. But the rate of return is not predetermined. The IRR is based on facts which are internal to the proposal. The idea of the method is that the internal rate of return is equal to the maximum borrowing interest rate that can be repaid over the period of the project life, if the project is financed only from borrowed funds. So the IRR is a measure of investment effectiveness.

P.M.: Which method, do you think, suits us best?

Con.: It's a difficult question to answer. The choice of the method depends on the company's position, size of the investment project, the situation in financial markets. It would be a good idea to use all the methods.

P.M.: It's a hell of a job, isn't it?

Con.: Yes, but these criteria can be easily determined using modern computer equipment.

Words you may need:

capital budget смета капиталовложений

service life срок службы

depreciation n износ, амортизация

profit and loss statement счет прибылей и убытков

UNIDO (United Nations Industrial Development Organization) Организация Объединенных Наций по промышленному развитию

manual n руководство, справочник

cash flow risks риск денежного потока

payback period срок окупаемости

discounted cash flow будущие поступления наличными, приведенные в оценке настоящего времени

internal rate of return внутренняя норма доходности

time value of money временная стоимость денег

present value приведенная стоимость

Ex. 14. Give extensive answers to these discussion questions:

1. How is financial management organized in a typical firm?

2. What sources of financial resources are used by businesses? How do business firms use their funds? How can they increase their capital?

3. Explain why all firms need both fixed and working capital.

4. How are different assets, say current or fixed, managed?

5. How are financial risks managed?

6. What do financial managers take into account when they try to strike the right balance between different sources of funds, e.g. between long- and short-term debt or between debt and equity?

7. What formula for finding the best financial structure for a firm would you suggest?

8. How can investment projects be evaluated?

9. What most typical investment strategies are used by business firms?

10. Financial analysis is the use of financial data to evaluate the financial position of a firm. How does it work in practice?

11. The purpose of accounting is to keep track of sources and uses of funds and to give an accurate picture of the firm's financial position. What accounting data are used in financial management?