Economic Evaluation

Aug 3, 2018 in Business

Introduction

Planning and development division of a company examines projects from the technical, social, commercial, financial and economic points of view. Strategic investment decision in today’s economic environment identifies that the financial metrics alone cannot properly evaluate investment projects (Butler et. al., 1991). Highly competitive financial environment emphasizes the use of non-financial factors in investment appraisal along with the financial. The corporate management is accepting the pivotal role of non-financial parameters in capital budgeting. Academic researches also explain the necessity of the use of both financial and non-financial parameters in investment appraisal. This is noted in scholarly works of Adler (2000), Chen (1995), Lopes & Flavell (1998), and Skit more et.  al. (1989). This work intends to discuss and determine the importance of the use of both financial and non-financial parameters in project appraisal.

Project Appraisal: Concept and Parameters

Project appraisal is a decision-making process. The objective of this process is to confirm that the investment proposal meets cost-benefit, as well as technical and economic parameters.  Any investment project is applied to the fixed assets over a period. The large amount of cash is required in capital investment project; the cash is tied-up for a substantial length of time. The management needs to pay close attention to the entire project appraisal process to reduce the risk of the project, and properly identify cost and benefit relationship of the project. Underestimation of cost and overestimation of benefit could eventually lead to disaster to the investment.  Final value of the project has to be higher than the investment value.  For decades, industry has generalized various appraisal techniques (Remer and Nieto 1995; Kaplan and Atkinson 1998). Appraisal techniques are developed to evaluate financial aspects, non-financial aspects, capital structure, agency problem, and governance issues (Moutinho and Mouta 2011). This report limits to the study of financial and non-financial aspects.

Identification and impact of non-financial parameters

Any serious investment decision requires implementations of both financial and non-financial aspects. Non-financial aspects in project assessment perform the same valuable role as financial aspects. Sometime they act as the backbone, which will either make or mare the investment (Investment and Business Accountants 2009). That is why; non-financial aspects take an active role in project appraisal process. Technical, human resource, organizational, management, political, social and environmental aspects may serve as non-financial variables in project appraisal (Moutinho and Lopes 2011). Indeed, a large array of non-financial variables influences the outcome of an investment project. Identification and analysis of all of them is out of scope of this project, and many of them depend on the nature and character of the project.  For this research, we identified non-financial variables based on web data analysis and empirical study performed by Nuno Moutinho (2011). We categorized non-financial parameters as intangible, subjective, and qualitative (Moutinho and Mouta 2011).

Climate issues

This aspect falls under intangible category. The world is facing serious problems due to the facts that commercial investments did not pay necessary attention to the adverse side effect of production system and products. Among many negative effects, we can raise, greenhouse effect, hole in the ozone layer of the atmosphere. Green activities have gained popularities to the extent that consumers consider those companies irresponsible who do not invest in equipment that protect the environment.  Environmental protection agencies voices could be hard louder and louder all over the world.  Ignoring this issue in the evaluation phase may eventually bring enormous financial losses in the form of penalty or termination of production, even jail time.

Staff  motivation

This aspect falls under subjective and qualitative categories. It is a part of project’s strategic analysis. Over the last century, many theories have emerged in this area. Taylor, Mayo, Maslow, Herzberg have recommended various methods to motivate workers at work. Why do we need to motivate workers? The reason is how financially viable a project could be, however; it might never see the daylight if the working force in the project did not see motivation in the project.  How to motivate the workforce; Taylor says it is money, Mayo defines by meeting their social needs whilst they are at work, Maslow recommends focusing on the physiological needs of employees, Herzberg emphasizes on recognition, promotion and hygiene factors (tutor2u 2012). Recent studies show that financial metrics do not measure performance of the company. Performance is measured through total quality management, which requires considering satisfaction of workers at work. Ignoring employee motivation issue at appraisal phase would increase the company’s financial losses associated with poor product quality, worker retention.

Customer satisfaction

It falls under intangible, subjective and qualitative categories. The goal of an investment is to sell products or services. The ultimate intangible metric of success of an investment is customer satisfaction.  It is an invisible relationship between workers, management on one end and consumers on the other end (Nigel et al. 2007). The metric “benefit” that financial aspects calculate is based on customer satisfaction. Even though, it falls under subjective category, but it determines quantitative parameter (finacial). That is why project appraisal technique must consider if the product or service meets the customer’s expectation level.

Human resource

It falls under intangible and qualitative categories. This feature determines technical knowledge, problem-solving ability, ability to work as a team of the entire workforce.  Project appraisal must learn and determine technical and intellectual quality of human resource that the project requires for its success (Lopes and Flavell 1998). Failure to resolve this feature may result in delivering poor quality product or service, which will cause significant losses to the company.

Government regulations

This falls under intangible and qualitative categories.  This factor determines technical knowledge, problem-solving ability, ability to work as a team of the entire workforce.  Project evaluation must review and determine technical and psychological aspect of human resource that the project requires for its success.  Failure to determine this feature may result in delivering poor quality product or service, which will cause substantial losses to the company.

Time factor

It falls under qualitative category.  This non-financial factor evaluates the impact of various financial factors.  In project appraisal, it is necessary to consider three time factors: project life cycle, equipment life cycle, and product life cycle.  Project life cycle is essential for the calculation of all financial information. Equipment life cycle must be higher than the project life cycle, or the project cannot produce the product in the project’s life cycle.  Product life cycle is crucial to evaluate if projected return may be achieved with the same product during the project life cycle.

Commercial factor

It falls under qualitative category.  It determines market needs and ability to seize the opportunity, and company’s capacity. This factor determines if the appraisal team has studied closely the demand and supply side of the intended product or services. Ignoring of this factor may cause losses.

Back-end profit

This falls under intangible and qualitative categories. Time to time, the company needs to invest on a non-profitable project.  The company expects to make a profit from another project by investing in a non-profitable project.  This factor plays as a bet to bring in customers for some future products. Project appraisal team needs to pay attention if this might be necessary direction for the proposed project.

Critical assessment: Influence of financial and non-financial parameters

Use of reliable techniques for project appraisal is essential because it determines the survival of an organization and its ability to rejuvenate through the allocation of capital to productive use (Arnold and Hatzopoulos, 2000). The previous section identified and explained the purpose of non-financial factors in project appraisal.  This section will review and analyze methods and techniques used in project appraisal process both for non-financial and financial aspects.

Non-financial parameters do not have any industry accepted evaluation criterion. The parameters are of intangible nature and depend on evaluators’ subjective analysis. For example, there is no metric for evaluating customer satisfaction or employee satisfaction.  It is necessary to apply tangible method to quantify non-financial parameters.  The evaluation process for non-financial parameters is different for each parameter. Because of its intangible and subjective nature, many companies in industry use multi criteria decision-making methods (MCDM).  However, MCDM is complex and based on theoretical mathematics and psychology.  Some of the MCDM in investment appraisal are Analytic Hierarchy Process (AHP), Fuzzy Decision Methodology (FDM), and ELECTRE.  These methods are software oriented, and discussion of them is beyond the scope of this work.  However, much easier way could be the use of benchmarks against peers, industry and leading practice of non-financial parameters.

On the other hand, for decades industry has evaluated methods and techniques for the evaluation of financial parameters in project appraisal. Two different methodologies (Freeman and Hobbes 1991) are widely used to evaluate financial parameters in project appraisal.  One of them is accounting data method and the other cash flow model.  Both accounting data method and cash flow model are backed by financial theories. Financial theories establish the cost and benefit relationship of the project.

Accounting data method uses Payback period (PB) and Accounting rate of return (ARR). Payback period determines the total number of period of cash flow, which is equal to the initial cash outlay. PB determines the length of the time that is required to get the initial investment back. The company may establish a cut off time for an investment. The project is accepted, if PB is less than the cut off period.  Drawbacks of this method are it does not consider the time value component of money, it does not evaluate profit for the life of the project, and it maximizes the firm’s equity value.  Strong appeals for this method are its easy application, contribution to liquidity. ARR is a ratio of the arithmetic mean of accounting income for the project life cycle to the average investment at the end of the project.  Drawbacks of ARR are it does not consider the time value component of money, and it can be calculated in different ways, so creates consistency problem. Strong appeals for this method are it can be calculated easy way and shows profitability of investment.

Cash flow model is based on two conceptual parameters: cash outflow and cash inflow. The model encapsulates these concepts.  Use of cash flow model is the traditional approach in project appraisal.  The decision –making parameter in this model is the difference between incoming and outgoing cash flow. Conceptually this parameter is called “benefit”.  Decision-making process is based on the value of “benefit”.  In other word, this model evaluates cost benefit theory of the investment. The important approach in the model is the use of the time value component of the money.  The essence of all investment appraisals is to determine the value of the money invested, by comparing benefits with costs. If this is not done in appropriate ways, then the investment may jeopardize the company’s success (Mott 1987). Another way of looking to this model is through the balance sheet since the cash taken from the company is tied to some long-term assets.  From this aspect, an investment is called capital budgeting.  The “benefit” of capital budgeting is defined as the monitory values through acquiring a long-term asset that attributes steady cash for the life of the project.  The concept benefit applies to the life cycle of the project. The life cycle consists of phases: planning, implementation and utilization. Project appraisal is a part of the planning phase.  This work will focus only on the planning phase of the project. The planning phase establishes different tasks in order to evaluate the project.  The description and explanation of these tasks are out of the scope of this project. Cash flow model is widely accepted in project appraisal because it considers the time value component of money. In the context of the time value component, it is called discounted cash flow (DCF).  Discounted cash flow offers two parameters for project appraisal.  They are Net present value (NPV) and Internal rate of return (IRR). NPV and IRR determine the profitability of the project.  NPV calculation uses two values: initial out lay or cash out flow and cash inflow from project life cycle.  Project is accepted if the NPV is positive.  Initial out lay is always a negative, and cash inflow may be positive and negative.  IRR calculates the rate of return when NPV is zero (no profit and no loss). If IRR is higher than the cost of capital, then the project is accepted. The main criticism of this model is it undermines investment opportunity discounting the money over time.

Conclusion

The above analysis described financial and non-financial parameters involved in investment appraisal (Investment and Business Accountants 2008). The industry has developed rigorous methods for the assessment of financial parameters. However, it has not developed specific methods for the analysis of non-financial parameters.  Nonetheless, understanding of non-financial parameters plays a significant role in investment appraisal.  It is not only significant, but one or several of them could be determinative factors in project appraisal.

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