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Investment Appraisal Process

Info: 16910 words (68 pages) Dissertation
Published: 22nd Nov 2023

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Tagged: InvestmentBusiness Analysis


Decisions related to investments are one of the most important and vital decisions for any organization. Making investments is the only way to increase, and maximize return on the shareholder's wealth. However, taking the right investment decisions is the biggest challenge that management faces. Investment decisions are always characterized by risk and uncertainty. According to Lumby (2004) investment decision defined in simple terms, is one in which organizations make an initial cash outlay, with the aim of receiving, in return, the future cash inflows. Investments can be analyzed from several perspectives, like its suitability according to the company's objective, social cause, environmental concern etc. Yet, for the purpose of investment appraisal, it is analyzed from the point of view of cash flow only. Thus, the basic aim of investment appraisal is to check whether the initial outlay would result in enough future cash inflows, to be considered worthwhile. In order to achieve this objective, companies require certain inputs. These inputs are put through the process of investment appraisal, to reach the final outcome.

Inputs Required For Investment Appraisal

Investment appraisal in broad terms requires only two inputs – the estimated cash flows, and discount rate. The estimated cash flows includes all the cash outflows starting from the initial stage till much later, and inflows taking place during the lifetime of the project. This gives the final figure, which is positive or negative cash flows i.e. either inflows are more than outflows which is the acceptable case, or outflows are more than inflows which obviously leads to rejection of that project. Calculation of these cash flow figures, involves the treatment of a number of items.

Cash Flows And Time Value Of Money

For the investment appraisal process as discussed earlier, cash flow estimates are the primary input. Initial outlay is easy to estimate as compared to future cash inflows, and even outflows. This is because current requirements for any project, would be ascertained according to which the required finance, can be obtained. Whereas, in the case of future estimates, all the figures are estimated on the basis of some premise, which is always prone to uncertainty. Once these estimated figures are available, companies calculate these future cash flows, in terms of today's value. This is known as the time value of money, according to which, a pound today is not equivalent to a pound tomorrow. According to the time value of money, the investor needs to be compensated for certain factors. Firstly, the investment made has delayed the current consumption of the investor. Current consumption is preferred over future consumption for which, the investor needs to be compensated. This compensation is the interest that is expected on the money invested, for that period. The second factor is inflation, the current inflation rate in UK, is 1.8% (for the month of July - Bloomberg.com) Thus, what can be bought for one pound today, will be available for 1.018 GBP, the next year. Thus, future estimates must be converted in terms of present value, so as to find out its present worth. In order to compensate the investor for these two factors, the rate of return offered, is called the risk free rate. This is equivalent to the rate offered by reputed government bonds, or bills.

Other Inputs

There are some other factors which are required to be considered for the calculation of cash flows. The first is depreciation, which does not form a part of cash flows. For the purpose of calculating true cash flows, the precise time when the cash flow has occurred, is needed. However, depreciation does not involve any cash transaction. So, this is not included while calculating the cash flow. The second is working capital. According to Arnold (2008) besides the large and obvious depreciable assets, investment is also made in working capital. It includes the items like cash, debtors, stock which are part of company's assets and creditors which is the part of company's liabilities. Another important factor is interest. Treatment for interest is again, not straight forward. Interest can be viewed from two aspects. Firstly, if the company is employing its own funds. In that case it is losing the interest which it would have earned, by depositing money in the bank. This does not require any treatment here, because this has been considered as the opportunity cost, and treated accordingly. Secondly, if the organization has borrowed funds from the financial market, then the interest is paid on it, which is a cash expense, and must be included in cash flow calculation. Yet, what is seen in most of the cases is that, organizations use combination of both debt and equity. Now, the same item i.e. interest cannot be treated in two separate ways. As a result, it is considered as an opportunity cost. Besides interest on capital, opportunity cost also includes a number of factors, like a building used in any project, would have earned rent otherwise, which is also the opportunity cost of the project. Other similar factors could be machinery, human resources, and other assets. The last factor is the taxation which also reduces the cash flow, by the amount of tax paid. In this case the notable factor is that debt capital gets the tax shield. However tax is to be paid on equity capital, making it costlier.

Once all the inputs are gathered there are number of techniques available to evaluate the investment, in order to find out whether it would be profitable or not.

Discount Rate

Once the cash flow figures are derived for the entire period of the project, there are several methods using which we can perform the task of investment appraisal. There are some methods in which there is no allowance for the time value of money, like payback method, and accounting rate of return (ARR). In such methods, the discount rate is not required. However the more sophisticated and widely used methods use the discounted rate of cash flows like net present value (NPV), and internal rate of return (IRR). What is the discount rate and its components is discussed below.


The rate of return used for the purpose of finding the present value of future cash flows, is the discount rate. This rate includes the time value of money. Thus, as discussed above it is the risk free rate, plus risk premium. Risk premium depends upon the risk involved, in any particular project.

Risk Free Rate

Risk free rate includes the expected inflation rate, and the interest on capital which is treated as the opportunity cost of capital. As Arnold (2008) has mentioned “The risk free rate (RFR), forms the bedrock for the time value of money. Calculations such as the pure time value, and the expected inflation rate, affect all investments equally”.

Risk Premium

The discount rate is not the risk free rate. Rather, it is always more that that. The rate which is above the risk free rate is risk premium. Risk is the probability of not receiving the estimated return, owing to the uncertainty in any business. Higher the risk, higher is the return expected, and vice versa. However calculation of risk in itself is a difficult task. There are numerous methodologies available, for evaluating risk. The most famous among these are, sensitivity analysis, scenario analysis, and probability analysis.

After getting the cash flows and discount rate, the next step is to evaluate the project. This is to determine whether the project is worth undertaking, or not. For this purpose, there are various methods. Some of the most popular ones, used across the globe, are discussed here.

Investment Appraisal Techniques

Payback Method

This method is used to find out the period in which the future cash inflows would be sufficient, to cover the initial investment. Once this figure is obtained, it is then compared with any arbitrarily chosen time period, set as a threshold by the company. If the payback period is shorter or equal to this chosen time period, then the investment is acceptable else it is rejected.

Accounting Rate Of Return

It is more popularly known as return on capital employed (ROCE), or return on investment (ROI). The ARR is a ratio of the accounting profit to the investment, in the projects. It is notable that here, accounting profit is used, and not the final cash flow figure.

Net Present Value

This method uses the discounted cash flows. In this, the present value of outflows is subtracted from the present value of inflows. If the result, known as NPV, comes out to be positive or zero the project is accepted else not.

Internal Rate Of Return

This method also takes into account, the time value of money. This is used to find out the rate of return, at which net present value of an investment is zero. If this rate is higher or equal than the discount rate, then the project is acceptable else it is rejected.

Issues To Be Addressed

Research Question

How an investment appraisal technique helps companies move in the right direction, regarding investment decisions?

Other related questions are:

What are the pre-requisites for this?

What are the methods applied?

What are the challenges faced by an organization?

Why The Question Is Important?

This holds a lot of importance for the organizations since the sizeable investments made by the companies, have long term consequences. The company's strategic position too, is determined by such large investments made in terms of tangible or intangible assets. It impacts the future cash flows. Thus, in order to ensure that every thing moves efficiently in future with any investment made by the company today, investment appraisal is not only necessary, but also inevitable.

Research Objective

The main objective of this research is to find out if there is any gap between the theoretical concepts studied and analyzed, and its implementation. In practice, matters are always little different, than what it is taught academically, or found in literature on any subject. However, to what extent there is a level of variance in case of investment appraisal, between theory and practice, is attempted to be determined, in this research.

The previous research on investment appraisal discussed in broad terms, about changes in methodologies with time; factors to be considered for appropriate calculation of cash flows; and components of discount rate. Yet, none of these studies have shed much light on its practical application, which is empirically investigated, in this research. In particular, three divisions of investment appraisal – objective, inputs and process, is examined.


In this section research work already done on investment appraisal process and its various other aspects have been studied. It will also reveal some elements which are quite important but still not treated appropriately to achieve effective and unambiguous evaluation of capital investments like inflation and taxation.

Companies have limited resources. In order to achieve the best utilization and maximum output from these resources companies require a mechanism to decide or analyze which investments are worth taking and which are not. It is a multifaceted and analytical process and many prior studies on this practice exist.

A number of surveys scrutinizing the investment appraisal process have been conducted from time to time. These surveys shed light on the changes in the use of methodologies and other practices, which formed an integral part of investment appraisal.

A review of the existing literature reveals that, there have been continuous changes in the techniques used for investment appraisal. Different models and methods have been developed for investment appraisal and risk analysis. Over the period of time these developments have been incorporated into corporate practice. What does this investment appraisal process involve as found in literature analyzed and secondary sources providing quantitative data regarding the same is discussed below.

Estimation Of Future Cash Flow

Investment appraisal requires detailed cash flow forecasts as inputs for sophisticated evaluation methods which have been discussed above. For an investment decision to be considered as successful, it must add value to the firm. Such a project would surely increase the cash flows of the firm, but how much? At this juncture, the firm confronts the problem of estimating the future cash flow, investment outlay and cash inflows emanating from any new project, and finding out whether it adds value to the firm or not. Considering the case of Alaska pipeline project setup by many oil majors, initially its cost was estimated to be $700 million. The final cost, however, came out to be $7 billion. This shows estimation of project cash flows is one of the most important and critical parts of investment appraisal, because in case these estimates turn out to be unreliable or biased, the project would lead to poor business decisions. There are many variables involved and numerous people participate in this exercise. Capital outlays are estimated by engineering and product development departments; revenue projections are delivered by the marketing department; and operating costs is aggregate of estimates given by number of departments like production people, cost accountants, purchase managers, personnel executives, tax experts and others (Chandra, 2008: 304). To estimate the possible future values, past events are generally used in order to estimate what possibly could be the future outcome or results for the same, or similar kind of event.

Earlier, the most conventional method was to find out the best estimate from the information available. This estimate is generally the single value derived, using the mode or average, or a similar likely outcome. However, evaluations based on the single value estimates, show that the estimated value is certain, with no possible margin of error or variance. As a result, instead of using a single value as the best estimate, a new methodology of using a range of outcomes, is used. These outcomes are based on the probabilities of occurrence or non occurrence of events, which affect the cash flows (Dayananda, 36: 2002).

Stages In Cash Flow Estimation

According to Dayananda (2002) cash flow estimation comprises of four stages:

  • Forecasting the initial capital outlays and operating cash inflows and outflows.
  • Tax factor, which is an important element to be adjusted against these cash flows.
  • There are certain other variables apart from tax like inflation, opportunity cost and depreciation etc. which need to be checked in order to find out its impact on cash flows.
  • Allocating any further resources in order to improve the accuracy and reliability of the variables which have greatest influence on cash flow estimate.
  • This entire process requires close monitoring and early intervention, when required. Monitoring is required at all stages from data acquisition process to project's implementation (Dayananda, 2002: 37 - 39 – capital budgeting: financial appraisal of investment projects).

Estimating Incremental Cash Flows For Investment Apraisal

The fundamental principle for the inclusion of cash flows for the purpose of investment appraisal is to include only the incremental cash flows. This refers to the cash flow incepted after the implementation of the project. The time when the investment is made, is considered as time 0, and the cash flows generated after time 0 constitutes a part of the incremental cash flow. For ascertaining the firm's incremental cash flow, it is required to identify the cash flow of the firm in two situations i.e. with the project and without the project. The difference between the two gives the incremental cash flows. In estimating incremental cash flow all incidental effects are also considered. Incidental effects lead to an enhancement in the value of some existing activities, such as a rise in the demand of an existing product. However, incidental effects may also turn out to be negative like product cannibalization i.e. with the introduction of a new product, the sale of some existing products may decline (Arnold, 2008: 99-100; Chandra, 2008: 307-308).

Opportunity Costs And Sunk Costs

There are also certain aspects which are not apparently detected and need to be treated in the valuation of cost of capital. Opportunity costs and sunk costs are the two types of costs which fall under this category. Opportunity cost is the revenue lost by using the resources forming part of the project, under consideration. These resources might be rented out or sold, or used elsewhere. The sunk cost is the cost which the firm has already incurred, and has no effect on present or future decisions. It is the previous cost which was incurred in the past, and is irrecoverable irrespective of the fact, whether the company accepts the project or not.

Furthermore, Rustagi (2005) classified the cash flows associated with a project as original or initial cash outflow, subsequent cash inflows and outflows, and terminal cash flow.

Initial Cash Outflows, Subsequent Cash Flows, And Terminal Cash Flows

Original or initial cash outflow is the initial investment, occurring at the beginning of the project. This is required to get the project operational. Since the investment cost occurs in the beginning of the project, it is easy to identify the initial cash outflow. It includes the acquisition of assets like machinery, building, technology etc. Along with the cost of assets, other incidental costs must also be considered, like the cost of transportation and installation. Sunk costs and opportunity costs as discussed above are also a part of this.

Subsequent cash inflows and outflows are generated after the initial outlay of capital. The investment is expected to generate a series of cash inflows, through the project that has been initiated. These inflows may be the same every year or may vary from one year to another throughout the lifespan of the project. In addition to inflows, capital budgeting decisions also consider the subsequent outflows, that might be required for periodic repairs or maintenance.

The third classification is the terminal cash inflows. These are the cash inflows in the last year. Firstly, this would include the scrap value, or the salvage value of the project, which is realizable at the end of the economic life. The second, is the working capital which gets released at the completion of the project. This is again, made available to the firm.

Estimation of cash flows as a measure of the cost and benefits of any project, includes these three forms of cash flows, and forms the part of any good technique to evaluate a proposal (Rustagi, 2005: 486 - 489).

In addition to all these factors, cash flows also get affected by the factors which are unlikely to be precisely forecasted, and keeps changing with time, like inflation and taxes.

Treatment Of Inflation

Inflation has a direct impact on the final outcome of investment appraisals. It affects both the future cash flows, and cost of capital. If inflation is not properly adjusted, the future cash flows are increased, over and above, what they would be. For the adjustment of inflation, cash flows have to be either presented in the real terms or money (nominal) terms.

Adjustment Of Future Cash Flows In Real And Money Terms

In real terms, future cash flows are adjusted in terms of today's current purchasing power, and in money terms cash flow is adjusted, according to the purchasing power, at the time they occur. For applying the correct treatment, companies are required to discount the real cash flows at the real discount rate, and nominal cash flows at nominal discount rates (Drayery and Tayles, 1997). As per Carsberg and Hope (1976) in Arnold and Hatzopoulos (2000) the companies earlier, adjusted for inflation in a rather inappropriate manner. Companies have been either estimating the future cash flows in nominal terms. For the purpose of discounting, they have used real rate of return. Or, they have been estimating the future cash flows in real price terms, but discounted at the money discount rate. There is a significant change in this practice from the last two decades (Arnold and Hatzopoulos, 2000: 12). However in contrast to this, according to the data collected by Drayery and Tayles, 1997 There are still a majority of firms, treating the problem of inflation, incorrectly. The survey was conducted on 195 firms in UK,out of which only 53 or 27% are doing the correct treatment of inflation, with regard to future cash flows (Data attached in appendix 1).

Common Mistakes In The Adjustment Of Inflation

Thus, we can see that the adjustment for the treatment of inflation, regarding future cash flows and relative discount rates, is not a very uncommon mistake. The most common mistake is using the money discount rate of return for discounting the cash flow estimates, available in terms of real prices. This leads to the undervaluation of NPV, leading to the rejection of the project in some cases, which are worth undertaking, yet, are not. In case of the converse scenario, the result would be overvaluation of the NPV, leading to the failure of projects in the long run. Long term projects, are more prone to this kind of mismatch, because with a longer time period, the variation in cash flows, due to non inclusion of inflation, gets compounded. The cash flows accrued after many years, are valued in current terms, and that turns out to be highly distorted. In case of short term projects, even if inflation has not been included, the distortion in the values of future cash flows, is not very high (Drayery and Tayles, 1997: 3).

Treatment Of Taxes

Taxes have a direct and considerable impact, on the project viability. For a complete project appraisal, it is important to consider the complete taxation implications, over the cash flows. It is vital for the purpose of investment appraisal, to consider the cash flows after paying taxes, since only these are available to shareholders. There are many important aspects to be considered, regarding taxation.

According to Arnold (2008) if the tax liabilities of the firm gets increased due to the project, then the increased tax effects must be incorporated in the analysis, to reach the actual cash flow figure. Secondly, taxes are not generally paid in the same year in which they occur. Companies pay a part of the current year's taxes and part of the accrued taxes, which must be considered accordingly. The time factor must be correctly accounted for, while analyzing the cash outflow of taxes.

According to Rohrich (2007), due to the investment, tax would arise and NPV must be calculated only after taxation. The implications of taxation would affect the NPV considerably. Firstly with taxes, cash flow will decline and so will the NPV calculated out of that cash flow. Secondly, the capital structure of the project also results in the decline in discount rate, with an increase in gearing ratio. Since the interest on debt is tax deductible, it reduces the cost of capital, and thus leads to fall in the discount rate. Besides these Lumby (1988) has also thrown light on one more important aspect. This is the system of writing down balances, which also provides tax relief on capital expenditure. Thus, the net effect of the taxation could be seen as a decline in NPV, due to a decrease in cash flows, on one hand. On the other hand there was an increase in NPV, due to a decrease in discount rates.

Cost Of Capital

“The cost of capital is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk” (Arnold, 2008: 717).

The definition given shows that the rate of return on the capital, is what determines its cost. This rate of return is the discount rate used by the companies. If it is evaluated higher than what actually it should be, then it constrains the investments. Like Arnold (2008) has quoted Michael Haseltine, one time President of the Board of Trade “Businesses are not investing enough because of their excessive expectations of investment returns” (Arnold, 2008: 717).

High Rate Of Return

According to Ashford et al. (1988) companies use considerably high discount rate than required, as per the opportunity cost of capital. The reason for this, is the risk premium which companies apply, especially in case of investments made in the projects using new technology. Such projects are considered to be more uncertain, so the discount rate is higher than in other investments (Ashford et al., 1988: 2). Arnold and Hatzopoulos (2000) have quoted Antle and Appen (1985) and Antle and Fellingham (1990) that managers in order to keep a strict control over corporate resources and to reduce the tendency to over invest, keep high discount rates (Arnold and Hatzopoulos, 2000). Similarly according to Dimson and Marsh (1994) in Drury and Tayles (1996) firms in UK use excessively high discount rates, which in turn, have led to the under-investment in UK firms.

In USA too, firms use hurdle rates for project evaluation, which are higher than their estimated cost of capital (Drury and Tayles, 1996: 12).


In order to attract investors, companies have to provide returns, higher than the opportunity cost of capital. Companies use a standard means to express their cost of capital, using weighted average cost of capital (WACC). According to Bruner et al (1998) WACC is the method used by most of the companies, advisors and even textbooks, as a method to derive the discount rate used as the cost of capital. Bierman (1993) conducted survey in which 74 Fortune 100 companies participated. The results obtained showed that all the companies use some form of discounting in their capital budgeting, and 93% use a weighted-average cost of capital (Bruner et al, 1998: 2-3). Arnold and Hatzopoulos (2000) presented information given by Westwick and Shohet (1976) stating that company's bank overdraft rate was the most popular method among UK companies for selecting the rate of return to be used for evaluating capital investment. At the same time WACC was in practice by less than 10% of firms. However, this trend changed substantially over the period of time and according to the data collected by Arnold and Hatzopoulos (2000) more than half of the firms use WACC to calculate the cost of capital (results attached in appendix 2). In addition to this, it is also notable that still significant minority firms use interest rate payable on debt as a measuring tool to calculate the cost of capital (Arnold and Hatzopoulos, 2000: 17).

For calculating the WACC a company needs to acquire information about the cost of various sources of capital and their proportions in the capital structure. Considering that we have two sources of finances i.e. equity and debt, here cost of capital is determined by the formula:


Here, KE = cost of equity

KD = cost of debt

WE = proportion of equity finance to total finance

WD = proportion of debt finance to total finance

Cost Of Debt

Debt entails to more or less fixed payments, so estimating the cost of debt is relatively easy. Arnold (2008) has covered three factors which determine the cost of debt, these are:

  1. Existing rate of interest on debt capital.
  2. The risk of default by the debtor and recovery rate or chances in case of default.
  3. Benefit derived from debt capital due to the tax shield.

Cost Of Equity

While the estimation of cost of debt is easy, the cost of equity is rather difficult to estimate. This is due to the fact that companies do not have any commitment towards the shareholders to pay dividends. However, companies have been reaching some reasonably good estimates of the cost of equity using some prevalent methodologies like Capital asset pricing model. Although, some firms mention other models as well like arbitrage pricing theory but these are in small proportion. Another model which was most influential in 1960s was Gordon growth model. However, there was a problem of obtaining a reliable estimate of future growth rate of dividends in this model. This was obtained objectively using past data which was not considered to be a trustworthy estimate (Arnold, 2008: 726).

According to Bruner et al. CAPM is the most popularly used model for estimating the cost of equity. In a wide survey conducted by Trahan and Gitman (1995) of 84 fortune 500 large firms and best small Forbes 200 companies it was found that 30% of respondents use the capital asset pricing model. Similarly, in a survey conducted in Australia, CAPM is the most commonly used method in estimating the cost of equity, with 72% of the companies under survey, using this model (Truong et al., 2006: 3).

In contrast to this Arnold and Hatzopoulos (2000) has mentioned views from several sources stating that:

According to Bruner et al there are theoretical, practical and empirical doubts cast on the most heavily promoted method of calculating the equity component of WACC, that is, the CAPM (Lewellen, 1977; Mullins, 1982; Lowenstein, 1989; Tomkins, 1991; Fama and French, 1992; Rosenberg and Rudd, 1992; Mills et al., 1992; Strong and Xu, 1997; and Adedeji, 1997). The difficulty faced under this model is to determine a particular divisional beta and cost of capital. This problem has been discussed in quite an elaborate manner by Bruner et al. using different beta rates and expected market return. The result produced shows substantial variation in the cost of equity and in turn had a great variation on cost of capital (result attached in appendix 3).

To conclude, what can be seen is the result drawn out of study on the corporate cost of capital and the return on corporate investment. This shows average corporate investment produced returns that exceed the cost of capital. This is analyzed for the period of 1950-96, the real cost of capital for non-financial firms is high, 5.95 percent. The real return on cost is higher, 7.38 percent as a result on average investment seems to be profitable (Fama and French, 1999).

Analysing The Level Of Usage Of Appraisal Techniques

Since decades companies have been in continuous search of reliable investment appraisal techniques. These techniques helps to rank the multiple competing projects on the basis of benefits that can be derived out of each one as against the costs incurred over the same.

Conventional Methods

The first analysis studied here is the survey conducted by Arnold and Hatzopoulos in the year 1997. The survey examines the level of usage of four main conventional appraisal techniques – payback method, accounting rate of return (ARR), internal rate of return (IRR) and net present value (NPV). 300 companies are surveyed which are ranked in the Times 1000 companies according to capital employed (results attached in appendix 4). This survey is also compared with two previous surveys one is by Pike covering the period from 1975 to 1992; and Alkaraan and Northcott for the year 2002. These are chosen for comparison because of similar characteristics in all the three surveys. According to the results, it is quite clear that payback method has been the most widely used technique till early 1990s as compared to discounted cash flow methods – IRR and NPV. However, thereafter rise in the usage of NPV can be seen and as for now it became the most popular appraisal technique. Yet, this was not at the expense of a decline in the usage of the payback method. Even payback method is used quite a lot along with other methods.

According to the survey conducted by Alkaraan and Northcott, 2002, all four methods are used extensively. In addition to this, it is apparently obvious as which are the two most popular methods used by almost all the companies under survey – the payback method which is used by 96% of the companies and NPV which is used by 99% of the companies.

This also shows the trend of using more than one method by the companies in order to ensure the investment undertaken is correct. On this Arnold and Hatzopoulos (2000) has found that in 1975 one third of large firms used only single technique; one third used two methods with maximum number using payback and ARR; and payback and IRR; and remaining one third used three or four methods (results attached in appendix 5). Whereas by 1997 there is a major shift in this practice showing 67% of firms (76% of large firms) using three or four methods. In this 29% of all the firms used all four methods making it the most popular choice followed by combination of payback, IRR and NPV.

Although the payback method is not considered to be too sophisticated still it is used extensively because of its simplicity. Besides, it is not used as the primary appraisal method. Rather it is used as a secondary method, which supports the other more sophisticated methods (Arnold, 2008; Ashford et al, 1988).

Size Of The Organisation As A Criterion For Choosing An Appraisal Technique

In a similar survey by Drury and Tayles in UK on a wide range of organizations of different sizes, similar results were found (results attached in Appendix 6). Discounted cash flow techniques are used much more widely than the payback method, which was the most common method, used previously (Drury and Tayles, 1997: 2).

At the same time, in contrast to this, there was another view point which was expressed. According to Lefley, 1994 in his study of large UK manufacturing firms 94% of the companies use payback technique making it the most popular technique and 69% use either IRR or NPV (Alkaraan and Northcott, 2006). As per Drury and Tayles (1997) regarding which method is considered to be the most important shows that to be the payback method. This was followed by the IRR. However, there is change of opinion, based on the size of organizations.

In this case researchers discovered that IRR is the most important technique for larger organizations. This was followed by, the payback method and intuitive judgment being the least important. In the case of smaller organizations, the payback method is ranked as the most important, and intuitive judgement as the second most important.

The survey conducted by Arnold and Hatzopoulos, 2000 which is differentiated on the basis of size of the organization, shows that NPV is more popular in the case of large and medium scale organizations. Yet, not in the case of small scale companies. Peel and Wilson (1996) also found that 67.6% of firms in a sample of enterprises employing 50 people or less, have been found using the payback method, while in Austin et al. (1994) the only quantitative decision criterion used by any firm was the payback method (Ekanem and smallbone, 2007).

Furthermore, in Australia according to Truong et al (2008) in a recent international survey which included Australian companies, indicated that discounted cash flow methods for investment appraisal, were found to be most popular with 73% of the surveyed companies, using all these methodologies (Truong at al, 2008: 3).

Shortcomings Of Discounted Cash Flow Methods

Discounted cash flow techniques, are the most popular among all the methods used for investment appraisal. Yet, there are still some shortcomings associated with it.

Projects With Long Initiation Time And Recovery Time

Firstly, some projects have a longest-initiation time and a long recovery period like power generation companies, which take up construction time of more than three years, with an expected life of more than 25 years. In the NPV method, discount rates are calculated, keeping the risk level as one of the considerable factors. In case of projects like these, and the existence of a highly competitive business environment, the risk level varies. Yet, it is not possible to change the discount factor, for planning the entire life of the project. Thus, the constant risk measure is an inappropriate measure, in assessing the viability of a project. Secondly, discounted cash flow methods, are based on estimated future cash flows, which may also vary due to the changes. Due to longer duration of project changes are very much likely to take place. This would make the primary NPV evaluations invalid (Lu et. al., 2006: 2).

Arnold and Hatzopoulos (2000) also have deduced from their findings of a survey conducted by them that “standard NPV is unable to capture the complexity of corporate investment decisions” (Arnold and Hatzopoulos, 2000: 9).

Soft Projects

The discounted cash flow methods are also criticized for their inappropriate appraisal of soft projects, such as research and development (R&D) and Information communication technology (ICT). As a result the management had to select such projects on the grounds of intuitive judgment, experience and rule of thumb methods (Akalu, 2003: 2)

Operating Flexibility And Strategic Value Of Project

Similarly, according to Schwartz and Trigeorgis, (2004) there are two main aspects which are not covered in NPV analysis. Firstly, it is the operating flexibility which gives an option to the management, to reconsider their decision. Secondly, it is the strategic value of the project, which may vary in future because of other interdependent projects, or other competitive factors. Since these two aspects are missing in the NPV method, it may result to the misevaluation of projects.

To overcome this problem, the management requires flexibility to change its decision, according to the changes in the future environment. Such unforeseen changes would either bring more positive outcome due to the rise in NPV or vice-versa. Such flexibility can be achieved by using real options (Scwartz and Trigeorgis, 2004: 79).

Real Options

Helen Weeds has explained this as “When a firm has the opportunity to make an irreversible investment facing future uncertainty there is an option value of delay” (Weeds H., 2001: 1). The method of project appraisal leaves the manager with the option of either to accept the project right now, or to reject it for whatever the most valid reason. However, real options make it possible for managers to change their decision to suit changing circumstances.

As per the expanded NPV rule as given by Scwartz and Trigeorgis, (2004) asymmetry, brought by the unforeseen changes, makes it important to use both the traditional or initial NPV of direct cash flows, and a premium for the flexibility, which can be derived using the operating options, thus

Expanded NPV = Static NPV + option premium.

Here, the point discussed is that, in order to overcome the drawback of NPV due to uncertain future events, real options are being used by the companies. These options are just like the call options on stocks, with a difference that these are the options on real assets. It is just like how the owner of a call option on stocks, has the discretion to buy the stocks within the stipulated time period still it is not under any obligation to buy. Similarly, the companies can undertake similar discretionary investment opportunities, and have right to benefit from it. Yet, it is not under any obligation to acquire the present value of expected cash flows, by making an investment outlay on or before the anticipated date.

With all these different surveys and findings, we cannot find any consistent result regarding the usage of any particular technique. Still, most of the research findings can be considered to be in favour of discounted cash flow techniques, especially in the case of large organizations. Nevertheless, usage of payback method is still quite high irrespective of change in trends.

Besides deriving this inference there could be one more view point to see all the surveys discussed above. Whether the information collected holds authenticated data, since there are many instances according to which surveys contrasts each other. This is also questionable because the information under discussion involves disclosure of financial facet of any organization, which is always treated as confidential and trade secret.


Thus, according to the various surveys and information available from different sources we can conclude that investment appraisal is an important section of capital budgeting process. Entire analysis conducted under this makes it possible for the company to judge whether company would be better off or worse off if it undertakes any particular project. Various approaches are analyzed here and what can be concluded is as follows:

  • Over time, discounted cash flow methods have gained importance and NPV is the most popular evaluation methods.
  • Firms use multiple evaluation methods.
  • Payback method is widely used as a supplementary evaluation method.
  • Weighted average cost of capital is the most commonly used discount rate.
  • Understanding the critical importance of cash flow forecasts in project evaluation, adequate care must be given to avoid certain biases which may lead to overstatement or understatement of true project viability.

Research Methodology

In this section the research that has already been conducted on the investment appraisal methodologies, and their application is linked with its practical application, by the companies. Empirical research to study the actual usage is conducted in India. The study endeavored to find information from various companies, and verify as to what extent, they support the literature findings.

The reason for conducting research in India, is because India is the fifth largest economy in the world (ranking above France, Italy, the United Kingdom, and Russia), and has the third largest GDP in the entire continent of Asia. It is also the second largest, among the emerging nations. (These indicators are based on purchasing power parity.) (Government of India, Ministry of Finance, 2009)

In the past two decades Indian businesses and the financial sector have witnessed a dramatic transformation, mainly due to deregulation, liberalization, partial privatization, globalization and the influence of the service sector. In the context of these factors, development, investment and financing avenues have expanded considerably.

According to an autonomous body called the centre for monitoring Indian economy, development through capital investments undertaking in Indian economy can be adjudged by the following information:

  • Financials of 2,144 listed manufacturing companies show a 22.6 per cent rise in real sales, during April-June 2008. Other indicators like growth in industrial credit disbursement by banks, private final consumption expenditure, transportation activity, and flow of fresh capital investments, also show a healthy trend.
  • The industrial production was expected to grow by 9.1 per cent in 2008-09. this projection is based on the detailed analysis of projected capacity, and expected capacity utilization of major individual industries. (Centre for Monitoring Indian Economy Pvt. Ltd. , 2009)

Looking at the rate of growth in the Indian economy and large investment opportunities being tapped by companies, it is evident that the example of India provides immense opportunity to examine how exactly investment appraisal is conducted by companies. Besides this, how accurately companies are applying appraisal techniques before making any investment, is also examined. As we mentioned earlier, there are a number of factors to be taken care of, in order to reach unbiased and inappropriate values to determine whether to accept or reject any project. Are the companies from where data has been gathered in this research, also doing a careful, and in-depth analysis of all these factors?

Methodological Approaches

The objective of this research is to find out if there is a gap between grounded theory and its application in the corporate world.

Grounded Theory

The grounded theory is defined by Neergaard and Ulhoi as “theory derived from data that has been systematically collected and analyzed using an iterative process of considering and comparing earlier literature, its data and the earlier theory” (Neergaard and Ulhoi, 123: 2007).

The literature review section of this research concluded that investment appraisal is quite effective and important, in order to judge whether the company would be better off or worse off, if it undertakes any particular project. Data collection is the next step which is required, in order to compare it with the existing literature.

Eisenhardt (1989) in Neergaard and Ulhoi have explained the grounded theory research process in a very pragmatic manner. They have begun with defining the research question, and the following steps. This subsequently leads to sampling. Once the sample population for collection of data is decided, then actual data collection begins. For this purpose, the data pertaining to the pre-requisites of the methods applied, and challenges faced in the investment appraisal process by the organizations under study, is collected and analyzed.

For empirical scrutiny, all the factual descriptions available in literature review regarding the application of proper investment evaluation techniques, qualitative methods for data collection, have been used.

Qualitative Methodology

Most of the information used in the literature review; which is gathered from various books and articles, emphasize upon quantitative methods of collecting data. However in this research, the qualitative method is used. This is because purpose of this research is not to find out how many companies use a particular technique. Or, how many companies are not dealing with a particular aspect for example inflation, in an appropriate manner. Rather, as per what has already been stated above, we are studying as to how after the application of all these techniques, companies are able to make their decision making process more reliable and accurate. This is with reference to obtaining their expected results to a certain extent, even if not exactly.

As Bryman (2007) affirmed, qualitative research deals with words, rather than numbers. It is the quantitative methodology, which deals with numbers. How the participants in the social world interpret it, is examined through qualitative methods (Bryman, 2007: 402). Thus for this research, the qualitative method is preferred.

Other noteworthy features of qualitative methodology, discussed by Kvale (1996) which makes it more suitable for this research are as follows: firstly, it is based on conscious research, as it emerges from study or theory. In this instance, we have a well-established theory, which states that companies use investment appraisal techniques in order to check out whether a particular investment is worth commencing, or not. There are several techniques that can be used, and factors to be considered, in order to achieve this result. Data collected from various organizations using qualitative methods, would either XXXXXXnforce this theory. Or, they would accentuate, the contrasting facts. These contrasts could be a total denial of the usage of this theory. This practice in entirety. Or, using it up to a certain level, yet without such long sightedness has been discussed.

Secondly, the analysis using qualitative methods would constitute findings based on the patterns of events or processes, so that these could be related to theoretical concepts.


After considering the various alternatives of qualitative research from the point of view of this research, interviews seem to be the most appropriate method. This is because, as according to Kvale (1996) qualitative research interview, helps the interviewer to understand the world from the interviewees' point of view. It encourages the interviewer to discover their existing world, prior to scientific explanations, and to disseminate the meaning of people's experience. Similarly here too, interviews are conducted to ascertain the participants' interpretation, towards the process of investment appraisal. How much importance does it hold according to them? Is it just a formality, or a method to get some vague idea about the returns that can be obtained from any investment? Or, is it actually a stance on which investment decisions critically depend? Replies for these questions need to be explained properly with some reasoning behind it, then only it can be considered as a justified response. For this reason in all the interviews conducted for this research, open ended questions have been asked. This way the participants get more opportunity to explain their points of view. Such details are quite necessary, because nothing can be considered as naïve decisions, without knowing the underlying reasons for those decisions, and their implications.

Kvale (1996) has classified qualitative research interviews as semi-structured, for the reason that it is neither an open conversation, nor is it a structured questionnaire. It focuses on a particular theme, which happens to include some suggested questions. Beyond that, the conversation itself leads to further questions, which lead to exposition of more subject knowledge, by uncovering different layers of the interviewee's point of view, on a particular topic.

A similar kind of interview structure or pattern has been put to use, here. There is an effort to form a base with some standard opening questions, addressed to all the interviewees. This was so as to make them understand, what the purpose of the interview was. Thereafter, the subject is discussed in the context of various factors like the size of the organization, management practices, role of political factors, and other such issues. This way through interviews subject has been discussed in a very exhaustive manner covering views from existing literature, its acceptance or rejection by interviewees, their views for doing the same and what else is done in this particular area which is missing or not done which has been mentioned.

Ethical Standards And Access Considerations

Furthermore, ethical considerations form another important element of research methodology. As discussed earlier in this research, interviews are conducted for the purpose of collecting primary data. According to Polonsky and Waller (2004) whenever there is interaction with people, there is always a possibility that participants might get harmed, unintentionally. In order to avoid such situations the researcher must ensure that their behavior conforms to the appropriate ethical standards. The researcher must also examine deeply, as to how the research can lead to any negative impact, on the participant. Finally, all possible steps must be taken to ensure that any such situation does not arise in future, so as to protect himself; his supervisor and teachers; and institution from any consequences (Polonsky and Waller, 53: 2004). All the interviews are conducted keeping in view these essential elements, so as to ensure that ethical standards are well maintained, and none of the participants is hurt even unintentionally.

For this purpose, all the participants were sent a mail (attached in appendix 6) prior to their interview, stating the objective of this interview, its subject, where the collected information will be submitted and an assurance of using it with utmost responsibility. Since the subject under study requires information regarding any new projects started by the companies in recent past or currently, and its appraisal methodologies, it was quite essential to assure that no data that is confidential in nature, and not allowed to be accessed by any body from outside the organization is required. Secondly, besides this, whatever information is collected and the discussion of the subject, is not shared with any of the competitors, and is used only for the purpose of research. The permission is sought as a reply to that mail, and only after that the interviews are conducted.


Interviews with senior executives in the finance department of various organizations were conducted, in order to ascertain different aspects pertaining to the practical application of investment appraisal techniques. The subject was very familiar to all the participants. This was especially since; it was a part of their routine tasks. At the same time, it was observed that investment appraisal techniques hold a different meaning for representatives from different companies. Or, to be more precise we can say from different industries.

Here, it doesn't refer to the literal meaning of the term. It refers to its level of importance, and its qualitative description. The basic differences in opinions are easily discernible, because each interviewee has their own environment, and the reactions are based on this environment. For instance, an Assistant Vice president of finance, from a real estate company has to lay emphasis on political factors as well (which plays an important role in India) while evaluating an investment. At the same time, a vice president of finance from a company that manufactures mouth fresheners does not consider political factors, as important.

Besides the meaning, the techniques also vary. This is according to the size of the organization, and project. This feature conforms to the previous research that was conducted. This is apparent in the literature review, where investment appraisal methodologies vary, according to the size of the organization. Other factors discussed and examined, include information required by the organizations; challenges faced in obtaining this information and performing appraisals.


The people interviewed were chosen with the purpose of representing different industries, and organization sizes. Participants are from both listed and non-listed companies. Eight people are interviewed personally and one over the phone due to his busy schedule. In all data is collected from nine people from varied industries and size of the organization.

The participants included hold senior positions in the finance department, in their respective organizations and one is at a senior position in financial institution itself. The financial institution is a multi national bank XXXXXX. Other interviewees belong to mix of several industries like two are from real estate organizations – XXXXXX Limited which is a listed company and XXXXXX Group private limited which is medium scale organisation; one is in the food division of a conglomerate Dharampal Satyapal Limited ; one participant is from retail store chain named XXXXXX this again is a medium scale organisation; next is XXXXXX – largest low cost airlines in India this is also a listed organisation; BPO - XXXXXX, division of XXXXXX in India another listed organisation; XXXXXX Agro Limited which is India's largest Rice processing and marketing company again a listed organization and last organisation is a small scale organization with about fifty employees – it is in a footwear industry with the brand name XXXXXX Limited started an year ago presently with 16 retail outlets again in Delhi and adjoining states. (Details of all the interviewees attached in Appendix 7)

Limitations And Challenges

The main challenge faced in this context, was related to the Non Disclosure Agreement (NDA) signed by the employees and Code of Conduct adopted by their Board of Directors as per Listing Agreement entered between the Company and the Stock Exchanges, where their scripts are traded. According to the said agreement/code the employees are not allowed to discuss any information related to their organization, with anyone outside the organization. In order to comply with this, an assurance was given that no such question which relates to the company's exact accounting figures or any other confidential information is asked. Besides this, other important factors have also been complied with.

The limitations in this research can be directly related to the limitations related to the interview, as a qualitative method of collecting data. In the interviews less number of people are willing to express their actual experiences. This may be because of some pressure, like the truth revealed in the interview may cause harm to one's reputation or job. Participants may also hide their actual perception about the subject, in order to demonstrate that he is performing his duties very efficiently. Although this might be true, but the method of doing tasks is different, as compared to prescribed procedures in the company rulebook, which the participant is not willing to reveal.

Another reason given by them for participant's ignorance is due to large number of requests for interviews. In case of this research, it is not due to the large number of requests for interviews. Instead, it is due to uneasiness among the participants, in sharing any information or knowledge with a stranger. That too, in their office hours, and office premises, itself. To overcome this problem, a few of the interviews are conducted outside the office premises, and during weekends. Still, the other two reasons for hiding the actual insights seem true, to some extent.


To conclude this section, here the objective of linking existing research on the same topic which is under study is accomplished. For this purpose qualitative method of collecting data – interviews are used. The semi structured interviews used here leads to conversation between interviewer and interviewee related to the subject. This way it explores the subject in a very pragmatic manner giving insights about how it is actually applied. This conversation tried to capture answers to three main sects of investment appraisal – its objectives, inputs and process. The sample population included some senior executives in finance department of various organizations. The organizations include both listed and non listed firms varying from middle to large scale organizations. These are also from different industries like real estate, food and beverages, low cost airlines, dairy products, clothing and shoes. The data collected has been analyzed to find out if there is any gap between theory and its practical application. It also tried to identify differences in opinions of various participants regarding what are considered as important factors and how important is this entire process.

Data Analysis

The research conducted throws light on various aspects of investment appraisal done by companies before making any investment. This chapter brings out the outcome of this research work. It was conducted with a question that how does investment appraisal help organisations in taking vital decisions? The data collected from the vast existing literature on this subject and various interviews conducted are analyzed and interpreted to derive results for this and also other related questions under study in this research.

Three different sects of investment appraisal – its objectives; pre-requisites and its process, as the title of this research also mentions, is examined in the light of existing literature study and empirical research done. It has drawn some facts about the gap regarding investment appraisal as in literature and in practice.


Investment appraisal or evaluation – the name itself makes the purpose very clear for which it is performed. This is considered as quite important part of capital budgeting method. Along with this there are number of other elements, apart from financial aspect, which are also considered very important. Firstly, any investment essentially requires being inline with company's objective and strategy. The other such factors which were discussed in literature review also included the social context and intangible benefits.

However even after laying some emphasis on these factors existing literature deals with investment appraisal in a quite in depth manner. The vastness of literature existing on this or even the description given regarding this step in entire capital budgeting process makes it appear like holding prime importance in making any investment decision. Whereas in corporate world investment appraisal as a part of the capital budgeting process holds lesser importance. The other factors mentioned above and discussed in literature review are considered as more relevant. Yet, it is something which all the firms do include in their routine tasks related to investment.

In order to find out the objective for various companies under study, the interview included certain questions like – is investment appraisal an inevitable part of every new project and other investments made and why?

Investment here referred to sizable capital investment. All the participants replied yes for the first part, confirming it as an inevitable part. However, it was not straight forward yes. The reason for evaluating investment before actually making, did not only included the financial aspect, it included the other important viewpoints as well.

Like Mr. XXXXXX from XXXXXXreplied

“Firstly we try to acquire lot of information about market competitiveness of any project which the management suggest. Once the thought process needs to be given proper shape, we start with investment appraisal only. That makes it more logical to decide whether any project has to be taken or not.”

Mr. XXXXXX's reply reflects that investment appraisal provides some strength to any new project by finding out its financial viability. On the other hand, the following three respondents did not segregated the factors like government policies, technological factors, changing customers' demand and overall spontaneous business environment while talking about investment appraisal. This reflects their outlook, to consider these other factors of primary importance and if these are well understood and acted upon then investment appraisals is just another step.

Mr. XXXXXX from XXXXXX Airlines

“Airlines industry in India has more supply than existing demand. Nowadays low cost carrier is in great demand. Besides other factors, the investment decision needs to be taken considering the technology available to meet such requirements.”

Mr. XXXXXX from XXXXXX Agro Limited

“Considering the good factors like liberalized government policies, easy availability of paddy, and rise in consumption patterns from both domestic and international market, investment in this sector sounds profitable comparing with the risk involved.”

Mr. XXXXXX from of retail chain xxxxxxxxxxxx

“Opening a new retail outlet requires foresightedness of future requirements of the people, changing trends and investment to be done at the current date so that it can fulfill the present and future needs. Investment appraisal helps in taking such decision.”

Now, again our next respondent was mixing the two aspects i.e. the other factors to be considered for any investment decision and evaluation of the investment from financial point of view only. At this she was interrupted and asked to be more precise.

Ms. XXXXXX from XXXXXX – BPO division of XXXXXX in India

“Before we think of entering any new project there are number of factors to be considered, besides investment only. First of all we consider the market potential according to the concerned campaign.”

As mentioned above here she was interrupted and asked to consider that lets assume for a particular project all other aspects have been approved, at this juncture how important is it to evaluate that project's investment from financial point of view. On this she replied

“See, this is just an expansion of existing business and that too from tier 1 to tier 2. Still, evaluating investment is important because we are stepping into Tier 2 projects for the first time. In this…...[S]o we are also expecting to reach break even soon as initial expenses are really less.”

In this case the, company is doing expansion. Tier 1 refers to the clients providing business in big cities which results in more business and tier 2 refers to the business in smaller cities may be from existing client or new clients. The objective of conducting is quite clear and in concurrence with what our literature review talks about. It helped company to find that they are keeping expenses low consequentially the payback period is short.

In brief it is tried to find the financial worth of the project which is the sole objective of investment appraisal process. The same view point is reflected in very straight forward manner in the responses from our other participants.

Like Mr. XXXXXX from XXXXXX Ltd. replied

“The minimum investment made by XXXXXX is of 100 to 125 crores (approximately 800 million to 1 billion GBP). For such substantial investments proceeding without evaluating investment is next to impossible.”

Mr. XXXXXX from XXXXXX Ltd. said

“Since taking any new real estate project requires a huge quantum of funds, efforts and manpower, investment appraisal is a necessary element that needs to be considered before taking such a step.”

These two participants are from real estate industry and they replied particularly in monetary terms. It was clear from their statements that project has been approved on other grounds and only financial aspect is analyzed at their end. The objective is also clearly reflected that through investment appraisal they are trying to ensure that such sizable investment is worth undertaking. It cannot be started without checking for the required returns which appraisal technique presents clearly.

Mr. XXXXXXfrom XXXXXX bank also shared same perspective with little difference, his reply was

“Of course investment appraisal is important for opening any new branch as we are not talking about short term investment we are talking about investment which will give output for real long period.”

His reply reflects the long term consequences of any sizable investment, for which investment appraisal guides through the way to move ahead.

Finally the last respondent was very particular about the objective of investment appraisal conducted in their organization.

As per Mr. XXXXXX, owner of XXXXXX, one of the leading footwear brand of India

“Investment appraisal forms the foundation of any project. Now at later stage, before starting with any new outlet also we check the period in which our initial investment will be recovered.”

Inputs And Process

In the earlier sections, the inputs required for investment appraisal have already been discussed. In broad terms only two inputs are required for the purpose of investment appraisal. Cash flow statement and discount rate. Even out of this, the discount rate is required in case discounted cash flow is needed.

The cash flow statement requires estimated outflow and inflow figures. Besides this the other necessary inputs include information about working capital, opportunity costs, sunk costs and taxes.

In case where discount rate is also needed, different companies derive it through different methodologies like using weighted average cost of capital, interest payable on debt capital, cost of equity derived using capital asset pricing model (CAPM) and prime lending rate are the most popular ones, although there are other ways as well.

Further, if methods to derive cost of equity using CAPM is used then some more inputs like risk free rate, beta factor and risk premium is also required.

Well, this is what all is required as per the literature reviewed. Now, the findings of the empirical research conducted here are widely in contrast to all this. Broadly the two factors are surely required i.e. cash flow statement and discount rate, where necessary. But besides this there are other important factors or inputs on which any investment depends. This primarily has dependence on the industry or sector discussed. The factors discussed above according to all the interviewees constitute only the basic inputs required for investment appraisal. It does not provide complete and exhaustive information. In such situation company may take misleading decisions resulting into unworthy investments.

In addition to this all the respondents did mention importance and requirement of other external factors as well. How these factors affected their decision making and what makes it indispensable for investment appraisal? It is quite visible from the information gathered from the interviews.

In order to find out what is the ideology about inputs required the question asked from all the interviewees is – what are the pre-requisites (or information required) for investment appraisal? It was again specified to be more focused and consider on the grounds of financial evaluation. However, here the co-related inputs have such deep impact with any investment's monetary aspect that these have to be considered as essential inputs. Replies to the question asked above throws light on this fact and its underlying implications.

In regard to the process they were simply asked to elaborate more on the entire process of evaluating investment in order to accept or reject the proposal.

Mr. XXXXXX and Mr. XXXXXX are both from real estate industry viz. XXXXXX and XXXXXX, respectively. Information regarding the cash flow estimates was the starting point of their replies. For them cash flow statement holds due importance in giving them fairly good idea about any new project. Both the organisations are using IRR and Payback method. Although according to literature review the most common was NPV and least one was payback, in practice payback is still popular for its simplicity and it provides the vital information about when the company will reach break even. This was even mentioned by Ms. XXXXXX from XXXXXX.

As far as NPV is concerned IRR involves calculation of net present values so these two are though studied separately but can be derived in IRR itself. That is what Mr. XXXXXX from XXXXXX replied when asked about which method do they use?

At the same time the intricacies discussed in literature review were not found to that extent in practice according to all the participants.

In cash flow statement inflation was not considered anywhere separately, it is considered as an obvious part of discount rate. Though in theoretical concepts also it formed part of risk free rate but at the same time there were many references about its proper treatment in terms of real rate of return and nominal rate of return. However, there is no such concept in practice. In fact inflation is not treated separately according to all the interviewees.

Next was tax, which again was considered as very obvious factor and even proper treatment was found. It reduced the cash flow figure and thus NPV. However, reduction in the cost of capital due to tax shield on debt capital was not considered. Not only in large organizations like XXXXXX, XXXXXX and XXXXXX but even in other organisations whose representatives were interviewed.

Resuming with the interviews from Mr. XXXXXX and Mr. XXXXXX from XXXXXX and XXXXXX respectively when they were asked about cost of capital, none of the methodologies as discussed in earlier sections were found to be used. Cost of capital depends upon bank lending rates and additional rate at which capital from private lenders is obtained, if capital is raised from private lenders. The project which was discussed here was the township named Indirapuram in which the discount rate is 10.52% i.e. the bank lending rate. Cost of equity does not play any role in deriving the discount rate.

Further, they discussed about the other important external factor which have great impact on their investment decision in real estate is political connections.

Regarding this, both were on the same footing that decision of real estate projects highly depends upon the ruling political party. Companies generally keep good political relations in order to get great discount on purchase of land. Although this involves some illegal practices, yet it plays major role in making investment decision in real estate companies.

Recently on 10th of August similar land scam related to allocation of 14 hotel plots has surfaced in Uttar Pradesh one of the largest states of India. The scam has caused a loss of 4721.14 crores in Indian Rupees (approximately 380 billion GBP) to state exchequer. The scam took place two years ago when the ruling party was not the existing one (IBN Live, 2009). This shows extent of such malpractices taking place in real estate industry. Consequentially every player in the industry has to consider these factors due to fierce competition.

Besides that, availability of land and presence of renowned competitors and local players are the other major factors to be considered.

Next is XXXXXXwhich has recently made investment in Sandalwood Oil manufacturing unit. While appraising the investment in 2006 before this plant was set up besides just checking the financial figures, Vice President Finance, Mr. XXXXXX, had to change the decision of setting up of plant from Uttar Pradesh to Jammu. This was due to the 100% tax benefit which the government is providing on all the large scale investments in some of the states where unemployment level is on rise.

Besides this he also discussed the role of Government policies and environmental factors apart from other inputs in setting up sandalwood oil plant. The project involves deforestation which required lot of bureaucratic problems but still the project was pursued. This was because the difference in buying sandalwood oil was quite expensive as compared to its own manufacturing. However, the cost figures also included money spent in obtaining licenses and due to the corruption it even involve lot of bribes and gifts provided to government employees in concerned departments.

They used bank rate of interest on loan as discount rate which they revealed to be 10.59%. This company also used IRR to accept or reject investment. They also used another technique for evaluation called Debt service coverage ratio (DSCR) i.e. the amount of cash flow available to meet annual interest and principal payments on debt. This is considered to be healthy if ratio comes out to be greater than 1 which DS was achieving. Hence investment was undertaken.

Mr XXXXXXCluster head of XXXXXX, due to lot of restrictions felt very hesitant in sharing there methodologies, discount rate and other inputs. However, he discussed the requirements of the other factors like identification of pin code where branch doesn't exist, existence of other banks, customer base, customers' profile and other similar factors. However, he also stated

“Any investment decision cannot be taken in isolation, by just looking at its positive cash flow after using a decent discount rate. Combination of all the factors let us decide what would be the potential asset business and liability business if we set up new branch in any colony. On these grounds branch is put into the category of diamond, gold or silver branch category. According to which funds are allocated for it.”

Thus evaluating any investment needs certain requirements to be analyzed in combination of all the affecting factors. Inputs required for evaluating investment as per the literature cannot be just kept aside and produce results by performing simple mathematical calculations. It has to be a combined result of all the factors together.

Ms. XXXXXX, Business development manager from XXXXXX laid emphasis on drawing up of cash flow statement, which she said

“…[I]s an important part to give us the idea of what we have planned, in financial terms, which is very important to know before heading towards its implementation.”

The investment discussed with her was about investing in new set up which is altogether a new sector for organization as well. At this she was asked since the risk is higher in this project is it that company is using higher cost of capital as risk premium. Since this is the case which has been found in our literature review where in companies generally keep high cost of capital incase of projects with higher risk. According to her, the project is aimed at penetration in the market so high cost of capital is out of question. The cost of capital she said was generally based on opportunity cost like the interest on capital which invested here and a minimal margin above it. When she was asked to elaborate on this margin factor, she related that to the reward of company (by which she referred the staff members) for working so hard and serving people even in smaller cities. The exact discount rate used by the organization was also not disclosed because of the company policy.

Regarding the process/methods used, payback method is again used here to know the time duration by which the investment would be recovered. Along with this NPV is also used to find out whether the net cash flows are positive or negative. In fact NPV calculated here is always positive because, company figures out compensation required for their services from the client after all the outflows and other expenses have been considered (in terms of present value). The inflows are then calculated as a balancing figure in order to keep the NPV positive. This way they reveal the minimum return on hourly basis which the company would be charging and only after it is accepted by the client the project is pursued.

At the same time even she also did not missed talking about other factors important for their project. Regarding this she talked about existing competition which is very stiff within India and from neighboring countries like Philippines, Vietnam, Thailand, Malaysia and others.

XXXXXX was the company which made maximum investment in both the financial years 2006 – 2007 and 2007 – 2008. XXXXXX ordered for 8 aircrafts in the former and 10 aircrafts in the later period mentioned. These are to be delivered by Boeing during the year 2008 through 2011.

Mr. XXXXXX discussed that the investment made is quite substantial and needed detailed analysis. For this estimated cash flow statements are drawn according to different scenarios. These scenarios firstly depend upon the variance in the expected time of delivery for new aircrafts. Secondly the industry is quite volatile and especially in India where already supply is more than demand. Thus for estimates to be made these factors have to be considered under different scenarios like different levels of demand. He quoted the recent example of spread in Swine flu has affected the tourism industry which has direct impact on Airlines. Further, it is expected to worsen, if the problem is not handled effectively by the government.

Regarding cost of capital and its calculation, Mr. XXXXXX also did not talked about any of the methods like WACC or CAPM for calculating cost of equity. In fact he told use of CAPM for portfolio investment which XXXXXX undertakes, but was not under his supervision. However, for calculating NPV the discount rate used was not based on any of the given criteria. It is quite high owing to continuous rise in fuel prices, which recently was hiked by 30% to 40% since March 2009. Further, High sales tax exacerbates the situation. Against which private airlines in India announced one day strike on 18th August which was later called off. But their woes still exist. (The Times of India, 2009)


He also mentioned the fact Indian Airlines Industry getting matured and lot of consolidation is happening. As a result small players are being absorbed, acquired by the big ones. XXXXXX might go for some acquisitions later.

Thus all the interviewees were found to be in agreement with the findings of literature review to some extent. It can be seen to the extent where according to all the participants basic inputs are cash flow estimates and discount rate. At the same time process is also the same as covered in literature review and the three are widely used techniques out of the four most popular techniques payback method, accounting rate of return, internal rate of return and net present value as covered in previous sections.

However, besides this basic level or what can be seen as the framework of investment appraisal, all the participants revealed lot of practical state of affairs. According to which there are lot of other factors which needed to be analyzed before we actually start with any new project. At the same time, there are many items covered in literature in great details, which in practice holds hardly any importance.


This chapter deals with the final outcome derived from this research. The result is based on two factors. First is the data and information procured from various books, articles and other sources on investment appraisal covered under the section literature review. Second factor is covered under the section data analysis, in which findings from the empirical research work done on this subject are given. Under the empirical research, executives from finance departments of nine organisations, who in near past have conducted investment appraisal for any of their new projects were interviewed.

Data analysis section also contains the simultaneous comparative study of literature review with various findings on investment appraisal in practice. This comparative study revealed lot of gap between theory and practice. The previous section analyzed theoretical and practical aspects of three divisions of investment appraisal – objective, inputs and process. This section will reveal the point of agreement and what exactly is the point of difference and why does it exist?

Theory And Practice In Consensus

Firstly, the points of agreement between theory and practice in investment appraisal process are discussed hereunder.

Beginning with the objective of investment appraisal, it is something conducted before making actual investment. The aim is, to find whether the proposed project would be adding value to the company in monetary terms. Also for best utilization of limited resources available as it helps in selecting a project in case of mutually exclusive project proposals available with the organization. This is the sole objective of all the organisations also covered under our research. At the same time it was also found that interviewees attached another view to this evaluation. According to which the value adding objective is evaluated not only in financial terms but keeping in mind the other aspects as well like companies' objective and strategy, government policies, market conditions etc. However, this mixed response is obvious because in practice no decision is taken in isolation and all the matters are discussed altogether. Although the purpose which we can derive from all the discussions confirms to what is given in literature.

Regarding inputs and process, both in theory and practice cash flow statement is starting point. It requires items like estimated figures of cash inflow and outflow. It must also incorporate appropriate treatment of items like initial outlay, incidental expenses, taxes, depreciation, working capital, opportunity cost, sunk cost and salvage value at the end of the project.

Once all the cash flows for the entire duration of the project are obtained then discount rate is required in case company considers time value of money, which nowadays every company takes into consideration. The discount rate can be any of the various items as discussed above like weighted average cost of capital, cost of equity, bank lending rate or arbitrarily chosen figure or may be any other figure obtained using some other criterion. Using this, net present value (NPV) and internal rate of return (IRR) can be obtained which are used as the criteria for accepting or rejecting any project. Other methods i.e. payback and accounting rate of return does not require cash flows to be discounted.

Contrasts In Theory And Practice

To the extent discussed above everything goes similar in theory and practice. This is something which can be considered as the investment appraisal process without lot of intricacies as discussed in theory apart from items covered here. This is also very simple form without taking into account number of external factors which in practice are inevitable part of this process according to data empirically collected for this research. Hence two scenarios are found which leads to gap in theory and practice.

Impractical Theories

According to the first scenario theory contains lot of concepts which are not at all found in practice and reason for the same was tried to find in the interviews conducted for this research.

The first and foremost in this is treatment of inflation. Theoretically there is vast literature available on this to be taken into consideration. Thereafter, its proper treatment as well is also discussed widely. In practice its treatment is not found to be considered. Companies consider all the cash flows in real terms and the discount factor used for discounting involves cost of capital and opportunity cost. The inflation part is not discussed at both the ends, neither in estimating cash flows nor in obtaining the discount rate. This does not lead to discrepancy also which has also created lot of fuss according to the literature reviewed.

Under shortcomings of discounted cash flow methods, projects with long initiation period are discussed as more prone to wrong results in investment appraisal process due to the same discount rate for such long period. The long initiation period was found in case of XXXXXX in practice. The companies also know there project's initiation period and accordingly they consider all the factors. Similarly, the discount rate taken by such companies is higher than others as revealed by Mr. XXXXXX from XXXXXX.

Further, companies try to make their working easy and avoid getting into risky instruments like real options. This is what is found from the discussion with Cluster head of XXXXXX bank and Assistant General Manager, Finance, of XXXXXX – one of the largest real estate companies of India. This may be the stand after this recent sub prime mortgage crisis. However, in literature real options have been discussed in many articles and almost all the books forming part of literature review of this research but in practice it is still almost non existent for capital investments, although, the concept is quite popular in portfolio investments.

The next contrasting item is cost of capital. Weighted average cost of capital has been discussed as the holistic method in the entire literature for calculating cost of capital. Again in practice companies have their own methodologies to find cost of capital. Other external factors have more impact on cost of capital than cost of equity. For instance political factors as discussed by the real estate companies, even in case of XXXXXXalso which started with the sandalwood oil production unit. For XXXXXX such factor included the long initiation period. Generally, companies in practice have used the cost of capital plus some additional rate depending upon these external factors.

External Factors

The data analysis section revealed number of external factors playing important role in investment appraisal process as discussed by interviewees from different companies. These factors can be broadly categorized as follows.

First and foremost is the political factor, especially in India where bureaucracy and red tapism is a common phenomenon.

Second is somewhat related to it i.e. government policies. It refers to the policies which are common for all and before making investment companies check out these policies for their trade and industry.

Third is the technological factor. These were discussed in case of XXXXXX Airlines, where the company is trying to use same technology so as to keep cost low in terms of commonality of aircraft spares and training for crew and engineers. This can also seen in XXXXXX – BPO where better technology used would make organization provide better services but at the same time cost effectiveness is also important.

Finally, there are lots of other factors like climatic conditions for XXXXXX agro limited, environmental factors for XXXXXX Limited as in raw materials required for leather shoe production etc. These are the factors according to the companies analyzed here. Similarly every industry would have its own such external factors which cannot be ignored for the purpose of investment appraisal process.


On the basis of the factors discussed above it is recommended to cover the gap between theory and practice from both the ends. As regard with the techniques which have been seen in literature on investment appraisal but are not widely used in practice, it must be oriented more towards practical application. This would result in existing practice become more sophisticated and derive better results. At the same time, towards the external factors which are more of organization or industry specific, there must be more researches conducted so as to find out what actually needed steps are and what just some outdated practices are. There must be some categorization of these factors and there categorically in-depth analysis must be done. This would help the companies which are not including such factors and finding it later as an extra cost in their project to remain well prepared for it before hand only.


There exists vast research work on investment appraisal process covering various aspects of it not only from recent times, but from long time back. Even the changes in methodologies and view points regarding treatment of some items have been witnessed in this field. Many empirical research works have been conducted for instance which techniques are more popular and why; how do companies derive the discount rate; various methods of implementing any particular technique; methods of dealing with inflation etc.

However, there is no research found on implementation of entire evaluation process, from aim of conducting the same till the final outcome of the process is obtained. Further, there was lack of research analyzing the factors besides what are given in the literature available on this subject. This void has been tried to fill through this research. The objective of this research has been accomplished to some extent. The accomplishment is not considered to be achieved fully because of the problems faced in conducting interviews.

Interviews have been the most difficult part of this research. This was because the subject relates to the data and information which is considered as confidential. Sharing this involved risk of passing trade secrets to competitors. The main challenge faced in this context, was related to the Non Disclosure Agreement (NDA) signed by the employees and Code of Conduct adopted by their Board of Directors. According to the said agreement/code the employees are not allowed to discuss any information related to their organization, with anyone outside the organization.

The outcome of the research revealed lot of information reflecting the gap between theory and practice. Although this was the objective to find if there is any gap which has been achieved, but it has lacked in collecting more data due to small sample size. Besides this, some of the participants who have even agreed for interview have also been reluctant in answering questions in very exhaustive manner. The participants tried to avoid interviews in their office hours and after that they were not ready to give lot of time for the same.

Finally, it can be considered as structured research paper only to some extent but not in its entirety. This is owing to the lack of access to any library, since the research is conducted in India where public libraries are not so well equipped and private libraries do not allow outsiders. Insufficient time left, since the research is conducted along with the internship program which involved full time office hours. Along with this literature review should have covered more intricacies on investment appraisal process and more primary data would have thrown light on its practical application beyond what is covered here.


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