FINNANCIAL MANAGEMENT

Finnancial Management

Finnancial Management

Q1: Investment Appraisal

Financial appraisal of capital projects continues to be a topic of discussion, with new models being developed and old ones refined. Although the Financial Appraisal Profile (FAP) model,(n1) which I introduced in 1997, has gone through a number of refinements, its original concept has remained unchanged. The idea of using the 'true' cost of capital as the discount rate in calculating the discounted cash flows in the model (producing what has now been termed the 'economic value' from a project) is controversial, as it goes against the concept of risk-adjusted discount rates. However, the FAP model does not ignore risk. In fact it places a great emphasis on identifying and evaluating project risk, presenting the analytical results in the form of a Risk Index (RI). Strategic benefits are also evaluated using the Strategic Index (SI). (Lefley, 331-32)

The model is therefore capable of evaluating the three main aspects of an investment decision: financial, risk and strategic. This gives a wider profile of each investment opportunity on which to make a more informed decision. A main attribute of the FAP model is that it adopts a 'management team' approach to the evaluation of capital projects. Unfortunately, space only allows me to give a brief outline of the FAP model, but it is hoped that it will be sufficient to stimulate interest.

Most managers prefer to use the internal rate of return (IRE), or one of its modified versions, rather than the net present value (NPV), although the NPV is argued to be the most appropriate financial appraisal model. The FAP model uses the NPV is known as the 'corporate risk threshold' (CRT). The CRT represents the cut-off point for risk acceptance. Any project with a potential risk, from any one risk area, greater than the CRT would be automatically rejected, unless that risk could be reduced in some way.

The CRT will be influenced by the Make More PLC.'s attitude to risk: a lower threshold denoting risk profile (Lefley, 26-29), which was developed to give managers the best of both worlds. In the NPV profile, by using an unadjusted discount rate, we can calculate the NPV, the discounted payback period, the discounted payback index, and the marginal growth rate. This gives us a financial profile of a project's economic value. It establishes the NPV, it measures the time-risk and liquidity of a project, and gives us the marginal growth rate (MGR), the rate required to take the initial investment in a project to the project's present value (PV) of net cash inflows (which is equal to the NPV + the capital cost of the project). In other words, it answers most of the financial questions asked about a project. Managers like to use a number of financial criteria when evaluating projects. The NPV profile allows us to make such an evaluation from a sound base--the NPV.

Case Study Applying The FAP Model

Make More PLC. is considering the purchase of some new manufacturing equipment which will change the ...