104 Financial Management
A company in practice should take all care in selecting a method or methods of
investment evaluation. The criterion or criteria selected should be a true measure of
evaluating if the investment is profitable (in terms of cash flows), and it should lead to
the net increase in the companyís wealth (that is, its benefits should exceed its cost
adjusted for time value and risk). It should also be seen that the evaluation criteria do
not discriminate between the investment proposals. They should be capable of ranking
projects correctly in terms of profitability. The net present value method is theoretically
the most desirable criterion as it is a true measure of profitability; it generally ranks
projects correctly and is consistent with the wealth maximisation criterion. In practice,
however, managersí choice may be governed by other practical considerations also.
A formal financial evaluation of proposed capital expenditures has become a common
practice among companies in India. A number of companies have a formal financial
evaluation of almost three-fourths of their investment rojects. Most companies subject
more than 50 per cent of the projects to some kind of formal evaluation. However,
projects, such as replacement or worn-out equipment, welfare and statutorily required
projects below certain limits, small value items like office equipment or furniture,
replacement of assets of immediate requirements, etc., are not often formally
evaluated.
Methods of Evaluation
As regards the use of evaluation methods, most Indian companies, use payback criterion.
In addition to payback and/or other methods, some companies also use internal rate of
return (IRR) and net present (NPV) methods. A few companies use accounting rate
of return (ARR) method. IRR is the second most popular technique in India.
The major reason for DCF techniques not being as popular as payback is the lack of
familiarity with DCF on the part of executives. Other factors are lack of technical
people and sometimes unwillingness of top management to use the DCF techniques.
One large manufacturing and marketing organisation, for example, thinks that conditions
of its business are such that the DCF techniques are not needed. By business conditions
the company perhaps means its marketing nature, and its products being in sellerís
markets. Another company feels that replacement projects are very frequent in the
company, and therefore, it is not necessary to use DCF techniques for such projects.
The practice of companies in India regarding the use of evaluation criteria is similar
to that in USA. A study by Schall, Sundem and Geiljsbeak (1978) showed that whereas
86 per cent of the firms used either the internal rate of return or net present value
models, only 16 per cent used such discounting techniques without using the payback
period or average rate of return methods. The tendency of US firms to use naive
techniques as supplementary tools has also been reported in other studies. However,
firms in USA have come to depend increasingly on the DCF techniques, particularly
IRR. According to Rockleyís study (1973X the British companies use both DCF