Chapter 4 • Investment appraisal methods
We have already seen in section 4.2 that NPV’s major theoretical justification
stems from an assumption that businesses pursue the objective of shareholder wealth
maximisation. If this is the objective that they pursue in fact, we should expect to find
strong adherence to NPV as the primary appraisal technique in practice. A&H found
that 80 per cent of the large businesses surveyed used NPV, in almost all cases in
conjunction with at least one other method. They also found that all of the large
businesses surveyed used either NPV or IRR or both. In most circumstances, IRR is
a good proxy for NPV.
It would probably be wrong, however, to conclude that, since NPV is not used by
all businesses, shareholder wealth maximisation is not the primary objective. Indeed,
Pike and Ooi (1988) found that there was no significant association between the import-
ance to a particular business of shareholder wealth maximisation and the use of NPV.
It may be that there is a lack of sophistication among some financial decision makers
that causes them not to relate a particular objective to the appraisal method that will,
in theory, promote it.
Some businesses refer to their use of NPV, and how this relates to wealth maxim-
isation, in their annual reports. In its 2006 annual report, Rolls-Royce plc, the engine
and power systems manufacturer, said: ‘The group continues to subject all invest-
ments to rigorous examination of risks and future cash flows to ensure that they cre-
ate shareholder value.’ The report goes on to say that it uses discounted cash flow
analysis to assess investment decisions.Multiple appraisal methods
The fact that the totals in Table 4.2 are all greater than 100 per cent reveals that many
of the businesses surveyed use more than one method. This does not necessarily mean
that more than one method is consistently being used by a particular business in
respect of each decision. It seems that businesses vary their approach according to the
nature of the capital investment decision concerned. For example, A&H found that
80 per cent of their large business respondents used NPV. Within that 80 per cent, how-
ever, nearly three-quarters of those businesses used NPV for all decisions. At the other
extreme, about 4 per cent of that 80 per cent rarely used it. It seems likely, however,
that many businesses use more than one method concurrently to assess a particular
investment project.
The incidence of multiple use seems to have increased over time, as is clear from
Table 4.2. According to Pike’s 1975 survey, the average number of methods used was
two. This increased steadily and by the time of Alkaraan and Northcott’s 2002 survey,
it was averaging 3.44 methods.
The fact that the use of multiple appraisal methods is so widespread may provide
evidence that businesses pursue multiple financial objectives. On the other hand,
managers may take the view that, once having estimated the cash flows, they might
as well use them in as many ways as possible in an attempt to gain as much insight as
possible about the investment proposal.Discounting techniques
Both NPV and IRR have shown strong growth in popularity over time. Although
all of the studies have tended to show increasing popularity of all four methods, it is
the discounting methods, particularly NPV, that have made the greatest progress.