Investment appraisal methods used in practice
Having considered the attributes and the theoretical strengths and weaknesses of the
methods used in practice, it seems appropriate to consider the extent to which these
methods are actually used by businesses.
The past thirty years have seen a large volume of research into the methods of
investment appraisal used in practice. The more relevant of these for UK businesses
were conducted by Pike (1982, 1996), by Pike and Wolfe (1988) (P&W), by Arnold and
Hatzopoulos (2000) (A&H), and by Alkaraan and Northcott (2006) (A&N).
Pike and P&W concentrated on very large businesses, in fact 100 of the largest 300
UK businesses. A&H surveyed 100 of the largest 1,000 UK businesses. A&N surveyed
271 large manufacturing businesses. These survey results are broadly comparable and
provide an indication of how practices have changed over recent decades.
Appraisal methods and corporate objectives
An important point that we should bear in mind as we consider these research
findings is that the choice of investment appraisal methods can quite logically be seen
as evidence of the financial objectives that businesses are following. This is because,
when making investment decisions, businesses are frequently making judgements
that will have the most profound effect on their future welfare and success.
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 importance 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 maximisation, 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 investments to rigorous examination of risks and future cash flows to ensure that they create 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, however, 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.
It seems likely that all, or all but a few, large businesses now use a discounting method
in respect of most investment decisions.
The increasing popularity of the discounting techniques is comforting to the
theorists who have long argued the merits of NPV and, to a lesser extent, IRR. Why
IRR remains so popular, despite its theoretical weaknesses, is not clear. It is felt by
some observers that financial decision makers respond more readily to a percentage
result than to an NPV expressed in £s.
It is also felt by some that decision makers prefer to leave the question of the
‘hurdle rate’ (minimum acceptable IRR) until after the analysis. This is something that
NPV will not allow since the NPV cannot be deduced without selecting a discount
rate. Since most discounted cash flow analysis will now be done using a computer
spreadsheet or similar device, this point does not seem totally valid. This is because
it is very easy to enter the predicted cash flows for a particular project and then try
various discount rates to see their effect on the NPV figure.
The suggestion has also been made that some businesses may prefer to keep the
minimum acceptable IRR as information confidential to senior management, and
that by leaving it out of the quantitative analysis it need not become accessible to less
senior staff who may be involved in deducing the IRR for particular projects. This
seems unlikely to be valid. Many major businesses specify their required investment
return in their annual report, so it is clearly not regarded as information that they
would prefer to keep secret.
From the popularity of NPV and the fact that, in most circumstances, IRR will give
exactly the same decision as NPV, there is some evidence that businesses do, in fact,
pursue shareholder wealth maximisation as a primary objective.