2003 AACE International Transactions
INT.06 Acceptable Project Investment Criteria
Tamuno Olumide Olu-Tima
t is not unusual in some parts of the world, during the site construction phase of a major project and its operation, to experience demand for infrastructures, amenities, preferential employment, and subcontracts. In some cases a memorandum of understanding has been drawn-up todocument the obligations of the investors, contractors, and the host communities’ social strata of leaders of men, women, and organized youth . Engineering economics and current investment appraisal methods are mainly concerned with the measurement of capital productivity, profits, and the enhancement of shareholders returns. The use of discounted cash flow (DCF) models such as net present value(NPV) and internal rate of return (IRR) are wellestablished . The basic principle of the DCF methodologies is the time value of money, based on the cost of capital. When all the cash flows of an investment proposal are changed into the present value (PV) at a certain discount rate, the present value should be greater than or at least equal to zero if the proposal is to be accepted. The NPV isused as a measure of a project’s ability to increase corporate wealth. It is normal practice to look at the feasibility of a project by checking if it meets the specified corporate huddle rate for investment, by comparing individual investment’s IRR with the required corporate rate. When the IRR expressed as an interest rate is greater than the minimum attractive rate of return or discount rate,the proposal is acceptable and proposals are then ranked in the order of descending positive NPV and IRR. Since DCF methodologies depend heavily on the estimating and forecasting of future cash flows, there is an inherent risk and uncertainty in decisions based on these data. The current approach toward risk and uncertainty can be found in the works of Rose , Thuesen and Fabrique , Merretand Sykes , and Canada, Sullivan, and White . Lack of historical data and information are serious limitations to the use of probabilistic methods in the analysis of risk. The use of sensitivity analysis is well accepted to deal quantitatively with imprecision or uncertainty. The DCF models are usually used along with other financial analysis tools. The most used methods include paybackperiod (PBP). The shortcomings of the payback period method is in its ignoring the time value of money as well as the cash flows after the payback period. Due to its easy use, the method is used as a supplementary tool for risk and liquidity analysis . Bankers are particularly interested in the firm’s ability to meet short-term obligations associated with a loan, rather than maximizing the wealthof
the owners of the firm. With a shorter payback period, better forecasts can be made on changes in market conditions, interest rates, the economy in general, and other factors that may affect the project investment. The PBP is highly recommended in industries where there is volatility of the product market and to corporations experiencing financial pressures. Kaplan  in his paperhighlights quality, inventory, productivity, innovation and workforce capabilities as critical nonfinancial aspects of manufacturing performance. In a paper by Pace and Huppert  on financial feasibility in implementing process change, in addition to the financial measures (NPV and IRR), standardization, worker productivity gain, expenditure reductions, and employee utilization gains wereconsidered as essential for the information technology (IT) implementation phase of a total cost management process within a construction firm. Hence the financial appraisal methods used by industry to evaluate capital investments may be inappropriate for certain industries and by extension different investment environments, be it oil and gas or advanced manufacturing technologies or change management...
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