III. Investment Appraisal Techniques and their Associated Risks
Return on Equity (ROE) is a business ratio that measures the return the firm is earning on equity funds invested by its shareholders (Macmenamin, 1999, p. 304). It is calculated by dividing the net profit with average common equity of the firm or in symbol: Net Profit/ Average Common Equity (as cited in Investopedia, 2003). According to the preceding literature, ROE guides investors to build an equity portfolio whose components are able to derive profits efficiently. Therefore, they can obtain optimal returns in the form of dividends though minimum investments. An annual rising of ROE shows that the firm is valuing as well rewarding investments because it is sacrificing to avoid waste-saving in every organizational function but still maintain effectiveness to generate income. In effect, shareholders have more financial residual to manage its portfolio with flexibility without damaging its individual investments.
Internal Rate of Return (IR) is a discount rate equivalent to investment project’s expected rate of return (Macmenamin 1999 p. 371). Its calculation is far more complicated than ROE as it attempts to bring to zero the net present value of the cost of capital coming from the investors (cited in ACCAD Global, 2000). As a result, shareholders can have understanding on whether to invest or otherwise to a certain project because they can compare the expected rate of return to what they viewed as required rate of return. As observed, unlike ROE, IR merely measures projects cash flows not the whole business especially those who are under going-concern stance. This is due to the ever-changing discount rates in which IR will be based and used to arrive at a decision. However, IR is still effective when evaluating the profitability of two projects with single discount rate, predictable cash flows, equal risk and shorter time horizons (Investopedia, 2006).
One advantage of ROE is that it can evaluate a number of firms within an industry (as cited in Investopedia, 2003). For example, between 1998 and 2003, Dell, HP and gateway have ROE of 46%, 12% and 2.5% respectively. In terms of profit efficiency, investors can easily discern that Dell is an ideal investment and ROE mimics the cost-effectiveness and value of its direct marketing. It is also a good indicator of growth potential. However, ROE can be easily manipulated by a firm who wanted to make their reports attractive to prospective investors. Through write-downs and/ or buyback programs, the net income in the numerator and equity on the denominator is distorted to result in a high Roes. Further, even if manipulation is not applied, an ethically-prepared report can have unintended impression by providing high Roes that is caused by excessive debts (as cited in Investopedia, 2003).
Ire’s capability to analyze cash flows stems one of its strength which is to compare cost streams between two projects (Martin, 1998). It is a tool to screen individual projects and their profitability in which ROE lacks as the latter is holistic in its financial analysis. However, aside from its historic position being an underdog to NP, IR is ineffective in calculating a project with a mixture of multiple positive and negative cash flows because there can be at least two solutions due to the effects of market factors (Investopedia, 2006). Another bottleneck is the determination of well-developed and well-analyzed discount rate in which IR is to be compared. Without discount rate, IR cannot be a stand alone measurement. In the contrary, even with these blemishes, IR is a simple decision tool requiring less assumptions and research from the firm unlike ROE or NP (Investopedia, 2006).
Placing their varying advantages and disadvantages in the realm of foreign investment, ROE is suited for investors who wanted to establish assets abroad or foreign direct investment (FID). This type of stake is relatively more costly, long-term and requires internal structure and strategy for maximum returns. In effect, this places prospective investors to evaluate their investments within the lens of the whole corporate value and operations. On the other hand, IR can be compatible with non-equity investments as its measurement can give investors simple approach to risk and abrupt market changes. In addition, IR is effective in project-based activities of a firm which gives investors the opportunity to earn and receive back their profit share in a short span of time. The motivation to use IR is derived from the ease of pulling out investments abroad unlike fixed assets in which expatriation or war can diminish investor’s income generating stake. Since ROE uses evaluation inputs from the elements of the firm while IR from the elements of a specific project, investors can choose appropriate tool in relation to their risk level, withdrawal preferences and self-proclaimed goals.
The key in determining Net Present Value (NP) is the discount rate. Used in capital budgeting, NP is the most dynamic and widely used method in evaluating long-term projects. Its major criteria state that “projects that have positive Naves are worthwhile while those with negative are not”. But Naves are not perfect. Although analytical tools like net present value (NP) are helpful, the greatest obstacle to minimize the need for working/ physical capital to be able to enhance free cash flows is not guaranteed. There is some work to do even after computing for Naves. By locating inefficiencies and value-adding activities, deferral or elimination of projects that can be a deceptive action (due to savings) can be re-analyzed to locate possible opportunities that are kept untapped (1993). Naves are simply the summation of discounted annual cash flows of a project. It is derived after the net income of the project is illustrated (e.g. expenses like marketing costs are deducted or non-cash transactions like depreciation expense are brought back to the net income).
Ire’s capability to analyze cash flows stems one of its strength which is to compare cost streams between two projects (Martin, 1998). It is a tool to screen individual projects and their profitability in which ROE lacks as the latter is holistic in its financial analysis. However, aside from its historic position being an underdog to NP, IR is ineffective in calculating a project with a mixture of multiple positive and negative cash flows because there can be at least two solutions due to the effects of market factors (Investopedia, 2006). Another bottleneck is the determination of well-developed and well-analyzed discount rate in which IR is to be compared. Without discount rate, IR cannot be a stand alone measurement. In the contrary, even with these blemishes, IR is a simple decision tool requiring less assumptions and research from the firm unlike ROE or NP (Investopedia, 2006).
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