Evaluating the Investment Decisions of a Firm | Economics

An entrepreneur adopts the various methods of evaluating the investment while making the decision.

These methods can be classified into two major categories:

(i) Traditional Investment Approaches.

(ii) Modern Investment Approaches.

Traditional Investment Approaches:

The traditional methods of investment evaluation are based on three main assumptions:

(a) The profit making is the only objective of the firm,

(b) The investors take decisions about investment in the atmosphere of full certainty. In other words the entrepreneur knows fully about the present and future of cost, demand, degree of competition etc. and

(c) A firm is free to make decisions. Its decisions are not affected by the central authority decisions.

When an entrepreneur establishes any industrial undertaking he adopts any one of the following methods in order to evaluate his investment:

(i) The Payback Method:

It is a relatively easy but less scientific method of evaluating the investment proposal. Under this method the investor chooses a certain period, which is called payback period, at his sweet will, when he would regain the primary investment within a certain time limit.

The characteristics of this method are. The calculation in this method is easy and rational. It is a direct, method in which the objective of the firm is to get back its investment, as soon as possible. Thus the firm minimises its risks, because longer the time period, greater will be the risk.

The main drawbacks of this method are:

(a) In this method there is no discount on the future income.

(b) The assumption of maximising profit is impractical. In this method the period after payback is neglected, and

(c) This method says nothing about getting a definite rate of profitability on the proposed investment.

(ii) The Book of Accounting Rate of Return:

The book of accounting rate of return is the ratio of average annual profit on the primary capital. To calculate this ratio; gross profit and gross investment expenditure or as an alternative, average profit and average capital is taken into account. There are different methods of defining capital in different countries. Likewise the profit is defined variably in various projects of the same country.

(iii) The Net Present Value Method:

To main drawback of above method is that to know total net income or profit the returns of different years are added. This is not appropriate from the point of view of economics. Because the value of money received at present and that of money be received in future is not the same. Money has also a time value.

The value of sum received in the present is relatively more than that of a certain sum to be received in future. For example if we give 100 Rs. for a year on loan, we will receive Rs. 110 at the interest rate of 10%. Hence the present value of the income is calculated by discounting the future income from a project, time is an important factor of the every aspect of the project. Every project has an economic life which begins with the first year of production and ends with the project itself.

This life totally depends on future, while designing and evaluating it. This means, the inputs, output, their prices, direct costs and profits of the project are all things of future. The outline of the project is a future chronology of the input, output, cost and profit of the lifetime of the project.

(iv) The Internal Rate of Return or the Marginal Efficiency of Capital Method:

The present value of investment profit and profit-cost ratios of any project can be estimated only when we know the appropriate, rates of discount. If in any case the social rates of discount are not given, the only alternative left for the project investors to go on decreasing the zero ascending discount rates in the chronological order of social cost and profit.

The sum of the present value of profit on every rate and its difference with the sum of present value of cost should be calculated that means the present value of net profit. If the present value of net profit is positive on certain discount rate, then the present positive value of net profit should be calculated again on the next higher discount rate.

This process should be repeated till we reach the discount rate where net profits present value equals to zero. This discount rate is termed as the internal return rate of the project. It is called internal because it is derived from the cost profit figures of the project and requires no outward help. It is called the rate of return for in reality it is a per unit return on investment cost of any project.

Shortcomings:

According to the extra return rate standard, an early profit bearing project should be chosen, for it bears a high internal return rate. But this choice proves to be wrong, if the project is selected on the basis of the standard of profit-cost ratio of the present value of the net profit.

Apart from these shortcomings it does not provide any perfect decision-making law about the selection of internal return rate. Because it requires some standard of comparison, some pre-determined private or social interest rate on which the investment fund is loaned or made available.

Modern Approaches of Investment Decisions:

Some new techniques are discovered to evaluate the investment in the economic planning in the underdeveloped countries. Some economists like Mission, Morglin, Haberger, Organisation of Economic Commission for Development (OECD) and United Nations Industrial Development Organisations have developed some useful techniques of social evaluation of industrial projects.

(i) The OECD Approach:

This approach technique is developed by little and Missless. In this approach a legitimate criteria is given in order to evaluate the social cost-profit of a project. It was followed by another approach called the UNIDO approach in 1965.

(ii) UNIDO Approach:

The United Nations Industrial Development Organisation, UNIDO started its work in 1965 to develop the techniques and processes of evaluation of industrial projects through national profit-cost analysis. The most important work in this context was the study, captioned as ‘Guidelines for Project Evaluation’. It was prepared by Portuo Das Gupta, Amartya Sen (now a Nobel Lauriette) and Stephen Marglin.

In this study those projects were selected which help in achieving the ultimate objectives of the under developed countries. It produced the guidelines for government projects. Thus these guidelines provide a basis for social cost-profit analysis. The objective of this analysis is to maximize the net social profit. Net profit of a society is the difference between the gross social profit derived from a project and the total social cost.

Social-Cost Profit:

Which items should be included in the social cost and social profit while doing a practical evaluation of a project? According to the guidelines the difference between profit and cost is of sign only. A profit derived from a project becomes cost in the context of other project. For example a project produces extra consumption goods for society. In this situation it will be considered as a social profit. But in case, some other project is selected in place of the first, we have to make sacrifice of this extra consumption and this will become the cost of another project.

National Objectives:

(i) Objective of total consumption,

(ii) Objective of income redistribution,

(iii) Objective of reduction of unemployment,

(iv) Objective of self-dependence,

(v) Social goods (Female education etc.) objective.

After determining the social objectives, the next problem is to transform these objectives into profits and then to change them into single, gross measure.

Social Cost Profit Analysis:

In a social cost profit analysis social costs are also evaluated. UNIDO considers the opportunity cost as the measure of social cost. An opportunity cost of a project is defined as the maximum alternative benefits foregone. If to select X project, Y and Z project profits (prospective) are to be abandoned, then the maximum profit derived from these projects will be the legitimate social cost of the X project.

Hence it is clear that the total profits of a project are the social profits while foregone profits are social costs. The profit of a project includes net product. Net product refers to the quantity of available goods and services in the economy, which would not have been derived in absence of that project. Likewise net inputs are included in the cost of a project.

Indirect Profit Cost:

We have to consider also the indirect profit and costs while evaluating the investment. Generally these are included in the item of external effects. As these external, effects cannot be measured easily the UNIDO approach includes only those indirect effects or external effects which can be identified and measured easily.

These are the net profit of society which cannot be measured with the product, of title project. For example a road built for any specific project can be utilised by other also. In this situation, it is not possible to measure the indirect or external profits. Likewise there are indirect costs of a project. These indirect costs cause net loss for a society. For example, the climate is polluted after starting any industrial project. This is the indirect external effect which puts the society to loss.

UNIDO Method of Evaluation of Risk and Uncertainty:

Apart from the two methods, there is a third method to evaluate the investment having risk and uncertainty, developed by UNIDO. It calculates, is such position the ‘Expected Present Value (EPV). Alternative results cannot be pre- estimated in the condition of uncertainly and there can be many consequences in future. UNIDO method considers many possibilities in evaluation to solve uncertainty in the performance of the project.

For example different probabilities in the prices of future for the product under the industrial project are taken into consideration. Impossible situations, which cannot happen are excluded but of these probabilities. Remaining various results on the basis of their probably prospects are kept for consideration. In this context help may be taken from the past experience.

(iii) Cost Plus Method:

Price is the value of a product denoted in terms of money. It is the amount paid by a buyer to a seller for buying a unit of that product or service. A firm may adopt various price methods for the product being produced by it. These various methods can be grouped in two major groups.

A. Pricing Methods Based on Cost:

1. Full-Cost or Cost Plus Method:

It is the most common method utilised for pricing. In this method, price is adjusted to cover costs (of material, labour and overhead) and a pre-determined percentage for profit. Management works out the cost of goods manufactured or purchased for resale and adds a percentage of profit to determine the selling price.

This percentage is never alike among various units within the industry and even products of the same concern. It is because of the rate differences in competitive intensity, differences in cost base and turnover rate with risk exist. It shows some vague idea of just profit.

Limitations of the Cost Plus Method:

(i) Demand is Ignored:

There is no reciprocity between cost and demand for the goods. Demand is totally ignored in pricing.

(ii) Failure to Show the Forces of Competition:

It fails to reflect the forces of competition fully.

(iii) Exaggeration of the Precision of Allocated Costs:

It exaggerates the precision of allocated costs.

(iv) Based on Cost Concept:

It is based on concept of cost that may not be relevant for the decision of the price.

The cost-plus pricing method is suitable in the following cases:

(I) Ideal Method:

It is an ideal, fair and just method of pricing. Prices can be fixed very easily and with speed. Prices are more defensible on moral grounds.

(II) Uncertainly of Demand:

In practice, firms are very uncertain of the demand of their product and the probable response to any price change. The method is then a fool­proof method.

(III) Stability:

The firms which prefer stability can get it from full cost pricing due to uncertain market and incomplete knowledge. In such cases where costs of getting information are high with process of trial and error, they stick to it so that the cost of decision making is reduced to the minimum.

(IV) Management tends to know more about product costs than other factors relevant to pricing.

(V) Major Uncertainty in Cost Setting:

Rivals prices could not be known hence, it is difficult to set the price accordingly. Cost plus pricing only can live stability to set a price by which the profits could be acceptable to other members of the trade.

(VI) Product Tailoring:

When the selling price is predetermined, the products design can be determined very easily.

(VII) Other Advantages of Cost Plus Pricing are:

(a) Pricing or Products when they are Manufactured on the Orders of a Single Buyer as Per Specifications:

Pricing is determined cost plus gross margin.

(b) Monopoly Buying:

Buyers know of the suppliers’ costs. If they do not get the product to the price of their satisfaction, they will prepare the product themselves at relevant costs.

(c) Public Utility Pricing:

According to cost plus formula, if one expects decline in industry, he must increase price. This price policy is useful in times of depression. Cost plus is a pricing scheme based on arbitrary costs and arbitrary make up. It is taken into consideration as it is simpler to apply.

2. Going Rate Pricing:

Here we are more concerned with the market price and cost is not given any consideration. The firm adjusts its own price policy to the general pricing-structure in the industry. Where costs are particularly difficult to measure this may seem to be the topical step in a rational pricing policy. Here price leadership policy fits in well. Here the rates are fixed according to the competitors’ prices and this is the safest way. The risks of price fixation are saved. It is no more costly and no calculations are needed.

This process is adopted in the world markets. The firm has enough power to set its own prices and can be a price maker if it likes to face all the consequences.

3. Marginal Cost Pricing or Incremental Cost Pricing:

All traditional theories of pricing behaviour fall under the heading of marginalism. They assume an entrepreneur who weighs the penalties and rewards of price decisions. He compares the additional gain and additional cost of increasing output or charging price. He works at a point where gain and loss (cost) are equal. These theories are based on the recognition that both demand and cost condition influence pricing. The firm adjusts to changes in the market force revising price as demands shift or costs change.

The traditional theory has certain limitations.

Limitations are as under:

(a) Assumption or Profit Maximisation:

The theory rests on profit maximisation objective of the firm. Although profit maximisation is the primary objective there are other objectives as well that guide the entrepreneur. Maximising sales of increasing the market share interest the manager more than profit at times. The trusteeship principle of social responsibility sometime becomes more important than profit maximisation.

(b) Inadequate Dealing with Dynamics or Pricing:

The traditional theory does not distinguish clearly between the long-run and short-run effects of changes in prices. It does not indicate the effect of today’s price on future Profits. It considers the present marginal revenue curve and the present marginal costs curve only.

(c) Assumption on a Single Product:

In practice firm products not one but several products which are inter­dependent both in sales and in production.

(d) Problem of Uncertainty:

The traditional theory assumes full knowledge of firm’s demand cost functions to the manager. In real world this is hardly true. Uncertainty does exist and the manager must take it into account while pricing.

Under this method, prices are fixed on the basis of variable costs or direct costs of the products. This method is available when a new product is to be introduced in the market by existing firms. During depression period also this method is workable. But it is only a short-term phenomenon.

4. No-Loss No-Profit Price Policy:

It is a price equal to total costs per unit or where sales revenue is equal to total costs, total costs include fixed costs as well as variable costs. This method is suitable during depression periods, when there is acute competition in the market, when a special order is to be supplied or when a new product is to be introduced in the market by an existing firm.

5. Rate of Return Pricing Policy:

Many firms follow the policy of rate of return on their investments. Under this method, a price is fixed by manufacturer or distributor as to give him a fixed return on his total investment in the process. This method is more suitable for distributors and for the products which can be sold in bulk quantity and that have a quick, turnover of capital.

B. Pricing Methods Based on Market Conditions:

1. Established Price:

Sometimes, long-term prices of a product are established or stabilized in the market. It is its normal price or long-term price and the sport price or market, price or-short-term price of that product revolves around it. So, whenever any producer brings as new product in the market, he will have to fix the price of his product near about that price.

2. Leadership Prices:

In some industries, one or two large business units control the lion’s share or the market. This business unit acts as a price leader. Small firms in such a situation have no alternative except to follow the leader. The prices charged by these firms are identical to those charged by the leader firm.

They make changes in price at the time and to the extent as are made by the industry leader. Such a policy is adopted by a firm when it funds that undercutting of prices is dangerous and over-changing is not possible because it may be difficult to sell products at a price higher than the one charged by the industry leader. There is no price competition among the firms in the industry.

3. Penetration Pricing:

A firm may adopt the strategy of charging low price to obtain a larger share of the market and to develop brand preference. This is also used to obtain the advantage of economies scale because charging a lower price may be used to prevent the entry of new firms by keeping the margin of profit low. The firm adopting this policy benefits in the long-run because of the brand preference developed in the introductory stage.

4. Skimming the Cream Policy:

This policy if adopted in the case of speciality goods, a manufacturer may keep the price very high to recover the amount invested by him quickly. It is also adopted to make quick profits because of fear of competition at a later stage. Such a policy is possible to be adopted in the case of those products which are drastically departing from the available products.

This policy is desirable in the following circumstances:

(i) It may be used to avoid the loss resulting from competition especially when the entry in that line of business is easy.

(ii) When manufacturers may be interested in keeping the price high to earn a higher initial profit to be ploughed back in the business to meet the increased demand.

(iii) The initial cost of product is generally high. It is, therefore logical to charge a higher initial price.

5. Charging What the Traffic will Bear:

This policy is adopted by the persons and institutions engaged in rendering some personal service. Doctors, dentists, lawyers, for example, charge the prices for the services rendered by them on the basis of the customer’s ability to pay. This policy, obviously, takes into accounts the needs and resources of the customers. Cost factor does not dominate this pricing policy.

This policy is especially useful when the product of a unique type capable of creating a fad. This policy, however, does not find a wide recognition in the market because customers do not look with favour on a business unit following a policy of charging what the traffic will bear.

6. Psychological Pricing:

Psychological pricing is the practice of setting prices at odd amount such as Rs. 9.95 Rs. 13 or Rs. 39. It is known as odd pricing, it was originally introduced to check the honesty of sales clerks by forcing them to make changes more frequently in accepting payments from the customers. Today, it is used to secure a positive buying behaviour from the customers. It is thought that odd pricing succeeds in inducing a buyer to some extent to make purchases.

The reason for this expectation can be easily understood if we compare a price of Rs. 6.95 with price of Rs. 7. Although there is a marginal difference between these two price, yet a price of Rs. 6.95 appears to be over Rs. 6 rather than almost Rs.7. Similarly, a car priced at Rs. 15998 suggests the price to be over Rs, 15,000 rather than almost Rs. 16000. Not only this, price of Rs. 15998 suggests to a buyer that the price is reasonable and he is not being over-charged.

These two factors secure positive buyer behaviour. There is, however, little evidence to suggest the importance of psychological pricing in increasing the sales volume of a business concern. Yet a casual glance at prices indicates that psychological pricing dominates pricing particularly in the case of consumer goods.