Corporate Finance and Governance Essay Example | Topics and Well Written Essays - 2500 words

Corporate Finance and Governance - Essay Example "It has long been recognised that the recognition of risk is an important component in capital budgeting decisions. The future is uncertain and investment appraisal techniques that fail to recognise this fact will almost certainly lead to incorrect conclusions and erroneous recommendations." (Brookfield, 1995) "In a longitudinal survey of capital budgeting practices of large UK companies between 1975 and 1992, substantial increase in the usage of discounted cash flow (DCF) and risk appraisal techniques were reported. Despite the increased usage of the more theoretically sound discounting techniques, several writers in both the UK and US have claimed that companies are underinvesting because they misapply or misinterpret DCF techniques. It has been asserted by several writers that firms are guilty of rejecting worthwhile investments because of the improper treatment of inflation in the financial appraisal. Many firms are understating NPVs and IRRs because of the incorrect treatment of inflation and the use of excessively high discount rates. Concern has also been expressed by various commentators that many companies are failing to invest in advanced manufacturing technologies (AMT) as fully as they should. Financial appraisal techniques have been cited as a major reason for the under-invest ment in new manufacturing technology. DCF procedures should not be ignored or relegated in importance merely because they might be used incorrectly. Instead, decision-makers should recognize potential problems and be careful to ensure that the financial appraisal is performed correctly." (Colin and Mike, 1986) "In a world in which information is not costlessly and symmetrically available to all economic agents, corporate project choices do not abide by the golden rule that all positive NPV projects should be accepted. In a sense, this is somewhat unsettling because it is difficult to prescribe simple rules for managers, and there has been little normative research into optimal capital allocation policies in different types of informationally constrained environments. However, the contemporary research highlights the pitfalls of policy-oriented discussions about corporate investment behaviour and managerial compensation packages that rely on the prescriptions of the traditional, symmetric-information paradigm of capital budgeting and financing. The research done to date indicates that many interesting things can happen under asymmetric information, none of which may be irrational, but some of which could be deleterious to the shareholders' welfare." (Thakur, 1993) Given these observations about investment appraisal techniques and DCF techniques, in particular, this report aims to assess the feasibility of using traditional investment appraisal techniques, while incorporating real-time variables such as risk and uncertainties. In particular, the report focuses on NPV as a basis for capital budgeting and evaluates how the concepts of risk-adjusted discount rates and sensitivity analysis can bolster traditional NPV estimation and thus provide business managers with realistic and flexible options when it comes to assessing the suitability and profitability of a particular investment or project. Accordingly, the  management approach should not be limited to using a fixed number of investment appraisal techniques; rather they should be more flexible while appraising the gains from a particular investment.