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Pitfalls Of Using IRR Assignment
Capital budgeting is a step-by-step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company’s growth initiatives, involves determining the investment rate of return that such a project will generate.
An example of a bad capital budgeting is the Chevrolet Volt which has been a total failure.
The role of capital budgeting in a company’s long-term planning is;
Long term investment once made cannot be reversed without significance loss of invested capital.
Pros and cons of IRR
Pros – It is widely accepted in the financial community as a quantified measure of return and it’s also based on discounted cash flows – so accounts for the time value of money.
Cons – There are three well known pitfalls of using IRR that are worth discussing:
Payback Period PROS AND CONS
Pros – Allows for an easy understanding by management and stakeholders of when the initial investment will be recouped.
Cons – Does not take into account the time value of money. Discounted cash flow should be the preferred way to evaluate payback since it does recognize the time value of money..
PROS AND CONS OF NPV
Pros – Accounts for the fact that the value of a dollar today is more than the value of a dollar received a year from now – that’s the time value of money concept.
Cons – Does not give visibility into how long a project will take to generate a positive NPV due to the calculations simplicity.
In my opinion, I would recommend using NPV because of two reasons;
07 May 2014 Page 6 of 17 ProQuest
insurance costs); quality improvement; early adoption of new regulations; benefits in management and personnel (increased employee morale and involvement, stimulated innovation); external benefits derived (improved company image, access to new markets, engaged competitiveness, improved customer loyalty, improved stakeholder communication and feedback). Environmental protection as a strategic capability is supported and reinforced by other capabilities. Innovation, for instance, which is considered to be an operations area capability, allows firms to adopt environmental capabilities such as pollution prevention and product stewardship (Hart, 1995). Operations innovations are inherently difficult to replicate, slow to diffuse, and have a dynamic component when based on continuous improvement (Hayes and Upton, 1998, pp. 17-8). Likewise, environmental capabilities have been related to the capabilities derived from the human resource system, the TQM capabilities and the development of a shared view (Hart, 1995; Hanna et al., 2000). Stakeholder interaction and high-level learning are other capabilities that provide support and, at the same time, are reinforced by the firm’s environmental responsiveness (Sharma and Vredenburg, 1998). The complex interaction between resources and operations system capabilities, including environmental management, makes operations-based environmental advantages more robust and particularly suitable for supporting both the firm’s competitive strategy and its environmental sustainability. In sum, the finn is faced with a new area in which the organisation has to compete and in which it must assess its performance. If it does not pay explicit attention to these questions, the firm will show a weakness that could be exploited by its competitors. Therefore, it would be desirable to add a new operations management objective: “environmental performance. This objective can be met by jointly developing both the environmental and the operations capabilities. The objective “environmental performance” should be understood as the minimisation of the negative repercussions on the natural environment that stem from the productive activities of a company and the social perception of this impact. Environmental performance cannot be considered independently from the other operations objectives, but, in fact, they may actually be mutually supportive of each other, as we noted above. In the same way, the fact that a firm concentrates more on one of the objectives does not imply that it has reached the minimum level required by its surroundings and by the competition as regards the remaining objectives. Measuring environmental performance There is a wide variety of criteria that can be used to evaluate a firm’s environmental performance. Each of these approaches to measuring environmental performance has both advantages and disadvantages. Each organisation must select the measurement system which best meets the needs posed by its particular situation. Furthermore, environmental performance information increases its value when it is compared, because comparisons with other environmental information are central to its interpretation (James, 1994). Different bases can be used for this comparison, such as tracking over time, benchmarking against other businesses or best practices, as well as comparing it against an ideal (for example, zero emissions or total recycling). Corporate environmental performance can be represented by a relatively small number of dimensions (Lober, 1996). Ilinitch et al (1998) identify, differentiate, and validate four categories or dimensions: (1) internal systems measures; (2) external stakeholder relations; (3) external impacts; and (4) internal compliance. The first category refers to the organisational processes the firm has designed to improve environmental performance; for example, environmental auditing, or rewarding the best environmental initiatives. The second refers to the interaction between the firm and external agents such as the government, local community, clients, suppliers, etc. The third dimension refers to the negative externalities on the environment generated by the firm. Finally, internal compliance considers the degree to which the firm observes environmental laws or certain
07 May 2014 Page 7 of 17 ProQuest
minimum rules of an environmental nature that the company has agreed to respect, such as industrial agreements, or agreements between large corporations. Following on from this classification, firms could design indicators that correspond to each of the dimensions so as to evaluate the corporation’s environmental performance and any possible improvements. The first dimension, internal systems, evaluates the environmental initiatives, programmes and tools used by the firm. The main aspects are those that refer to the number of measures adopted and the degree to which their implementation has been acceptable. The environmental initiatives and programmes include both those for the whole of the firm, such as formulating an environmental plan, and those which involve the operations function to a greater extent, such as design for the environment (DfE), life cycle assessment (LCA), or total quality environmental management (TQEM). The second dimension, stakeholder relations, is a relevant component of environmental performance, insomuch as the firm can sustain a competitive edge based on environmental questions as long as public perception of the firm’s activities is positive. The relevant indicators in this area could be established by using the stakeholders’ opinion of the environmental effects of the firm’s activities (Lober, 1996). Due to the difficulty of individually tracking the stakeholders’ opinions on the firm’s environmental activities, many organisations evaluate their image in the eyes of the stakeholder by keeping an overall record of when they have appeared in the media in relation with environmental matters. In this case, negative press coverage usually affects the firm’s image more than positive coverage (Gilley et al., 2000). This procedure is, in fact, used by several authors to evaluate a firm’s environmental performance (Klassen and McLaughlin, 1996; Gilley et al., 2000). Certain stakeholder groups can evaluate environmental performance by paying particular attention to specific criteria. For example, Miller and Szekely (1995) detected that some environmental pressure groups (such as ecologist and consumer organisations) primarily want to see a company’s commitment towards reducing the cradle-to– grave impact of its products and operations and a willingness to embrace continuous improvement. Another stakeholder group, financial agents, looks at aspects that can be quantified and measured, over time, within industry sectors, and usually use indicators such as the US Toxic Release Inventory (TRI) to compare different companies. For external impacts, the indicators used to measure this objective should evaluate a firm’s contribution towards preserving or improving the environment. The state of the environment can be assessed through evaluating air, water and soil pollution (the presence of pollutant), the usage of environmental resources, and the level of noise. The firm should evaluate the extent to which it is involved in improving or worsening the situation. The main problem in evaluating this dimension of environmental performance lies in accurately quantifying the effect the firm’s waste generation has on the natural environment. This is made more difficult if we consider that many of the environmental problems are globalized and the scientific knowledge needed to measure the specific contribution of a single company is still in its initial stages (Welford, 1995). As a proxy of the impact on the environment, the indicators used in this dimension quantify the pollutants generated by the firm and the consumption of resources. Thus, these indicators can refer to the quantity of various types of waste generated (applying different weights according to the toxicity), or to the intensity at which certain raw materials are used, especially non-renewable ones. More specifically, the main indicator of environmental performance used in the environmental literature refers to the generation of contaminating substances, since there are already databases that have measured this aspect, such as the TRI. For internal compliance, the indicators used could be the number of environment laws not observed, in absolute or relative terms, the number and total amount of fines imposed, or the degree to which the firm carries out a commitment that goes beyond what the law states in environmental matters (Ilinitch et al., 1998). Additionally, for those firms with a repetitive process or which have an established environmental performance standard, the incidences or deviations from this standard are also a way of measuring environmental performance. Criteria may be classified on either one of these four categories. For example, James (1994) proposed a set of
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