Why Is the Investment Appraisal Process so Important? Essay

A) Why is the investment appraisal process so important? Capital Investment Appraisal is of fundamental importance because: 1. Large Amount of Company Resources: Involvement of large amount of company resources and efforts which will necessitate careful evaluation to be undertaken before a decision is reached. 2. Maximization of Shareholder wealth: Investment decision is linked with strategic and tactical business decisions and therefore need to achieve desired long-term objectives. The most usual objective being the maximization of shareholder wealth. . Difficult to Reserve: It can be very expensive and perplex to reserve an investment decision so caution need to be exercised in reaching the initial investment decision. 4. High Risk Involvement: Projected future benefits and costs are hard to forecast. As a result, the risk and uncertainty of undertaking medium to long-term investment can be high. B) What is the payback period of each project? If AP Ltd imposes a three year maximum payback period which of these projects should be accepted? Payback period for project A:- | | | |YR |NCF |CF | |1 |20 |20 | |2 |30 |50 | |3 |40 |90 |4 |50 |140 | |5 |70 |210 | Payback period of project A = 3 + 20/50 = 3 + 0. 4 = 3. 4 yrs, i. e. , 3yrs 4. 8 months. Payback period for project B:- | | | |YR |NCF |CF | |1 |40 |40 | |2 |40 |80 | |3 |40 |120 | |4 |40 |160 | |5 |40 |200 | Payback period of project B = 2 + 30/40 = 2 + 0. 75 = 2. 75 yrs, i. e. , 2yrs 9 months. When examining two new investment projects of AP Ltd, as in the case of projects A and B, the usual decision is to accept the one with the shortest payback, assuming the payback period satisfies some preconceived target. However, when only one investment opportunity is being examined, the payback of that opportunity will be compared with a target payback.

This concept of a target payback could be employed in the case of projects A and B above. The payback target is 3 years, so project B should be accepted because it pays back after 2 years 9 months where as project A payback only after 3 years and 4. 8 months which is more than the target. The longer the time period for receipt of cash, the greater the risk. C) What are the criticisms of the payback period? Payback is the number of years it takes to recover the initial investment. It is expressed in time or years. It is normally defined as the period, usually expressed in years, which it takes the cash inflows from an investment project to equal the cast outflows. There are three important criticisms of the payback period method.

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The first is clearly fundamental and relates to the fact that cash flows after the payback period are ignored. So it could be the case that whilst a project produces a large net cash flow (i. e. , where cash inflows significantly exceed outflows), they are generated in the later part of the project and may be ignored as this is after the payback period. For example, in the case of project A and B in this question , project B was preferred because of its shorter payback period, but overall project A generates more cash inflows, totaling ? 2,10,000 as compared to only ? 2,00,000 in the case of project B. However, project A`s cash inflows were mainly earned in the later years.

The second criticism of the payback method is that it relates to the method not taking account of the time value of money, similarly to the ARR. However, it does not have value in situations where the useful life of the project is short and difficult to predict. Japanese firms, particularly in consumer electronics, use the payback method when evaluating new products since the product life cycle can be quite short and a new product can be made unexpectedly obsolete by changes in technology. For example, imagine we have to choose between two alternatives that each require an initial investment of ? 4000. Option A returns ? 1000 at the end of fourth year. Option B returns ? 4000 at the end of fourth year.

Under the payback method, option A and option B are equally preferable. However, that option A is really better since the cash flows come earlier. Now if we add the information to 5 years, then, option A will produce an additional cash inflow of ? 5, 00,000. But option B will never generate another pound after the fourth year. So the payback method ignores the time value of money and does not measure profitability. It just measures the time required to recapture the original investment. The third criticism of the payback method is that the selection of the maximum acceptable payback period is arbitrary. D) Determine the NPV for each of these projects? Should they be accepted – explain why? Year |Project A |Project B | |0 |(110) |(110) | |1 |20 |40 | |2 |30 |40 | |3 |40 |40 | |4 |50 |40 | |5 |70 |40 | Project A |Year |Cash flow(? 000) |Discount Factor |PV | | | |@12% | | |1 |20 |0. 892 |17. 4 | |2 |30 |0. 797 |23. 91 | |3 |40 |0. 711 |28. 44 | |4 |50 |0. 635 |31. 75 | |5 |70 |0. 567 |39. 69 | | | | |141. 63 | | | | |(110. 0) | | | | |31. 63 | [email protected]% = 31. 63 Project B |year |Cash Flow(? 000) |Discount factor @12% |PV | |1 |40 |0. 892 |35. 68 | |2 |40 |0. 797 |31. 88 | |3 |40 |0. 711 |28. 4 | |4 |40 |0. 635 |25. 40 | |5 |40 |0. 567 |22. 68 | | | | |144. 14 | | | | |(110. 00) | | | | |34. 14 | [email protected]% =34. 14

Here project B should be accepted. Because, NPV of project B is higher than the NPV of project A. NPV is present value of future cash flow. If any NPV value is high, it means, NPV increases the wealth of ordinary share holders and selection of projects on an NPV basis is consistent with this object. NPV is considered to be highly acceptable method of capital appraisal. It takes into account the timing of the net cash flows, the project’s profitability and the return of the original investment. Project B is fulfilling above those things. Hence, project B is suitable for our capital investment appraisal. E) Describe the logic behind the NPV approach.

NPV, Net Present Value, allows us to value a company’s assets at their correct current value, normally end of the year and when the accounts are prepared. The calculation of NPV takes into account the assets original cost, less all accumulated depreciation allowed against that asset in previous tax computations. To make long term investment like purchasing land, buildings, machinery a firm have to earn an income greater than the fund committed. In order to handle these decisions, firms have to make an assessment of the size of the out flow and the inflows of the funds. One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the cost of these investments. Business organization can used two ways. ) traditional methods and 2) discounted cash flow techniques. The Net Present Value is the Discounted Cash Flow (DCF) which relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment. (F) What would happen to the NPV if: (1) The cost of capital increased? (2) The cost of capital decreased? (1)IF COST OF CAPITAL IS INCREASED: Cost of capital has indirect effect on NPV, i. e. if the cost of capital is increased NPV will decreased, now to explain it in a better way, consider the example in the above part of the report, if we increase the cost of capital from 12% to 15% the NPV goes down instantly from 31. 75 to 19. 76.

Although, even at this NPV project still seems to be feasible, but as it is clear that by increasing the cost of capital NPV decreases. This might result the company to end up with low cash flow as well. (2)IF COST OF CAPITAL IS DECREASED: Now if we decrease the cost of capital, it will have a positive effect on NPV, i. e. if the cost of capital is decreased the NPV will increased, consider the same example, if the cost of capital is lowered from 12% to 10% NPV will come down from 31. 75 to 40. 63, thus increasing the cash flows of the company and making the project much more feasible and interesting for the investors, it is very important to mention that it the company’s management who decide what will be the cost of capital.

The cost of capital is settle by the management and several issues are consider while making this decision like cash flows, project life payback time etc. G) Determine the IRR for each project. Should they be accepted? PROJECT A YearsNCFDiscount Factor 20%PV 1200,833316. 666 2300,694420. 832 3400,578723. 148 4500,482324. 115 5700,401928. 133 TPV = 112. 894 NPV at 20% = 112. 894 – 110. 000 = ? 2. 894 NPV at 20% = ? 2. 894 YearsNCFDiscount Factor 23%PV 1200,813016. 260 2300,660919. 827 3400,537321. 492 4500,436821. 840 5700,355224. 864 TPV = 104. 283 NPV at 23% = 104. 283 – 110. 000 = ? (5. 717) NPV at 23% = ? (5. 717) IRR = 20% + 2. 894 x (23% – 20%) = 2. 894 + 5. 717 IRR = 20% + 0. 01008245 IRR = 20. 10082% ? 20% IRR PROJECT A = 20% PROJECT B YearsNCFDiscount Factor 23%PV 1200,813032. 520 2300,660926. 436 3400,537321. 492 4500,436817. 472 5700,355214. 208 TPV = 112. 128 NPV at 23% = 112. 128 – 110. 000 = ? 2. 128 NPV at 23% = ? 2. 128 YearsNCFDiscount Factor 25%PV 1200,800032. 000 2300,640025. 600 3400,512020. 480 4500,409616. 384 5700,327713. 108 TPV = 107. 572 NPV at 25% = 107. 572 – 110. 000 = ? (2. 428) NPV at 25% = ? (2. 428) IRR = 23% + 2. 128 x (23% – 25%) = 2. 218 + 2. 428 IRR = 23% + 0. 00934 IRR = 23. 00934% ? 23% IRR PROJECT B = 23% IRR A = 20% IRR B = 23% IRR > ROF Both projects are accepted.

H) How does a change in the cost of capital affect the project’s IRR? The cost of capital is defined as a return which expressed as a percentage that an investor needs to receive on an investment. For example if an investor is looking for a return of 8% on an investment, and if any company giving 8% return on investment then he will invest on that company. But if the company’s initial cost of capital is 6% then the parson will not investment on the company. If the cost of capital is less than the IRR then the project is a good investment. If the cost of capital is larger than the IRR then the project is a bad investment. So a change in the cost of capital changes what a parson’s cut-off is but the actual IRR.

I) Why is the NPV method often regarded to be superior to the IRR Method? Superiority of NPV over IRR: The NPV method is new concept as compare to traditional methods i. e. Payback and Accounting Rate of Return (ARR). NPV method discounts the future cash flows linked with the investment project using the cost of capital as the appropriate discount rate. If NPV of required project is positive then we should accept the project and if it is negative then we should not accept the project. However if NPV of any project is zero then we can accept or reject the project it depends on management decision. Normally, to be competitive in market, managers like to accept the project if NPV is zero. Advantages of NPV are: Time Value of Money: It takes account of time of value of money, by discounting the cash flows arising in the future • Cash Flows: takes account of all relevant cash flows • Indicates Clear Decision: provides a clear decision rule concerning acceptance/rejection of a project • Primary Objective: It is consistent with the aim of maximizing shareholder wealth, which is assumed to be the primary objective of any business. As far as Internal Rate of Return is concerned, it is based on the principles of discounting cash flows and will normally give the same accept/reject decisions and will rank investment projects in the same way as the NPV method.

Contrary, it has difficulty in handling unconventional cash flows and does not address the issue of wealth maximization. It may give conflicting recommendations to NPV. IRR cannot consider changes in interest rates over the life of a project. It assumes that funds are reinvested at a rate equivalent to the IRR itself, which can be produce unrealistically high. Due to above reasons we can conclude that NPV is superior to IRR. Reference Dyson, J. R (2004). (6th edition) “Accounting For Non-Accounting Students” Weetman, P, 2006, Management Accounting, Essex, Prentice Hall Lumby, S & Jones, C, 2003, Corporate Finance Theory and Practice, London, Thomson Aidan Berry and Robin Jarvis “Accounting in a Business Context”3rd Edition Printed by: Zrinski dd. , Croatia

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