Investment Appraisal - Case Study Example

Introduction Investors always face the dilemma of choosing between projects as to which of the projects will give the best returns that will help them maximise their wealth should they risk their money and carry out the investment. Investment therefore assumes that any investment that is carried out by the investor will yield future income streams greater than the cost of the investment. In order to handle these decisions therefore, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. This process takes the form an investment appraisal, through the investor has to look at several factors before taking this decision. This process includes; Forecasting investment needs, Identifying project(s) to meet needs, appraising the alternatives, selecting the best alternatives, making the expenditure, and monitoring the project(s). they are obviously several methods that investors use to make this decision – Net Present value method, Payback period, Accounting rate of return, profitability index, and the Internal rate of return. Internal rate of Return (IRR) IRR is discount rate often used in capital budgeting that makes the net present value of all cash flows streams (cost of investment) from a particular project equal to zero.1 As matter of general rule, IRR is used to rank several prospective projects a firm is considering be it the purchase of a piece of land, an office equipment, a machinery, etc. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and most desirable project and should be undertaken first. The following graph gives an explanation of the IRR (Source: http://www.solutionmatrix.com/internal-rate-of-return.html) Assume that an investor has the choice of investing between two projects represented by case A and case B. The discounted cash flows are represented on the vertical axis and the interest rates used on the horizontal axis. The illustration uses nine different interest rates from 0,00 (0%) up to and including 0,80 (80%). As is often the case with NPV calculations, as the interest rate used for calculating Net Present Value of the cash flow stream increases, the resulting NPV decreases. This decrease is all due to the fact that the cash flow stream has been discounted against a large discount factor, therefore giving a lower NPV value. As can be seen from the graph therefore, for Case A, an interest rate of 38% produces NPV or DCF = 0, whereas Case B moves to 0 when the interest rate is 22%. It can be said here that Case A therefore has an IRR of 38%, while Case B has an IRR of 22%. (Recall here that we defined IRR as that interest rate that sets the NPV of a stream of cash flows to zero). The question here therefore is which of the two projects is the better Investment to undertake? As per definition and other things being equal, the one with the higher IRR should be the most desirable and undertaken first. What will happen if we had a third project with an IRR of say 40%? The answer is obvious. The project with the highest IRR should be considered the best option for investing and be undertaken first. In other words, IRR tells the investor just how high interest rates would have to go in order to "wipe out" the value of this investment or for the cost of the investment to become zero. For the Case A cash flow, the prevailing interest rate would have to rise all the way to 38% to make this investment worthless. The Case B investment would become worthless if interest rates rose to 22%. And since the investor wants the project that will help maximise his wealth, the higher the IRR, the better the returns relative to cost, and the lower the risk to the investor. Advantages and Disadvantages of the IRR As in every investment appraisal method, all cannot be said to silver and gold when it comes to the IRR. The method has its strong and weak points as compared to other investment appraisal methods. Advantages: The main advantage of the internal rate of return calculation is that it illustrates the overall returns from an investment in a clear and direct manner that provides an easy decision-making process for companies/individuals to determine which investments to select. The IRR is a “true” return on the investment compared to the other accounting rate of return. This is because, the IRR uses the Present value concept when calculating. The IRR uses all cash flow streams during the calculation making it more superior to other accounting methods The IRR uses the hurdle rate concept in that, if a company has specified it’s “hurdle rate” or a required cost of capital that new projects must achieved in order to be accepted, then by just calculating the IRR, and then comparing it to the company’s specified hurdle rate if the IRR is above the rate and then project can be accepted. When making an investment, one wants to have a good internal rate of return that is higher than initial investment. Some returns on an investment have a continuous flow of income while others have an inflow of money that is received at irregular intervals. Cash flow is the income or expenses in an investment at various times within a year. The internal rate of return method allows one to consider the time value of money by determining the interest rate that is equivalent to the returns expected from an investment. Once the rate is found, one can compare the rates of other projects or investments and make a decision based on the calculations to select the best investment to make that would generate the most money in the future. Disadvantages of the IRR IRR does not tell us anything about the size or scope of a potential investment. This is especially important when we are choosing between two mutually exclusive investments, where only one of the investment projects can be chosen. There is always that possibility that for a single project, one can get several values for the IRR. This is because, the calculations for IRR are complex. When a project is accepted following the IRR rule, the IRR does not show any dollar value improvement in the project. Another problem with the IRR is that any formula used for solving it assumes that the payments will be invested at the same interest rate, which is unrealistic. This is for the simple reason that, interest rates are never fixed. So thinking that a project will be invested in some kind fixed rate makes the whole story unrealistic. A comparison of IRR with other project appraisal methods Making a decision on the choice of an investment project to invest in from a multitude of projects available is often a daunting task. This involves the use of the different project appraisal methods. But is worth mentioning that all the different methods have differences at the level of use and criteria. It is worth remembering here that the IRR is the rate at which the PV of measured benefits equals the PV of measured costs. But unlike, NPV, where a discount rate must be selected, the IRR derives a percentage value representing the rate of return on the project. IRR can be used to appraise individual projects, or provide information to help make decisions about appraising and ranking multiple investment opportunities, NPV can be used to rank projects in order of priority with the sole objective being the maximisation of NPV. In capital budgeting processes, and when the company multiple projects that are being appraised and faced with the constrain of limited budgets, this means that some projects cannot be funded. The company has therefore to make a budget rationing exists, NPV is probably the preferred method of appraising projects. While the NPV remains the preferred means to use when selecting projects, the IRR can also be used along side the NPV. NPV addresses efficiency objectives and the IRR can show relative efficiency. Unlike other project appraisal methods where calculations can be done manually, IRR calculations can be difficult to calculate manually especially as they are time consuming and may result to different rates. In most cases, financial calculations are done using spread sheet functions. Unlike the previous the NPV and IRR where discounted cash flows are used, payback period does not have to involve discounted cash flows. In this case, the Pay back period does not capture the value of time. Instead, the objective is to determine the length of time required to recover costs from the flow of benefits over the project life. The major disadvantages of this approach are first, as noted, the opportunity cost of time is ignored, and second there is no linkage between the payback period and the organisation’s cost of capital. In conclusion, the IRR can be said to be a good method for individual projects, but at same time may pose serious difficulties due to the fact that different rates may result from the calculation. Therefore, it is wise for my uncle to use this method wisely with the NPV so as to be sure of getting the right results. In using the IRR method, the project must not be accepted only because its IRR is very high. My uncle must ask whether such an impressive IRR is possible to maintain. In other words, he has to look into past records, and existing and future business, to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If he is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the project must be re-evaluated by the NPV method, using a more realistic discount rate. References http://www.investopedia.com/terms/i/irr.asp, retrieved on 10-05-2008 at 07,48am Module 8 of a training draft of the Forum for Economic and Environment available online at http://www.econ4env.co.za/training/MODULE8a.pdf, viewed on 11-05-2008 at 17.01pm Salmi T. Viltanen I. (1997): Measuring the long-run profitability of a firm: a simulation evaluation of the financial statement based estimation methods, Vaasa, University of Vaasa, Finland Mats Bergman (1996): Should internal rate of return, cost benefit analysis or net present value be used to evaluate road or rail investments? Umea University Aho T, Virtanen I (1982): Internal rate of return and rio as profitability of investment analysis. Vaasa, University of Vaasa Blackstaff, M (1998): Finance for IT decision makers. Springer Verlag, London Read More