Internal Rate of Return - AP Plc - Assignment Example

Internal Rate of Return - AP Plc 1. Payback of Proposals Proposal 1 - Research and development of a new product Year Cash Flow £ Cumulative £ A Outflow (100,000) B Year 1 - - C Year 2 - - D Year 3 73,000 73,000 E Year 4 73,000 146,000 F Year 5 73,000 219,000 Payback Period Between Year 3 & 4 Difference in Cumulative Cash Flow G=E-D 73,000 Fraction of the year H=(A-D)/G 0.37 Payback period 3.37 Proposal 2 -Installation of a mainframe computer system Year Cash Flow £ Cumulative £ A Year 0 (180,000) B Year 1 66,000 66,000 C Year 2 66,000 132,000 D Year 3 66,000 198,000 E Year 4 66,000 264,000 F Year 5 66,000 330,000 Payback Period Between Year 2 & 3 Difference in Cumulative Cash Flow G=D-C 66,000 Fraction of the year H=(A-C)/G 0.73 Payback period 2.73 Proposal 3 -Purchase of extra warehouse space Year Cash Flow £ Cumulative £ A Year 0 (200,000) B Year 1 145,000 145,000 C Year 2 145,000 290,000 D Year 3 - 290,000 E Year 4 - 290,000 F Year 5 - 290,000 Payback Period Between Year 1 & 2 Difference in Cumulative Cash Flow G=C-B 145,000 Fraction of the year H=(A-B)/G 0.38 Payback period 1.38 Proposal 4 -Creation of a formal staff training system Year Cash Flow £ Cumulative £ A Year 0 (40,000) B Year 1 16,000 16,000 C Year 2 16,000 32,000 D Year 3 16,000 48,000 E Year 4 16,000 64,000 F Year 5 16,000 80,000 Payback Period Between Year 1 & 2 Difference in Cumulative Cash Flow G=D-C 16,000 Fraction of the year H=(A-C)/G 0.50 Payback period 2.50 Proposal 5 -Introduction of approved quality assurance scheme Year Cash Flow £ Cumulative £ A Year 0 (70,000) B Year 1 70,000 70,000 C Year 2 70,000 140,000 D Year 3 70,000 210,000 E Year 4 70,000 280,000 F Year 5 70,000 350,000 Payback Period Between Year 1 Difference in Cumulative Cash Flow - Fraction of the year - Payback Period 1.00 Net Present Value (NPV) and Internal Rate of Return (IRR) of Proposals Proposal 1 - Research and development of a new product Year Cash Flow £ Discounting Factor Present Value £ A B C=A*B Year 0 (100,000) 1 (100,000) Year 1 - 0.9091 - Year 2 - 0.8264 - Year 3 73,000 0.7513 54,846 Year 4 73,000 0.6830 49,860 Year 5 73,000 0.6209 45,327 IRR 22% NPV 50,033 Proposal 2 -Installation of a mainframe computer system Year Cash Flow £ Discounting Factor Present Value £ A B C=A*B Year 0 (180,000) 1 (180,000) Year 1 66,000 0.9091 60,000 Year 2 66,000 0.8264 54,545 Year 3 66,000 0.7513 49,587 Year 4 66,000 0.6830 45,079 Year 5 66,000 0.6209 40,981 IRR 24% NPV 70,192 Proposal 3 -Purchase of extra warehouse space Year Cash Flow £ Discounting Factor Present Value £ A B C=A*B Year 0 (200,000) 1 (200,000) Year 1 145,000 0.9091 131,818 Year 2 145,000 0.8264 119,835 Year 3 - 0.7513 - Year 4 - 0.6830 - Year 5 - 0.6209 - IRR 29% NPV 51,653 Proposal 4 -Creation of a formal staff training system Year Cash Flow £ Discounting Factor Present Value £ A B C=A*B Year 0 (40,000) 1 (40,000) Year 1 16,000 0.9091 14,545 Year 2 16,000 0.8264 13,223 Year 3 16,000 0.7513 12,021 Year 4 16,000 0.6830 10,928 Year 5 16,000 0.6209 9,935 IRR 29% NPV 20,653 Proposal 5 -Introduction of approved quality assurance scheme Year Cash Flow Discounting Factor Present Value A B C=A*B Year 0 (70,000) 1 (70,000) Year 1 70,000 0.9091 63,636 Year 2 70,000 0.8264 57,851 Year 3 70,000 0.7513 52,592 Year 4 70,000 0.6830 47,811 Year 5 70,000 0.6209 43,464 IRR 97% NPV 195,355 2. As mentioned in the case study, the directors of AP plc has limited fund amounting to £ 300,000 where as the cumulative cost of all the investment proposal amounts to £ 590,000. Keeping in consideration the limited amount of the funds, the directors of the company must make prudent investment decision so to achieve the most lucrative and appropriate results. The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate in the economy. As mentioned in the case study, the directors of AP plc expects that the minimum return to be 10% of the borrowed funds, which is used as the discount rate in calculating the NPV of each project. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the investment. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture an investment where as the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Payback period is another method utilized in investment appraisal which calculates the time taken by the investment to generate enough cash inflows to recover the initial cost of the investment. As per the calculations, the proposal with the NPV is proposal 5 ‘introduction of approved quality assurance scheme’ with the NPV of £195,355. An analysis of the proposal will also give an insight about the rewarding attribute of the proposal as according to the situation given, an initial investment of £ 70,000 will generate £ 70,000 per year for five years. The proposal has the NPV to cost ratio of 279%. The next investment having higher NPV is proposal 2 ‘Installation of a mainframe computer system’ having NPV of £ 70,192. The NPV of proposal 3, proposal 1and proposal 4 is £ 51,653, £ 50,033 and £ 20,653 respectively. As per IRR method of appraisal, the best option to invest is again proposal 5 with IRR of 97%. Proposal 3 and proposal 4 have IRR of 29% where as Proposal 2 and Proposal 1 have IRR of 24% and 22% respectively. Proposal 5 have the lowest payback of 1 year, followed 3 and proposal 4 of 1.38 years and 2.50 years. Based on the above factors, the director of AP plc must rank proposal 5 as first it being having the highest IRR and NPV. Since IRR is a better method of appraisal than NPV method, second rank must be awarded to proposal 3. Although proposal 3 and 4 have the same IRR but the NPV and payback period of proposal 3 is comparatively better. 3. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The case study does not include any relevant information about the price inflation over the five year period which can significantly impact the expected rate of return. The director must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flows in the future for the payment of these finance charges. In order to commence any investment venture, the director must take approval of the shareholders. Although certain investment might appear to be rewarding and worth while to invest, do not get shareholders attention that easily. Shareholders, who are often short sighted and tend to ignore the long term feasibility, disapprove the decision of the board based on the fact that the cost of investment will weaken the financial outlook of the organization in the year of the investment. The director while making the investment decision must keep into consideration whether it is of a capital nature or would be reflected in the profit and loss of the company as an expense. Proposal such as the installation of new mainframe computer system and purchase of extra warehouse space are capital expenditure and the only of effect on the profit and loss statement of the AP plc would be the depreciation expense, spread over the years. Creation of a formal staff training system and introduction of approved quality assurance scheme would cast impact on the profit and loss statement and would decrease the profit for the year. 4. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the trade off between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several time over the period. The IRR method does not incorporate this fact into calculation, and thus is not suitable for long term investment appraisal. In NPV method the discount rate is known and is singular which makes it easier to evaluate the feasibility of the investment. An investment with a negative value represent an unattractive investment where as a positive value represents other wise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. Based on the discussed fact, NPV method of appraising investment is more practical and precise. References [1] Linda Grayson “Internal rate of return: An inside Look” investopedia.com. Investopedia, n.d. Web. 18 Dec. 2010. [2] “Net Present Value - NPV” investopedia.com. Investopedia, n.d. Web. 18 Dec. 2010. [3] Elazar Berkovitch “Why the NPV Criterion does not maximize NPV” rfs.oxfordjournals.org Oxford Journals n.d. Web. 19 Dec. 2010. [4] Randika Lalith Abeysinghe “Nature and introduction of investment decision” ezinearticles.com Ezine articles n.d. Web. 19 Dec. 2010. [5] “What influences investment decision” saching.com saching.com n.d. Web. 19 Dec. 2010. [6] “Which is a better measure for capital budgeting, IRR or NPV.” investopedia.com. Investopedia, n.d. Web. 19 Dec. 2010. [7] “Capital Budgeting and pros and cons of IRR and NPV” financialmodelingguide.com Financial Modelling Guide, n.d. Web. 19 Dec. 2010. [8] Mark Cook “Approaches to investment appraisal” findarticles.com CBS Business Network, n.d. Web. 19 Dec. 2010. [8] Mark Cook “Approaches to investment appraisal” findarticles.com CBS Business Network, n.d. Web. 19 Dec. 2010. [9] Frank Smith “Investment appraisal and capital budgeting: NPV and IRR” suite101.com Suite 101, n.d. Web. 19 Dec. 2010. Read More