Investment Appraisal - Essay Example

Project Engineering Assignment The following information relates to two projects which a manufacturing company is considering investing in. Project A Project B Initial Cost (£) 230,000 180,000 Life (Years) 5 4 Scrap Value (£) 15,000 8,000 Year Project A Cash Flow (£) Project B Cash Flow (£) Discounted factor (18%) Present value for project A Present value for project B 1 100,000 55,000 0.846 84,600 46,530 2 70,000 65,000 0.718 50,260 46,670 3 50,000 95,000 0.609 30,450 57,855 4 50,000 100,000 0.516 25,800 51,600 5 50,000 0.437 21,850 The cash flows given above do not include the scrap value of the equipment. The company uses the straight-line method to depreciate assets and estimates its cost of capital at 18%. Because of capital rationing only one project can be accepted. Depreciation Calculation with Salvage Value To calculate depreciation expense on a fixed asset with a salvage value, the depreciable value of the fixed asset is divided by the life of that asset. The depreciable basis is the cost less the salvage value. SL = (Cost - Salvage Value) / Life For project A: the annual depreciation is as follows: (230,000 - 15,000)/5 = 43,000 per year For project B: the annual depreciation is as follows: (180,000 – 8,000)/ = 43,000 per year (a) The payback period for each project. The payback period is calculated by counting the number of years it will take to recover the cash invested in a project. Payback period = Cost of project / Annual cash inflow Hence for project A The payback period is. (100,000+ 70,000+ 50,000= 220,000 in the first three years + 10,000 of the 50,000 occurring in the fourth year this is 10,000/50,000) = 3.2 years For project B The payback period is (55,000+ 65,000= 120,000 in the first 2 years + 60,000 of the 95,000 occurring in the third year this is 60,000/95,000) = 2.63 years Project B is the project of choice in this case, since it has the shorter payback period. (b) The net present value (NPV) for each project. Net present value is calculated by discounting all future income amounts based on the discount rate and adding the discounted income stream. Net Present Value calculation = (Cash flow amount) / ((1 + Discount Rate) to the power of n where "n" is the number of periods. Hence, calculating NPV with a discounting factor of 18% will be: Year Project A Cash Flow (£) Project B Cash Flow (£) Discounted factor (18%) Present value for project A Present value for project B 1 100,000 55,000 0.846 84,600 46,530 2 70,000 65,000 0.718 50,260 46,670 3 50,000 95,000 0.609 30,450 57,855 4 50,000 100,000 0.516 25,800 51,600 5 50,000 Year 4 Scrap value 8,000 0.437 21,850 4,128 Year 5 Scrap value 15,000 6,555 Total Cash Inflow 219,245 206,783 Less present value of initial investment 230,000 180,000 -10755 26,783 If the Net Present Value is positive, we should proceed and make the investment. If the Net Present Value is negative, then we would not make the investment. NPV for project A is negative and project B is positive, hence we would proceed with project B. (c) The internal rate of return (IRR) for each project. Internal rate of return (IRR) is defined as the rate of interest that equates I with the PV of future cash inflows. In other words, at IRR, I = PV or NPV = 0 For project A: NPV=0 if Decision rule: Accept the project if the IRR exceeds the cost of capital. Otherwise, reject it. Using the trial and error method, Year Project A Cash Flow (£) Project B Cash Flow (£) Discounted factor for project A (15%) Present value for project A Discounted factor for project B (20%) Present value for project B 1 100,000 55,000 0.870 87000 0.833 45815 2 70,000 65,000 0.756 52920 0.694 45110 3 50,000 95,000 0.658 32900 0.579 55005 4 50,000 100,000 0.572 28600 0.482 57200 5 50,000 Year 4 Scrap value 8,000 0.497 24850 3856 Year 5 Scrap value 15,000 7455 233725 206986 Initial investment 230,000 180000 NPV 3725 26986 Year Project A Cash Flow (£) Project B Cash Flow (£) Discounted factor for project A (16%) Present value for project A Discounted factor for project B (25%) Present value for project B 1 100,000 55,000 0.862 86200 0.800 44000 2 70,000 65,000 0.743 52010 0.640 41600 3 50,000 95,000 0.64 32000 0.512 48640 4 50,000 100,000 0.552 27600 0.410 41000 5 50,000 Year 4 Scrap value 8,000 0.476 23800 3280 Year 5 Scrap value 15,000 7140 228750 178520 Initial investment 230,000 180000 NPV -1250 -1480 IRR for project A =15.75% IRR for project B= = 20.26% As the IRR for project B is higher than cost of capital the project is accepted (d) The accounting rate of return (ARR) for each project. Accounting rate of return (ARR) measures profitability from the conventional accounting standpoint by relating the required investment-or sometimes the average investment-to the future annual net income. Decision rule: Under the ARR method, choose the project with the higher rate of return. Average investment is defined as follows: Where I = initial (original) investment and S = salvage value. For project A: Average investment= (230,000 - 15,000)/2 + 15,000 = 122,500 For project B: Average investment= (180,000-8,000)/2 + 8,000 = 94,000 Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows. Average profits after tax = average operating annual cash inflow- average annual inflation Hence average profit after tax for project A = (212,960/5) - 43000 = - 471 Average profit after tax for project B = (202,655/4) - 43000 = 7663.75 ARR for project A= (- 471/122,500) x 100 = - 0.3% ARR for project B= (7663.75/94,000) x 100 = 8.15% ARR is high for project B. Hence Project B may be chosen (e) The project that should be accepted and its rationale. From the results in question a, b, c, d. project B was selected from all of them with project A being rejected in all of the questions. As a result, Project B will be accepted. (f) Types of risk and uncertainty that can arise in investment appraisal decisions, and how they can be incorporated into investment appraisals Investment (project) appraisal refers to evaluations of decisions made by organizations on allocating resources to investments of a significant size. The purpose of investment appraisal is to assess the economic prospects of an investment project proposed. Investment appraisal involves the process of calculating the expected return based on cash flow forecasts of many, often inter-related, project variables. However there are various risks that emanates from the uncertainty encompassing the projected variables. As a result, it is important to identify and understand the nature of uncertainty in the key project variables and have the tools and methodology to identify its risk implications on the projects return to be able to evaluate the project risks. Uncertainty in a project is evident especially in estimating future values of project variable as being certain; by calculating a “best estimate” based on the available data and use it as an input in the evaluation model: however, a range of other probable outcomes for each project variable are not included in the analysis. The outcome of the project is, therefore, also presented as a certainty with no possible variance or margin of error associated with it. Risk analysis, is methodology whereby the uncertainty encompassing the main variables projected in a forecasting model is analysed in order to estimate the impact of risk on a projected results. It is a technique based on the Monte Carlo simulation by which a mathematical model is subjected to a number of simulation runs, whereby successive scenarios are built up using various input values for the projects key uncertain variables that are selected from multi-value probability distributions. After simulation, the results are collected and analysed statistically to arrive at a probability distribution of the potential outcomes of the project and to estimate various measures of project risk. In investment appraisal, it is important to recognise the fact that the values projected are not certain, hence the project should employ the use of risk analysis using sensitivity (to identify the projects high sensitive and important variables) and scenario analysis (to construct an alternative scenario for the project) tests should be used. Sensitivity analysis, involves changing the value of a (variables) in order to test its impact on the final result while scenario analysis remedies one of the shortcomings of sensitivity analysis by allowing the simultaneous change of values for a number of key project variables to get pessimistic and optimistic scenarios. General use of risk analysis would be able to utilise information (that is either objective data or expert opinion) to quantitatively describe the uncertainty surrounding the key project variables as probability distributions, and to calculate in a consistent manner its possible impact on the expected return of the project. As a result, the prospective investor will have at their disposal a complete risk/return profile of the project showing all the possible outcomes that could help him make a result making investment decision on a particular investment project. References 1. Brigham, FE & Houston, FJ 2012, Fundamentals of financial management, Cengage Learning, Mason, USA. 2. Glenday, G 1989, Monte-Carlo Simulation Techniques in the Valuation of Truncated Distributions in the Context of Project Appraisal, Harvard Institute for International Development, Harvard. 3. Hertz, BD & Thomas, H 1983, Risk Analysis and its Applications, John Wiley and Sons, New York. 4. Needles, EB, Powers, M, and Crosson, VS 2010, Financial and Managerial Accounting, 9th edn, Cengage Learning, Mason, USA. 5. Pogue, M 2010, Investment Appraisal, Business Expert Press, New York. Read More