Investment Appraisal: The Zeta plc. Case - Essay Example

?Investment Appraisal: The Zeta plc Case Introduction One of the major objectives of any company is to make itself efficient enough to undertake expansion of its business activities which can also be named as growth activities. Growth of any organization is mainly occurred either as organic growth or as growth through mergers and acquisition (Brigham et al, 2008). Whatever the kind of growth strategy an organization follows, the organization needs to evaluate whether that potential growth opportunity would be financially and strategically viable to the organization or not. For those evaluations, generally investment appraisal techniques are mainly utilized by the organizations to carry out financial viability of any particular growth opportunity or project (Baker et al, 2011). This article aims at carrying out an investment appraisal activity for a company named as The Zeta plc. The company has found an opportunity to manufacture a series of exclusive sailing boats over a period of four years and it is intended to dispose of the project after four years. However, the company needs to evaluate this investment opportunity as to whether it would be viable for the company on financial grounds or not (Baker et al, 2011). The overall project is mainly appraised by the discounted cash flow based techniques which include Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI) and lastly Discounted Payback Period (Dis. PBP). The theme of this article is set in such a manner that each of the above mentioned techniques are explained on their theoretical grounds and then the findings of the project of The Zeta plc are evaluated on the basis of underlying theories. At the last stage of this article, the main assumptions are stated which are used in conducting the investment appraisal of the project followed by the appendix in which the detailed workings are shown to arrive at the findings. Net Present Value The most famous technique which is highly used and regarded by the financial analysts and project evaluators is that of Net Present Value (NPV). NPV is famous due to many reasons are stated below: NPV works on the basis of discounted cash flows rather than profits due to which it provides those results which demonstrate the increase or decrease in the net discounted cash flows as a result of either accepting or avoiding any project (Vishwanath, 2007). NPV also takes into account the time value of money as a result the most actual cash flows are incorporated and used for the project appraisal (Brigham. 2008). NPV is also considered as the true measure of investment appraisal as it provides the ultimate results in absolute currency units rather than in relative terms such as percentage or ratio. NPV is computed by deducting the initial investment or cost of the project from the Present Values of the Cash Flows of the later years (Baker, 2011). If the computed figure turns out to be positive, it means that the project will increase the cash flows of the company, so the project should be accepted. However, if the computed figure shows a negative figure, it results in loss of cash flows therefore the project should be rejected or avoided. If the project under scrutiny of The Zeta plc is taken into consideration, the initial investment of the project is around ?270,000 and the project has a life of around 4 years. The company has the intention of selling off the whole project at the end of 4th year with the residual amount of ?108,000. The revenue streams of the company begin with 2nd year of the project however the cash based operating costs are incurred from the year 1 of the project. With the discount factor of 15%, the NPV of the project is computed as ?91,858 which is positive. Hence, the project sounds feasible on the basis of financial grounds by the help of the findings of NPV. Internal Rate of Return Another measure which is also quite used in appraising the projects is that of Internal Rate of Return (IRR). This technique mainly facilitates the providers of finance as it assists them with the amount of return a company can generate having accepted a certain project. IRR is basically the rate at which the Net Present Value of the given project becomes zero (Baker, 2011). It means that if the net cash flows of the project are discounted at this rate, the NPV will generate a nil figure. So, if a project has a positive NPV, it means that its IRR would definitely be greater than its cost of capital (Discount Factor). The difference between the IRR and cost of capital is effectively the excess return in which the investors are mainly interested in. Besides its greater utilities, this technique has some pitfalls due to which it is also criticized. For instance, it provides a relative figure (percentage form) due to which it becomes unable to demonstrate the project viability in money terms. A basis assumption of IRR states that cash inflows arising at the later stage of the project are reinvested into the project at the same rate of IRR which is practically not possible every time. However, besides the limitations of this technique, IRR has its importance under project appraisal evaluations. As far as the given project is concerned, it can be observed that IRR is found to be around 28.45% which is quite higher. Since the cost of capital used in the project is 15%, therefore the excess return that investors can anticipate from the project is around 13.45% which is near to double. In this way, the project seems to be highly beneficial for The Zeta plc. If the existing net cash flows of the given project are discounted at 28.45%, the NPV of the project becomes zero. Profitability Index This measure of investment appraisal is itself not an altogether a new technique rather it provides the results of NPV is a different form. As NPV provides the results in absolute money terms, this technique converts the results of NPV into relative terms in the form of ratio (Khan, 2004). Profitability Index (PI) is computed y dividing the NPV plus the cost of project by cost of project. PI = (NPV + Cost of project) / Cost of project The above formula provides the answer in the form of a ratio such that that if the ratio exceeds 1, the project under consideration is financially feasible. However, if the results arrive are less than 1, then the project is advised not to be accepted. For the current project of The Zeta plc under consideration, PI is computed as 1.34 which is greater than 1, hence, it is around 34% greater than the cutoff point. In this way, the project seems to be highly acceptable as NPV measure has already suggested the similar findings. Discounted Payback Period Discounted Payback Period (Dis. PBP) is the technique which effective describes the time required to recover the initial investment or cost of the project (Shim et al, 2008). This technique is highly rated by the analysts as it takes into account the time value of money which is not considered under the conventional technique of simple payback period. Investors are mainly interested in the required rate of return of the project as well as the duration in which their initial investment can be recovered therefore this purpose has increased the utility of this technique. The existing project of The Zeta plc has the discounted PBP of around 3.52 years which is quite normal. The overall life of the project is 4 years therefore in the last year of the existing projects the initial cost of the project is expected to be recovered around 6 months before the disposal of the project. Recommendation and Conclusion This article has highlighted the financial viability of the manufacturing of the sailing boats of The Zeta plc on the basis of four quite popular techniques which are NPV, IRR, PI and Discounted PBP. Given the assumptions and the findings of the results, it is advised to the management of The Zeta plc to accept the project as this project is likely to generate positive NPV of around ?91,858, IRR of 28.45% and PI of around 1.34. The initial investment of around ?270,000 is likely to be recovered in 3.52 years as demonstrated by Discounted PBP. Assumptions Cost of Capital of the project is assumed to 15%. It is assumed that project is bought on the first day of the year. Effects of taxation and inflation are ignored. Depreciation is not taken in working of Net Cash Flows as it is a non-cash expense. Overheads are not considered as they are only apportioned as part of the company’s overall overheads. All the amounts are taken under currency units of GBP (?). Appendix Years 1 2 3 4 Capital Investment (270,000)   Revenues   Additional Sales - 315,000 351,000 369,000 Operating Costs   Material and Components (45,000) (58,500) (58,500) (45,000) Salaries and Wages (63,000) (72,000) (76,500) (76,500) Advertising (22,500) (22,500) (22,500) (22,500) Residual Value - - - 108,000 Net Cash flows (400,500) 162,000 193,500 333,000 Discount Factor - 15% 0.8696 0.7561 0.6575 0.5718 Discounted Cash flows (348,261) 122,495 127,229 190,394 Cumulative Discounted Cash flows (348,261) (225,766) (98,536) - Net Present Value 91,858       Internal Rate of Return 28.45%   Profitability Index 1.34   Discounted Payback Period 3.52 years     References Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. Berk, Jonathan B. and DeMarzo. Peter M., 2010. Corporate finance. 2nd ed. New York: Prentice Hall. Bierman, Harold., 2003. The capital structure decision. 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