Investment Appraisal Project - Gryon Limited - Essay Example

? INVESTMENT APPRAISAL PROJECT GRYON LIMITED ___________ Contents INTRODUCTION OF THE PROJECT 3 CALCULATION BASED ON DISCOUTNED CASHFLOW5 SENSITIVITY ANALYSIS 7 THEORTICAL DISCUSSION BASED NPV AND IRR METHOD 9 CONCLUSION 12 INTRODUCTION OF THE PROJECT The company Gryon is considering an operational expansion and has decided to buy one of the two freehold lands available. Taking this strategic move into account, the company is conducting an investment appraisal in order to evaluate which of the two options is more financially feasible. The company’s cost of capital is 12%. It is assumed, in the absence of information provided, that this is the weighted average cost of capital (WACC) for the company which is calculated with the help of the following formula. WACC=wdkd(1-T)+wpkp+wsks Where  Kd = interest on debt  Kp = cost of preference shares  Ks = cost of shares and retained earnings.  WACC is calculated by multiplying the cost of equity by the market value of the equity and cost of debt by the market value of the debt. Cost of equity can be defined as the minimum rate of return that a company must generate and offer to their investors in order to provide a return on their investment and for assuming some level of risk. If the company does not offer this risk to the investors, there is a chance that the shareholders might sell these shares in the market. Selling of the company shares can be interpreted as a negative sign for the financial outlook of the company and will put a downward impact on the market value of the company. Cost of company’s equity can be calculated through ‘Dividend Growth Model’ and ‘Capital Asset pricing model.’ The formula for dividend growth model is as follows. E = Do Ke - g Where E is the market value of the equity, Do is the recent dividend paid or the dividend projected for the next year, Ke is the cost of the equity and g is the growth rate of the dividend. The dividend growth model assumes that the dividend grows in perpetuity at a definite rate. This growth rate can be computed by observing the historical dividend pattern of the company and calculating the growth rate through simple discount rate formula. Cost of debt is actually the rate at which the present value of the interest payments and redemption amounts equals the current market value of the debt. The following formula further clarifies. Where M is the market value of the bond currently on which it is being traded in the market, i is the interest payment and kd is the rate of return required by the debt holder. From the formula it can easily be deduced that the market value of any bond is the present value of the interest payment. But the above formula is only applicable in the case of debt having maturity till perpetuity. In case tax is involved, the interest is taken after tax. Cost of debt is basically the internal rate of return. As provided in the given information, the company’s debt equity ratio is 50%, which means that 50% of its operations are financed through debt and the other half is through equity. The company has available cash balance of ?450,000 and thus, in case the company opts to purchase any of the buildings, it will have to issue bonds by acquiring more debt. Since the company anticipates that the interest rates are likely to be increased in the future, it would be prudent to raise more funds through equity in order to curtail the impact of increased finance charge on the profitability of the company. The project under consideration requires a careful estimation of all the relevant costs and revenues; a misjudgment in the forecast will cause an error in the project net present value, which might result in the acceptance of a project which is not financially viable. CALCULATION BASED ON DISCOUTNED CASHFLOW First, consider the building A which costs ?1,112,000. The following table presents the calculation of the Net Present Value (NPV) of the particular investment decision. Item Amount in ? '000 Years Now 1 2 3 4 5 6 7 8 9 10 Cost of the site (1,112) Cash in-flow 100 100 100 150 150 150 175 200 200 200 Sale Proceed (assumed to increase by 50% average) 1,668 Discounting Factor 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 Present Value (1,112) 89 80 71 95 85 76 79 81 72 601 Net Present Value 218 The following table calculates the IRR of the particular investment decision. Item Amount in ? '000 Years Now 1 2 3 4 5 6 7 8 9 10 Cost of the site (1,112)                     Cash in-flow   100 100 100 150 150 150 175 200 200 200 Sale Proceed (assumed to increase by 50% average)                     1,668 Internal Rate of Return (IRR) 14.08%                     The following table presents the calculation of the Net Present Value (NPV) of the second site costing ?2,115,000. Item Amount in ? '000 Years Now 1 2 3 4 5 6 7 8 9 10 Cost of the site (2,115) Cash in-flow 100 100 100 150 150 150 175 200 200 200 Subletting Inflows 75 75 75 75 75 85 85 85 85 85 Sale Proceed (assumed to increase by 50% average) 3,173 Discounting Factor 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 Present Value (2,115) 156 140 125 143 128 119 118 115 103 1,113 Net Present Value 144 The following table calculates the IRR of the particular investment decision Item Amount in ? '000 Years Now 1 2 3 4 5 6 7 8 9 10 Cost of the site (2,115)                     Cash in-flow   100 100 100 150 150 150 175 200 200 200 Subletting Inflows   75 75 75 75 75 85 85 85 85 85 Sale Proceed (assumed to increase by 50% average)                     3,173 Internal Rate of Return (IRR) 6.81%                     SENSITIVITY ANALYSIS Following is the sensitivity analysis of the two investments decision Site A Item Cumulative Present Value NPV Measure of Sensitivity Cost of the Site 1,112 218 19.60% Cash in flows 793 218 27.49% Sale Proceed 537 218 40.59% As it is quite apparent from the sensitivity analysis, the cost of the site is the most sensitive of all the items in the cash flow projection whereas the sale proceeds are the least. Sensitivity analysis is basically conducted in order to evaluate which particular item of the cash flow projection is likely to affect the NPV of the project most (Smith, 2010). Sensitivity of 19.60% actually means that if the cost of the site increases by 19.60%, the NPV would be zero. The situation is vice versa with items which denote cash inflows. Site B Item Cumulative Present Value NPV Measure of Sensitivity Cost of the Site 2,115 144 6.81% Cash in flows 793 144 18.16% Subletting Inflows 444 144 32.42% Sale Proceed 1,021 144 14.10% In the investment appraisal of Site B, the land is the most sensitive item in the cash flow projection whereas the subletting inflows are the least. The following table summarizes the results of the investment appraisal Item NPV IRR Site A 218,000 14.08% Site B 144,000 6.81% As apparent from the above analysis, Site A is more financially feasible for the company as it offers higher NPV as compared to the other investment option, and it also offers higher Internal Rate of Return (IRR) as compared to the required rate of return of 12%. It should be taken into account that the interest charge is not taken into account in the cash flow projection. The reason behind it is that the impact of interest charge is already built in the cost of capital of the company and if we include it in the cash flow projection, its IRR will always be ‘zero,’ thus having no impact on the net present value of the company. Moreover, in the absence of the information provided, the depreciation is not included in the cash flow projection either. Depreciation itself is a non-cash item but it is included in the cash flow projection in order to calculate the tax shield on such depreciation. Such impact is not calculated in the investment appraisal as in the given information the tax rate and the rate of depreciation on the building is not provided either. In addition to the above analysis, as per the given information, the value of the site is expected to be increased by 20% to 80% over the period. Thus, based on this information, it is deduced that the value of the site at the end of the ten year period would increase by 50% (average of 20% and 80%). Since the company is expecting to buy the sites right away, no increase in their prices is expected as of now. THEORTICAL DISCUSSION BASED NPV AND IRR METHOD As mentioned in the case study, the directors of Gryon have limited fund amounting to ? 450,000. Keeping in consideration the limited amount of funds, the directors of the company must make prudent investment decision so as 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, is discounted based on the expected cost of capital of the company (Investopedia, 2010a). As mentioned in the case study, the directors of Gryon expect the minimum return to be 12%, 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 in year 0, i.e. at the time of making of the investment. An investment which NPV is positive is considered to be a rewarding one, whereas an entity does not venture an investment where 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 (Grayson, 2010). 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. 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 ten 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 (Abeysinghe, 2010). In order to commence any investment venture, the director must take approval of the shareholders. Although certain investment might appear to be rewarding and worthwhile to invest, it does 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 in mind 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 is capital expenditure and the only effect on the profit and loss statement of Gryon would be the depreciation expense spread over the years. Creation of a formal staff training system and introduction of approved quality assurance scheme would impact the profit and loss statement and would decrease the profit for the year. Investment appraisal through NPV method and IRR method are both very useful for a financially attractive prospect of any investment decision. A good financial analysis is based on the tradeoff 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 that it is comparatively straightforward and can be used without having prior experience in capital budgeting (Financial Modeling Guide, 2009). 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 rates for different investment proposals (Berkovitch, 2009). 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 make 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 investment 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 times 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 represents an unattractive investment whereas a positive value represents otherwise. 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 (Investopedia, 2010b). CONCLUSION Based on the above investment appraisal, it is financially viable for the company to purchase site A. References Abeysinghe, R. L., 2010. Nature and introduction of investment decision. [Online] Available at [Accessed 18 Aug 2011]. Berkovitch, E., 2010. Why the NPV criterion does not maximize NPV. [Online] Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=138643> [Accessed 18 Aug 2011]. Financial Modelling Guide, 2010. Capital Budgeting and pros and cons of IRR and NPV. [Online] Available at < http://www.financialmodelingguide.com/valuation-concepts/capital-budgeting-irr-npv/> [Accessed 18 Aug 2011]. Grayson, G., 2010. Internal rate of return: An inside Look. [Online] Available at [Accessed 18 Aug 2011]. Investopedia, 2010a. Net Present Value - NPV. [Online] Available at [Accessed 18 Aug 2011]. Investopedia, 2010b. Which is a better measure for capital budgeting, IRR or NPV. [Online] Available at [Accessed 18 Aug 2011]. Saching, 2010. What influences investment decision. [Online] Available at [Accessed 18 Aug 2011]. Smith, F., 2010. Investment appraisal and capital budgeting: NPV and IRR. [Online] Available at [Accessed 18 Aug 2011]. Read More