Project Appraisal Methods - Assignment Example

1) Cost = 300,000 Time = 5 years Cash flow = 35,000 R=' For an initial outlay of 300,000 GBP, for 5 years, with a constant cash flow of 35,000, we can compute IRR of the project to arrive at a rate which equates cash flows with the initial outlay and then finding out the net present value of the project to arrive at highest cost of capital. The calculations of the project are computed in following way using MS Excel: Since IRR (the rate at which cash inflows equates cash outflows) is negative therefore there is no case of investing into such project. However, taking a hypothetical case, this project may be accepted at a hypothetical cost of capital of just 1% because it is the rate at which NPV would be positive. 2) 3) Project Appraisal Methods Project appraisal techniques and methods vary in their importance and significance therefore their use is also dependent upon what are the intended objectives of the finance managers while assessing and evaluating projects. It is also important to note that the basic method which is now being widely accepted as more credible mean of project appraisals is based on the time value of money concepts. Since the project appraisal methods include both the TVM and non- TVM based methods therefore it is up to the finance managers to decide what basic philosophy and method they intend to apply. As a general rule there are different methods which are being employed over the period of time by the finance managers to perform project appraisals. These are: 1) Return on Investment 2) Payback Period 3) Net Present Value 4) Internal Rate of Return 5) Average annual profits These appraisal methods will be discussed in following section: Return on Investment Return on Investment is one of the several methods of making project appraisals. The basic philosophy behind this method is the fact that finance managers take the expected gains from the project with comparison to the total investment cost of the project. The basic formula for calculating Return on Investment is: ROI = Net Returns on the investment / Total Investment Cost ROI is preferred method because of its simplicity. It is to calculate and can be handy and a quick mean of having a look at the overall value addition capability of the investment made. The basic criteria to judge the suitability of the project through this method is the fact that if ROI is positive than the proposed project may be undertaken. It is also important to mention that ROI may not be the most sophisticated method as it has its own drawbacks. It is often argued that this figure can be easily manipulated because the accounting income figure can easily be tempered with by using different means of recording costs and profits. By changing the depreciation methods, the accounting income can easily be increased or decreased therefore ROI would also increase or decrease with the changes in accounting income. Further, Return on Investment also do not take into account the time value of money. Payback Period Payback period is another non-TVM based method used for making decisions on project. Payback period is the time taken to recover back the initial investment made into any project. This method is technically considered as simple and easy to calculate. However, despite its use, this method has some serious flaws including following: 1) Cash flows after the payback period are not taken. 2) It does not take into account any element of risk. 3) Payback period cannot be considered as a method which can be used an indicator of wealth maximization for shareholders. 4) As discussed above, this method also does not take into account the time value of money. Net Present Value Net present value is one of the most widely used methods for making project appraisal methods as it is considered as more accurate methods. Net Present value is basically the difference between the present value of the cash outflows and Cash Inflows. If the present value of Cash Inflows is greater than Cash out flows, the project is accepted and if it is negative project is declined. One of the most important benefits of NPV is the fact that it takes into account the time value of money therefore is considered as more accurate method as compared to other methods of project appraisal. Internal Rate of Return Internal Rate of Return is the discount rate, which is often used in capital budgeting process, equating the present value of the expected cash inflows with the present value of the cash outflows. It is the rate at which the NPV of the project is zero. Higher the Internal rate of return of a project, more feasible it is however as general criteria a project is accepted if internal rate of return is greater than the cost of capital of the project will be accepted otherwise not. IRR is one of the widely used methods of project appraisal methods however; one of its major weaknesses of this method is the fact that it assumes the same rate of investment over the total investment horizon i.e. over the period of the project. Average Annual Profit Average Annual Profit is the average profit generated by the project over the period of the project. This figure is achieved adding back depreciation to the incremental cash flows generated from the project. The annual profit is divided by the total investment made into the project. Like other accounting estimates, this figure can also be manipulated because of the availability of variety of the methods to calculate depreciation. Because of the various methods of calculating depreciation, the annual profit figure can easily be distorted therefore this method can also mislead finance managers to decide about any project. Apart from that, this method also does not take into account the concepts of time value of money and just rely on the accounting estimates. It is because of this reasons that this method cannot be relied upon as credible method of making decisions. Recommendations As discussed above that there are different means of choosing the projects based on different criterions. Since almost all the methods have their own advantages and disadvantages, therefore this recommendation will be based on the sole criteria of Net Present value. Since Net Present Value or NPV method is considered as the most accurate and widely used method therefore basing our recommendations on NPV alone, we recommend purchasing Queen at the discount rate of 10%. Since at this rate of return, the NPV is highest therefore purchasing Queen will add more value to the firm than KIPS. Read More