Project appraisal through discounted and non-discounted cash flow techniques - Essay Example

Project appraisal through discounted and non-discounted cash flow techniques Project Appraisal Through Discounted And Non-Discounted Cash Flow Techniques Analysis of following provided data has revealed relevant basic information that can assist the decision making process, for the purchase of one of the four suggested machines. The information has been extracted by evaluating data under two techniques, discounted cash flows and non-discounted cash flows respectively. Under discounted cash a flow, data is being processed under Net Present Value Technique, whereas, in the case of Non-discounted cash flow, data is assessed under Pay Back analysis. YEAR MACHINE - A £’000 MACHINE - B £’000 MACHINE - C £’000 MACHINE - D £’000 0 – CAPITAL COST (80) (100) (120) (140) 1 – CASHFLOW 15 35 25 10 2 - CASHFLOW 25 40 35 20 3 – CASHFLOW 25 40 40 50 4 – CASHFLOW 30 15 20 50 5 - CASHFLOW 30 10 10 50 The above data has been processed using different techniques over 6years time period, taking year of investment as year ZERO (0), where cost of capital stands 8% each year, in year 6, all machines can be sold for £10,000 except machine D, which has probability to be sold for £50,000. Discounted Cash Flows YEAR MACHINE - A £’000 MACHINE - B £’000 MACHINE - C £’000 MACHINE - D £’000 0 – CAPITAL COST (80) (100) (120) (140) 1 – CASHFLOW 13.889 32.407 23.184 9.259 2 - CASHFLOW 21.433 34.293 30.00 17.14 3 – CASHFLOW 19.845 31.72 31.72 39.69 4 – CASHFLOW 22.050 11.025 14.700 36.75 5 – CASHFLOW 20.417 6.805 6.805 34.029 6- SALE OF MACHINE 6.301 6.301 6.301 31.508 TOTAL NET PRESENT VALUE 23.935 22.551 (7.29) 28.376 The above calculations are performed under the light of Net Present Values (NPV) Analysis, results have shown that a positive NPV is generated by three of the machines out of four, machine A, machine B and machine D respectively. The highest NPV is generated by machine D that is £2837.5, cash inflows of this machine are not even throughout the period of 6 years but in the initial stages cash flows are increasing with huge distinctions, and after the end of year three these flows start to fall from their boom points. Apart from the fact that machine D generates good returns, initial investment in machine D is seen to be the highest as well being £140,000, bounding such huge amount in a machine can cause liquidity issues to the organization. Machine A generates second highest return with appositive NPV of £2393.5, consuming the lowest initial investment of £80,000 only. Cash flows have no specific manner of occurrence, and move in a haphazard manner. This machine could also be an appropriate choice if a lower amount of cash is available for tying up in the purchase. Purchasing Machine A instead of Machine D would save an initial investment of £60,000(£140,000-£80,000) but £444(£2837.5-£2393.5) of profits would be lost. Machine B generates the lowest but positive returns of £2255, with an initial input of £100,000. Cash flows are reducing constantly after year 2 and in period 5 this reduction has reached near to lowest limits. This can also proved to be a good option but gradual reduction in cash flows can create liquidity problems for the organization in future. Machine C has failed to recover investment due to heavy investments in the inception and low returns over forthcoming years hence are producing a loss of £ (729). Therefore, machine C is excluded from recommendations. Net Present Value This technique is very commonly used and easy to understand, answers/results generally appear in positive or negative figures, negative Net Present Value signifies that the project, asset or any item being forecasted is not financially feasible and will be generating a negative cash inflow, in other words, project is financially not sound and losses will be the only result of commencement of project, keeping other external and internal factors constant. The positive Net Present Value signifies that the project, asset, of any item being forecasted will generate positive cash inflows in future and project should be accepted an initiated if the decision only bases on financial grounds, the project will generate profits in the forthcoming periods if all other factors remained constant. Positive and negative values makes it easy to understand generation of profits and losses as well as assists decision makers to focus only on the highly positive items, the precious time of management can be saved by focusing on the relevant project (Fortes, 2010; Horngren, 2005). Calculations are comparatively easy and data of any finite period can be easily converted into present value of it. Net present value analysis is derived from some basic realistic and practical assumption it is based on a fact that value of £100 today will be more than the worth of £100 after a year. Keeping this assumption in mind a net present value of future cash inflows is calculated using a discounted rate, usually the rate of cost of capital of a company or industry this rate represents the percentage minimum requirement of return by an organization per annum. Annuity factors can also be used if cash flows are constant every year. The Net Present Value (NPV) is a useful technique to determine profitability of any item being assessed, but has few limitations as well, it only focuses on factual data that can directly hit the profit generation capabilities of an item and financial aspects only while appraising projects and does not account for the non financial aspects, areas and issue associated to that project; whereas, there is a high probability of any decision/ project to get affected by numerous external or internal non-financial events. It is based on an assumption that the inflation rates, interest rates and external environment will never affect the project, which seems quite unrealistic and impractical, because these rates effects any industry directly and its projects as well, a country which is hyperinflationary can never successfully apply this analysis to make sound decisions, variation in the rate of cost of capital is also not considered in Net Present Value Analysis. As in a growing market, rate of returns and cost of capital changes with high frequencies, it a change in basic applied discount rate occurs, net present value analysis has not provided any guidance for this treatment. WORKINGS: YEAR MACHINE - A £’000 MACHINE - B £’000 MACHINE - C £’000 MACHINE - D £’000 0 – CAPITAL COST (80) (100) (120) (140) 1 – CASHFLOW 13.889 15(1.08)^-1 32.407 35(1.08)^-1 23.184 25(1.08)^-1 9.259 10(1.08)^-1 2 - CASHFLOW 21.433 25(1.08)^-2 34.293 40(1.08)^-2 30.00 35(1.08)^-2 17.14 20(1.08)^-2 3 – CASHFLOW 19.845 25(1.08)^-3 31.72 40(1.08)^-3 31.72 40(1.08)^-3 39.69 50(1.08)^-3 4 – CASHFLOW 22.050 30(1.08)^-4 11.025 15(1.08)^-4 14.700 20(1.08)^-4 36.75 50(1.08)^-4 5 – CASHFLOW 20.417 30(1.08)^-5 6.805 10(1.08)^-5 6.805 10(1.08)^-5 34.029 50(1.08)^-5 6- SALE OF MACHINE 6.301 10(1.08)^-6 6.301 10(1.08)^-6 6.301 10(1.08)^-6 31.508 50(1.08)^-6 Non-Discounted Cash Flows Data has been processed under Pay Back Period technique. PAYBACK Period technique provides a clear view of the time period, which would be involved in getting results of any investment. It forecasts the time by which cash inflows start to exceed initial investment. MACHINE Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 PAYBACK PERIOD A (80) 15 25 25 30 30 10 ((80)+15+25+25)/30= 3.4 years B (100) 35 40 40 15 10 10 ((100)+35+40)/40= 2.625 years C (120) 25 35 40 20 10 10 ((120)+25+35+40+20)/ 20= 4 years D (140) 10 20 50 50 50 50 ((140)+10+20+50+50)/ 50= 5.2 years The analysis of the above data has shown that the shortest payback period is of machine B that is due to mediocre investment and good cash flows through future periods, choosing machine B for purchase can help organization to get its initial investment back in just 2.625years and options for reinvestment in other projects would become available, shareholders will be getting their returns sooner. The longest payback period has been shown by machine D that is mainly due to heavy investment at the initiation stage and low cash inflows in starting two years. cash inflows in rest of the years are remarkable and highest from the rest of machines with a consistency. Machine C has a 4-year payback period with uneven cash flows. Initial generation of cash is impressive and progressive, cash flows grow till year4, after year 4 flows start to decline and go to possible reduced level due to which time period is being affected and has prolonged. Machine A has the second best payback time period of 3.4 years. It has lowest investment level that gathers attention of decision makers towards itself. Improved cash flows can shorten the payback period but that needs to be planned. Payback period provides a panorama to decision makers to analyse an expected time period by which break-evens could be crossed and cash inflows would start to move above breakeven points. It is assumed that shortest the payback period would be, the best option for investment project becomes. Payback requires simple calculations, comparing inflows of cash with initial investment. It is easy to understand and calculation is quite simple, it saves time of accountants and reduces workloads. That’s the reason generally used by organisations in their annual reports to make it more clearly to stakeholders that by what time returns on their investments are expected to be generated and returns will be provided to shareholders. Time periods are calculated in terms of years and months. Despite of above advantages and merits, Payback Period technique has limitations too. It is generally experienced that payback time period varies with actual time period taken by cash inflows to exceed investment levels that is due to the fact that Payback Period doesn’t account for any external environment influence on the cash flows, in this technique PESTEL analysis (political, economical, sociological, technological, ecological and legal) factors are ignored. Payback period does not allow the effects of inflation on cash flows, changes in interest rates, and in the case of foreign investments it does not allow variations in the foreign exchange rates, excise duties, and taxes. Some projects are inherently long termed and generate consistent but slow cash inflows, this kind of projects will always be showing prolonged and extended payback periods. Any contingent liability, provisions for penalties and legal claims have not been provided any topographic point in the calculations of payback period. Conclusion Decision is often based on the nature of decision maker, whether decision maker is a minimax, maximin or maximax that is risk averse, neutral and risk seeker respectively. According to the assessment carried out above, the highest positive Net Present Value is generated by machine D, which can prove to be the finest decision on the basis of financial grounds. Whereas the analysis of payback period has shown that machine D has the longest payback period, a 5year period. Which would not be feasible for the organization, overall life of machine is 6 years and investment would be bounded in machine D for major period of its whole life that is 83%. Shortest payback period has been shown by machine B, 2.625 years, but has the lowest positive net present value that is of £2,255.1. Purchasing this machine can help organisation to get investment returned earlier and engage that money in other projects to earn interest or profits. Machine C cannot be recommended due to its negative net present value but under pay back analysis it has a time period of 4years, and at the end of 4years losses will be the result. Machine A can be purchased as it has a mediocre net present value and its time period is average as well. Machine D should be chosen if decision is based on financial grounds, ignoring the payback period. Machine B should be chosen if the basis of decision is getting the investment back as earlier as possible. These both above provided options are two extreme points on net present value and payback, machine A has an average payback period and an average net present value as well so an average, neutral, and middling decision can be taken by choosing machine A for purchase. References Dyson, J. R. (2010). Accounting for Non Accounting Students. London: London FT Prentice Hall. Fortes, H. (2010). Accounting Simplified. London: Pearson Education. Horngren, C. (2005). Introduction to Management Accounting. NJ: Printes Hall. Read More