Florence Regarding Investment Appraisal - Essay Example

Florence Regarding Investment Appraisal Introduction The paper is a report to the chairman of Florence regarding investment appraisal of three projects, namely, A, B and C. The firm has raised fund from shareholders by means of right shares and it was expressed by the chairman that the fund should be investment in the project that maximises shareholders’ wealth. The investment decisions of the project was appraised by using a number of capital budgeting techniques such as net present value, payback period, internal rate of return and accounting rate of return. The project was appraised using so many techniques only to strengthen arguments in favour of a particular project and to ensure that the fund is invested appropriately. a) Payback period of the projects Capital budgeting is primarily undertaken when investment outlay is done for a long period. In context of this paper, the investment will be done in heavy machinery and the project period is 5 years. Payback period denotes the time period that is absorbed by the project for recovering the total cost of the project. Payback may not be the primary technique but it is an important technique that determines whether a firm should undertake a particular project. The criterion is that when projects are compared on the basis of payback period, a project with shorter payback period is selected (Sangster, 1993; Cooper, Cornick and Redmon, 2011). The calculated payback period of each project is as follows: Table 1 (Source: Author’s creation) It was calculated that project A required the least amount of time followed by project B and project C respectively. In other words, Project B requires 0.52 years or about 6 months more than project A. From the perspective of payback period, project A can be recommended over the other projects as it takes the shortest amount of time to recoup the initial outlay (Sangster, 1993). b) Accounting rate of return of the projects Accounting rate of return is often considered as the true measure of profitability with respect to a project in capital budgeting as it not only take into account the net cash inflow but also focuses on expected net earnings from each project with respect to the fund invested initially. This technique works on the notion that earnings instead of generally cash flow are better measure of success of an investment. A project with higher accounting rate of return is generally considered as the superior choice (Kida, Moreno and Smith, 2001). The calculated accounting rate of return of each project is as follows: Table 2 (Source: Author’s creation) It is important to discuss reason for using incremental revenue prior analysing the outcome. The incremental revenue has been calculated after deducting yearly depreciation on the machinery from the cash inflow. The depreciation has been calculated based on straight line method with zero scrap value and life of 5 years. It can be observed that the incremental revenue from project A is negative for last two years and on average, the project has lowest rate of return. Contrastingly, project B scores the highest followed by project C and as a result, project A and C can be rejected from profitability perspective (Drury, 2013). c) Advice to the chairman on project preference A comprehensive investment appraisal method has been adopted for evaluating Florence’s three mutually exclusive projects. The project is relatively critical in nature as the initial investment comprises purchase of heavy machinery for the firm. The assessment has considered both discounted and non-discounted cash flow methods such as net present value, internal rate of return, accounted rate of return and payback period method. The calculated values are expressed as follows: Table 3 (Source: Author’s creation) The net present value method is one of the important discounted cash flow techniques that are commonly adopted by firms for evaluating projects. The primary reason for considering NPV method useful is consideration of time value of money. Among the three projects, it can be observed that each of the projects has positive NPV higher than $900. From a single project’s point of view, all three projects are acceptable as they have positive NP but comparatively, the project with highest NPV is preferred. Hence, Florence PLC should invest the fund in Project C (Schall, Sundem and Geijsbeek, 1978). Internal rate of return is another important discounting method which is generally used along with NPV method for evaluating projects. IRR method generally ranks projects based on the amount of return the project is generating internally. There are two key criteria for selecting a project on the basis of IRR. Firstly, the IRR should be higher than the cost of capital of the project and secondly, IRR is useful in selecting the most desirable project among more than one project. All the three projects have internal rate higher than the firm’s discounting rate or cost of capital however, project A has highest internal return followed by project B with marginal differences (Bamber and Parry, 2014; Graham and Harvey, 2001). The payback period is a non-discounted method as it does not use discounted value of cash flow and also does not lay emphasis on time value of money. It is a straight forward method where time to recover the initial investment is stressed upon. The analysis suggests that project A actually recover the total cost of the project in 2 years and 3 months approximately, project B recovers the total cost in 3 years and project C takes 2 years and 9 months to recover the initial outlay. The primary reason for project A having least payback period is that the project will earn very high inflow during the first three years. Accounting rate of return is also a non-discounted cash flow technique and this method is considered more competent than payback period because it assesses total inflow in the project’s life unlike the payback period. The incremental revenue of project A was observed to be negative in 4th year and 5th year. Consequently, the project B and C can be considered acceptable. Since project C has highest rate of return, it will be the most appropriate choice (Drury, 2013; Brealey, 2012). Overall analysis suggests that project C is the most appropriate from all the aspect as the project has highest NPV and return on investment. The payback period of project C is only 6 months more than that of project A; however, return on investment is relatively high for project C. Furthermore, project A has incurred negative return in last two years which may not be acceptable to shareholders. IRR of project C is marginally less than project A and hence, can be considered for future investment. Based on the complete analysis, the firm should invest in project C keeping in view the key aim of shareholders’ wealth maximisation (Romano, Tanewski and Smyrnios, 2001). d) Strengths and weaknesses of the investment appraisal techniques I. Net present Value method Strengths: NPV as the name suggests determines the actual present worth of a project after discounting the future cash flows on a time basis. Time factor is considered as essence of this technique. NPV is useful for evaluating single as well as multiple projects irrespective of being independent or mutually exclusive project. NPV is easy to calculate and comprises simple and straightforward measurement. NPV determines the amount of contribution that will be available to shareholders from the project. Weaknesses: There are certain ambiguities associated with the NPV process. The first issue that was recognised is discounting factor. There are a lot of perplexities regarding calculation of discounting factor which is generally the cost of capital. The cost of capital can be determined by different ways and the calculation process is complicated. Furthermore, minor error in NPV calculation can result in misleading outcomes (Bamber and Parry, 2014). II. Internal rate of return Strengths: One of the key strengths of IRR is time value of investment. IRR and NPV are considered complementary. The internal return reflects the actual return that is distributed over the total life of the project. Another reason for which IRR is selected over non-discounted cash flow techniques is that equal weight is allocated to each cash flow. IRR can be implemented in budgeting process as well so that a brief idea regarding potential scope of expenditure or saving is determined. The other strength of IRR is that it can be easily compared with discounting factor or cost of capital for determining acceptability of a specific project (Tirole, 2010; Burns and Scapens, 2000). Weaknesses: Every financial technique comprises certain flaws and IRR is no exception to that. IRR primarily believes that cash flow which can be reinvested will be done at the same rate. Ambiguity occurs when a firm invests the same at a rate higher or lower than the IRR. Another drawback of IRR is that it only appraises the projected cash flows and ignores the probability of external future costs which may affect the profit (Drury, 2013). III. Accounting rate of return Strengths: The primary strength or advantage of accounting rate of return method is that it calculates the overall return. In other words, in can be considered as the return on potential investment. Another important aspect of accounting rate of return is that it is more focussed on profitability instead of plain cash inflow. The techniques also take in consideration depreciation and scrap value of the project if any for calculation of incremental revenue associated with a project (Brewer, 2000). Weaknesses: The greatest flaw that was determined in the average accounting return method is negligence towards time factor associated with each cash flow. It does not appraise the uncertainty attached with the cash flows. The technique is useful when comparing average profitability of two or more profits but lack of consideration towards the time factor minimises its effectiveness (Dyson, 2010). IV. Payback period Strengths: Payback period is considered as an effective method of appraisal by analysts because it is simple, easy to calculate and determines efficiency of project returns. The process empowers analysts to determine time period within which total outlay can be recovered. In this regard, the discounted payback period is considered more useful because that takes in consideration the time value of investment. Payback period is considered important while comparing more than one project on the basis on faster return from an investment. Payback period can be used alone for small projects although is not recommended for long term projects (Bierman Junior and Smidt, 2012). Weaknesses: It has previously been pointed that payback period does not allow for time factor associated with inflows. This is a major shortcoming with the method and in addition, the payback period does not consider the inflow that may take place after calculation of the payback period. Payback period focuses on short term profitability of a firm and is not an appropriate measure for determining long term profitability (Sangster, 1993; Collier, 2012). Reference list Bamber, M. and Parry, S., 2014. Accounting and Finance for Managers: A Decision-Making Approach. Great Britain: Kogan Page Limited. Bierman Junior, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. London: Routledge. Brealey, R. A., 2012. Principles of corporate finance. India: Tata McGraw-Hill Education. Brewer, P. C., 2000. An approach to organizing a management accounting curriculum. Issues in accounting education, 15(2), pp. 211-235. Burns, J. and Scapens, R. W., 2000. 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