Investment Appraisal Methods - Coursework Example

Financial Management work The development costs incurred for getting both the models to design stage are to be included in the investment appraisal process. Development Costs: (£ 000’s) Spring Model £ 90 Autumn Model £ 80 The total development costs incurred is £ 170,000. This cost can be considered to be a part of the initial investment. The total initial investment required for the two models are computed as shown below: Costs Spring Model Autumn Model Development Costs £ 170,000 £ 170,000 Machinery £ 3,000,000 £ 2,200,000 Total Investment £ 3,170,000 £ 2,370,000 It is evident that the machinery for both the models has a useful life of 5 years. In the case of the machinery for the Autumn Model, the disposable value is the same after initial installation. However, the machinery for the Spring Model has a higher disposal value after 3 years. The cash flows for the Spring Model are analyzed to select the life period of the machinery that will be most profitable. It is evident from the cash flow forecasts that the Spring Model generates comparatively high revenue in the fourth and fifth years. Hence the life of the project life of Spring Model is taken to be 5 years for the investment appraisal process. The cash flows from the two alternatives are shown in the table below (including the initial investment and the disposable values). Year Spring Model Autumn Model 2009 (£ 3,170,000) (£ 2,370,000) 2010 £ 420,000 £ 800,000 2011 £ 420,000 £ 1,000,000 2012 £ 1,000,000 £ 450,000 2013 £ 2,400,000 £ 450,000 2014 £ 1,280,000 £ 600,000 Investment Appraisal - Methods: “Investment appraisal is the process of assessing potential investment projects to see which ones are most viable (and profitable) for the firm.” (Samuels et al, 2000). There are different methods of investment appraisal using which a project can be evaluated. These are broadly classified into Traditional Techniques and Discounted Cash Flow Techniques. Traditional Methods Payback period Average Rate of Return Discounted Cash Flow Methods Net Present Value (NPV) Internal Rate of Return (IRR) (Samuels, et al, 2000) The two models are analyzed using these investment appraisal techniques in the following sections. Payback Period: Payback period (PBP) is one of the simplest methods used. Payback period is the time taken by a project to generate cumulative cash flows which equals the initial investment. This can also be considered as the time taken to attain breakeven. In other words, Payback Period = Number of years taken for  Ct to be equal to initial investment where  Ct = Sum of cash flows (Samuels et al, 2000) Based on the cash flows for the two models, the payback periods are computed as shown below: Spring Model Year Net Cash Flow (£) Remaining Investment (£) 2009   (£ 3,170,000) 2010 £ 420,000 (£ 2,750,000) 2011 £ 420,000 (£ 2,330,000) 2012 £ 1,000,000 (£ 1,330,000) 2013 £ 2,400,000 £ 1,070,000 2014 £ 1,280,000 £ 2,350,000 Payback Period = 3.55 Years Autumn Model Year Net Cash Flow (£) Remaining Investment (£) 2009   (£ 2,370,000) 2010 £ 800,000 (£ 1,570,000) 2011 £ 1,000,000 (£ 570,000) 2012 £ 450,000 (£ 120,000) 2013 £ 450,000 £ 330,000 2014 £ 600,000 £ 930,000 Payback Period = 3.27 Years The acceptance of a project completely depends on this period i.e., lower the payback period, better is the project returns. In other words, in the case of two mutually exclusive project proposals, the one with the lesser payback period will be accepted. It is evident that the Autumn Model has a relatively shorter payback period than that of the Spring Model. However, this difference is not very significant and hence it can be considered that both the models have almost equal payback periods. The most beneficial feature of this method is that it takes into account the liquidity of the project, which is useful for businesses to understand and concentrate on the cash flows of the company. Also this is a very simple method comparatively (Samuels et al, 2000). The main drawbacks of using this method are that it does not take into consideration the time value for money and risks. The cut off period fixed is not based on any calculations and hence can be misleading at times. Another drawback of payback period is that it only takes into account the cash flows, and ignores all the accounting earnings and the possible cash flows that might occur after the payback period is reached (Johnson and Kaplan, 1991). Accounting Rate of Return (ARR): It is a simple accounting method of rating capital expenditures. Accounting rate of return (ARR) is computed as a percentage of average annual profits to the average investment in the project. The formula to calculate (ARR) Accounting Rate of Return: ARR = Average Annual Profit / Average Investment Where Average Investment equals half of the net investment. Once the ARR values are computed for the projects under investigation, the project with the higher ARR than the cut-off rate is accepted (Fisher an Martin, 1994). Year Spring Model Autumn Model 2010 £ 420,000 £ 800,000 2011 £ 420,000 £ 1,000,000 2012 £ 1,000,000 £ 450,000 2013 £ 2,400,000 £ 450,000 2014 £ 1,280,000 £ 600,000 Average Income £ 1,104,000 £ 660,000 Initial Investment £ 3,170,000 £ 2,370,000 ARR 17.41 % 13.92 % The ARR for Spring Model is 17.41 % whereas that of the Autumn Model is 13.92 %. Both the models have returns that are higher than the cost of capital to the company (12 %). Hence, according to the ARR values, the Spring Model is more profitable than that of the Autumn Model. ARR is one of the simplest methods for calculations since all the information required for calculations are easily available. Though this method is very beneficial it does not take into consideration the time value for money, cash flows or the market values but only concentrates on accounting information (Johnson and Kaplan, 1991). It may vary due to the fact that it takes into account the accounting information, since different accountants have different methods of determining costs. Net Present Value (NPV): Net Present Value (NPV) is the most commonly used method and it utilizes the discounted cash flows to compute the returns from an investment. In this method, initially all the future cash flows that will be generated by the project are discounted to present value. This value is then reduced by the initial investment to arrive at the Net Present Value (NPV). Step 1: PV of future cash flows = (t = 1 to n)  Ct / (1 + r) t where Ct is the cash flow generated in period t, r is the discount rate used and n is the number of years. Step 2: Net Present value (NPV) = PV of future cash flows – Initial Investment If the NPV value is negative, then it indicates that the investment is not worthwhile and that it will cause losses to the company. Hence this investment has to be discarded. In case, the NPV exactly equals zero, it indicates that the investment will neither generate any gains nor incur any losses. It then depends on the company’s policies to decide whether to take up the project. If the NPV value is positive, then it indicates that the investment will generate gains to the company and that it is worthwhile considering the project, as it will increase the value of the firm. If two mutually exclusive investments are considered and both have a positive NPV, then the project with the higher NPV has to be selected as it results in higher returns to the company (Weston and Copeland, 1988). The NPV for the two models are computed as shown below: Spring Model Year Cash Flow (£) PV Factor @ 12 % Present Value 2009 (£ 3,170,000) 1.0000 (£ 3,170,000) 2010 £ 420,000 0.8929 £ 375,000 2011 £ 420,000 0.7972 £ 334,821 2012 £ 1,000,000 0.7118 £ 711,780 2013 £ 2,400,000 0.6355 £ 1,525,243 2014 £ 1,280,000 0.5674 £ 726,306 Net Present Value £ 503,151 Autumn Model Year Cash Flow (£) PV Factor @ 12 % Present Value 2009 (£ 2,370,000) 1.0000 (£ 2,370,000) 2010 £ 800,000 0.8929 £ 714,286 2011 £ 1,000,000 0.7972 £ 797,194 2012 £ 450,000 0.7118 £ 320,301 2013 £ 450,000 0.6355 £ 285,983 2014 £ 600,000 0.5674 £ 340,456 Net Present Value £ 88,220 The NPV of Spring Model is £ 503,151 whereas that of the Autumn Model is £ 88,220. The Spring Model has a significantly higher NPV and hence this method recommends the Spring Model to be accepted. NPV is generally used to compare projects on the basis of factors like cost benefits, earnings, etc. It requires a lot of calculation to get the cost of capital, and the calculations can be a difficult and complicated. The decisions it provides are very simple and easily understandable, however it does not take into account a few factors like inflation, cash flows of a certain year, management flexibilities, etc (Samuels et al, 2000). This method is very useful for projects of the same size, mostly least cost situations. NPV enables the comparison of various rates of interest and also helps analyse what the earning would be if another project were taken up (Weston and Copeland, 1988). The main drawback in this method is that it does not take into account the profitability of a project (Burke and Wilks, 2007). Internal Rate of Return (IRR): Internal rate of return (IRR) is defined as the rate of discount that has to be applied on a project’s cash flows to make the Net Present Value (NPV) equal to zero. The meaning of Internal Rate of Return (IRR) is that the discount rate or the company’s cost of capital can increase till the IRR value and still the investment will not incur any losses to the company. The IRR is an indication of the maximum value that the discount rate can go up, so that the company does not undergo any losses. This method works on trial and error basis. Initially the NPV for an assumed rate is determined and based on this value, another rate is selected so that the new NPV approaches closer to zero. Based on these two values, the IRR can be computed using the cross-multiplication rule. The main rule of the project is higher the rate of interest over the cost of capital, the better it is for the company and hence the project can be selected (Constantini, 2006) (Samuels et al, 2000). The Internal Rate of Return for the two models are computed and shown in the following table. Year Spring Model Autumn Model 2009 (£3,170,000) (£2,370,000) 2010 £420,000 £800,000 2011 £420,000 £1,000,000 2012 £1,000,000 £450,000 2013 £2,400,000 £450,000 2014 £1,280,000 £600,000 IRR 17% 14% The IRR values for both the models are higher than that of the cost of capital for the company which is 12 %. As the IRR of Spring Model (17 %) is higher than that of the Autumn Model (14 %), the former is a more profitable and reliable option. This method allows assessment of risks involved in every proposal and has an intuitive appeal. The method adopts the usage of cash flows instead of the earnings and is adjustable according to time value for money. At every point in the calculation the cash flows are considered. However, this method in a way is not accurate since one project can have more than one IRR. It is not the set method to choose between two projects and moreover the calculations are complicated (Lefly, 1997). NPV vs. IRR: Both the methods discussed have their own merits and demerits. Net Present Value enables us to understand the possible profits a company would earn if a certain project is taken up. It provides results that are simple to comprehend (Weston and Copeland, 1988). The main drawback in this method is that it does not take into account the profitability of a project (Burke and Wilks, 2007). Internal rate of return, on the other hand, can be used to assess risk in all projects. However it is not possible to have an accurate solution using this method since one project can have more than one IRR, with very extensive and complicated calculations (Lefly, 1997). In a report on IRR, Anthes (2003) states that IRR might be misleading as it assumes that the cash flows generated are reinvested at the same interest rate. Moreover, “the error is magnified when comparing two investments of different durations” (Anthes, 2003, p32). Also, when the difference between the IRR and the cost of capital or the discount rate is high, the error also increases. Hence IRR cannot be used as a sole solution for investment appraisal decisions. Reasons for Conflicting Results: There are a few reasons why the results of NPV and IRR conflict. These are as discussed below: a) The life and size of the Project: This is one of the main reasons that the NPV and IRR tend to conflict in the results. It is not correct to compare a 10 year project with an initial investment of £100,000, and a 3 year project with an initial investment of £10,000. Using the NPV and IRR methods to compare two projects with differing life and sizes, will only lead to conflicting results. b) Different Cash Flows: It is also seen that although two projects have similar life as well as are of similar size, the cash flow of the projects can differ. These differences in the patterns of the cash flows can have a major impact on the results of the NPV and IRR. Take an example of a project which has cash flow which continuously increases over time while the other cash flow might have increase, decrease, stops or even negative flow of incomes. In a case like this, where the cash flows tend to be completely different, and if the discount rate is different then the order of ranking will also be different. As noted above there can be several different occasions where a conflict can arise between the NPV and IRR results. These include the factors like different lives, sizes, risk factors or even the cash flow timings. However it is essential to understand that the main cause or the underlying factor of the conflicts is mainly due to the assumptions that are made for the reinvestments of the cash flow and the capital budgeting decisions. Further Analysis: In order to analyze the two projects completely, the non- financial factors are also to be taken into account. These include the operational difficulties, availability of trained personnel for the different machineries and the infrastructure changes that have a high effect on the organization as a whole. The revenues used in the analysis are based on the estimated demands for the products. The reliability of these figures also play a major role and hence it is essential to obtain a range of possible revenues along with the probabilities of attaining them for a fuller analysis. From the given estimates, the analysis conducted revealed that the Spring Model is the most profitable out of the two and hence it has to be chosen by the company. Also, the machinery should not be resold within 3 years and should be used for the entire 5 year period. References Anthes, G.H., 2003, ‘Internal Rate of Return’, 17 February 2003, Computer World, p32 Bott, F., 2008, ‘Professional Issues in Information Technology: Chapter 8 – Investment Appraisal’, Accessed on 7 January, 2010, Retrieved from http://www.bcs.org/upload/pdf/profissuessamplechapter.pdf Burke, L. and Wilks, C., 2007, Management Accounting – Decision Management, 4th edn, CIMA Publishing Constantini, P., 2006, Cash Return on Capital Invested, 2nd edn, Butterworth – Heinemann Publishers, Boston, Massachusetts Duncan Williamson, 2003, Capital Budgeting: The Key Numerical Techniques, 12 October 2001 revised 8 May 2003, Accessed on 7 January 2010, Retrieved from http://www.duncanwil.co.uk/invapp.html Johnson, H. and Kaplan, R., 1991, ‘Relevance Lost: The Rise and Fall of Management Accounting’, Harvard Business School Press Kruschwitz, L. and Loeffler, A., 2005, Discounted Cash Flow: A Theory of the Valuation of Firms, 2nd edn, Wiley Publishers, New Jersey Lefly, F., 1997, ‘Modified Internal Rate of Return: Will it replace IRR?’, Management Accounting, Vol. 75, No. 1, January 1997 Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Weston, J. F. and Copeland, T. E., 1988, Managerial Finance, 2nd edn., Cassell Educational Ltd, London Read More