Gamma Plc - Capital Budgeting and Investment Appraisal - Case Study Example

Capital budgeting and Investment Appraisal The Gamma Plc. Case Total words: 2063 The Gamma Plc. Case Outline Investment Appraisal Techniques Calculation of Net Present Value (NPV) Calculation of Discounted payback Calculations of Return on Capital Employed Calculations of Internal rate of return (IRR) Calculation of Profit Index (PI) Comments on the acceptability of project Evaluation of robustness of findings Risk factors for Gamma plc General Conclusion Gamma Plc. Introduction Gamma plc manufactures high performance motorcycles and wan to increase its sales and profit level. For this purpose Company is evaluating the project of “Racing series”. For this purpose the company asked for advice from the external consultant for financial viability of the project. It is the requirement that the decision should be made on different investment appraisal techniques. The first part of this assignment is based on the workings of some essential investment appraisal techniques. The second part is based on the recommendations in relation with calculated information. At the end a general conclusion has also been made on the acceptability of the proposed investment. Discounted Cash flow techniques Net present Value: Net present value simply means the future value of the project in present terms. It is simply a method a achieving the present value of future cash flows in current situation. It can be calculated through discounting the inflows of future years with investor required rate of return. There are three simple rules followed in the decision of project feasibility through net present value. If the net present value of the project is positive – the project is financially viable If the net present value of the project is negative – the project is not financially viable If the net present value of the project is ZERO – the project break even According to the net present value calculations, Gamma plc will have 63,040 in pocket if invest on the rate of 15 % Calculations of NPV Notes: All figures are in £, All flows are incurred at the end of year excluding investment. Year 1 £ 2 £ 3 £ 4 £ Sales --- 350,000 390,000 410,000 Less direct expenses Materials and components (50,000) (65,000) (65,000) (50,000) Salaries and wages (70,000) (80,000) (85,000) (85,000) Advertisement Expense (25,000) (25,000) (25,000) (25,000) ________ _______ ________ _______ Net Cash flow (145,000) 180,000 215,000 250,000 Sale of Machinery 120,000 Net cash flow (145,000) 180,000 215,000 370,000 Discount factor @15% 0.870 _______ 0.756 ______ 0.658 _______ 0.572 ______ Present Values (126,150) 136,080 141,470 211,640 £ Sum of present values of future 363,040 Less Initial investment 300,000 _________ Net Present Value ` 63,040 Positive Payback technique The payback period is the time that a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity. According to the calculations of payback period for Gamma plc. The company has a payback period of 3 years and 7 months. All figures are in £ Calculations of discounted payback Year Discounted cash flow £ Cumulative cash flow £ 0 (300,000) (300,000) 1 (145,000) (445,000) 2 180,000 (265,000) 3 215,000 (50,000) 4 370,000 320,000 Discounted payback period = 3 + (370,000/50,000) = 3 years 7 months. Return on capital employed technique Return on capital employed is the measure of the return that how much return is earned on the initial investment. ROCE is also in percentage figure. This is also known as accounting rate of return Return on capital employed = Average annual profit before interest and tax / Initial capital investment * 100 Putting values in formula for Gamma Plc 90,760 / 300,000 * 100 = 30 % Alternate approach: Average annual profit before interest and tax / Average capital investment * 100 Putting values in formula 90,760 / 210,000 * 100 = 43 % Average capital investment = Initial investment + Scrap value / 2 ; 300,000 + 120,000 / 2 = 210,000 Probability Index Profitability index of the project shows the ratio of the profits related to investment of the project. Profitability Index = (NPV + Initial investment) ÷ Initial Investment Putting the values in formula: PI = (63,040 + 300,000) / 300,000) ; PI = 1.2 Or it is also calculated by another formula Profitability index = Present value of future cash flows / Initial investment 63,040/300,000 = 0.21 Internal rate of return technique (IRR) The IRR represent the discount rate at which the NPV of an investment is zero. As such it represents the breakeven cost of capital. The IRR of gamma plc is 19.32%. it means that at 19.32% the project will be at breakeven. Net present value at 15% = 63,040 Net Present value at 20%: Year 1 £ 2 £ 3 £ 4 £ Net cash flow (145,000) 180,000 215,000 370,000 Discount factor @22% 0.819 _______ 0.671 ______ 0.550 _______ 0.451 ______ Present Values (118,755) 120,780 118,250 166,870 £ Sum of present values of future 287,145 Less Initial investment 300,000 _________ Net Present Value ` (12,855) Negative IRR = L + [N/NL-NH * (H-L)] Where: L = Lower discount rate H = Higher discount rate NL = NPV at lower rate NH = NPV at higher rate Putting values in formula IRR = 15 + [63040/63040+12,855 * (20-15)] IRR = 19.32% Recommendation On the behalf of external consultant of Gamma plc recommendations made separately in relation with calculated results and on the company’s performance in the proposed investment. Net Present Value (NPV) The proposed investment has a positive net present value of £63,040 over four years of operation compared with an initial investment of £300,000 and so according to the NPV rules this it is favorable for Gamma plc to invest proposed investment. The results of other investment appraisal method do not alter this financial acceptability, as the NPV decision rule will always offer the correct investment decision. (ACCA - F9: Financial Management Kaplan page 158) The reason of this is that NPV is always better than other investment appraisal methods in following ways NPV always consider cash flows NPV consider the whole life of an investment project NPV consider the time value of money NPV is an absolute measure of return NPV links directly to the objective of maximizing shareholder’s wealth NPV always offer the correct investment advice NPV can accommodate changes in the discount rate NPV has a sensible re-investment assumptions NPV can accommodate non-conventional cash flows Payback Method The company has payback and discounted payback targets, but these are not a guide to project acceptability because of shortcoming of payback as an investment appraisal method. The directors set payback level of all the projects of the company is 3 years but proposed project is the payback period of approximately 3 years and 7 months. But this factor cannot affect the investment decision because it is mentioned in the accounts that there is no level of sales in year 1. But outflows remain unchanged at first year. That can be a reason of late payback period. It is possible that if the project will generate inflow for year 1 than there would be clear decrease in payback period of Gamma plc. The main problem with the payback proposed investment is that payback ignores the overall profitability of a project by ignoring cash flows after payback reached. In this case the benefits after the payback life are ignored. The discounted payback period of Gamma plc is 3.7 and is a significant proportion of the forecast life of the investment of four years, a time period which the information provided suggests is limited. The sensitivity of the sale level in year 1 should be analyzed for better payback figures. Internal rate of return (IRR) The internal rate of return (IRR) method also recommends accepting the investment proposal, since IRR of 19.32% is greater than the 15% return required by Gamma Plc. In general if the advice offered by IRR is differed from that offer by NPV method, the advice offered by the NPV method would be preferred. IRR uses discounting in a slightly different way to determine the probability of an on investment. The internal rate of return is defined as the discount rate at which the net present value equals zero. In the case of Gamma plc the IRR of 19.32% means that if the cost of capital exceeds by 4.32% then the investment would generate a negative NPV. Simply if the company is currently can afford to see its cost of 15% on its investment funds, then company can afford to see its cost of capital rise by 4.32% before the investment will become financially non-viable. This result shows that it is financially viable to continue with the project because IRR is a discounted cash flow method and so takes account of the time value of money.it also consider cash flow over the whole of the project life and is sensitive to both amount and timing of cash flows. Return on capital employed (ROCE) The calculated return on capital employed of 30% is greater than the return required by directors of Gamma plc. This figure also shows the project viability. The accounting rate of return can be calculated with different approaches. As in above calculations accounting rate of return is calculated by two ways. This depends on the Gamma plc that which method they used in their accounts figure Risk Factors for Gamma Plc As with the investment appraisal techniques the proposed investment project is financially viable for Gamma plc but there are also some risks associated with this project. As stated in mentioned information that appraisal should be based on the figure excluding taxation and inflation. Effect of Inflation: In the current economic system the inflation rates are increasing day by day. The project has the life of four years and inflation rates can change the accounts figure. For example Material price can be increase due to inflation. It is recommended for the management that before finalizing the project include inflation factor in investment appraisal techniques to get more accurate and appropriate results. For this purpose forecasts of future inflation of sales and variable cost should be prepared, So that a nominal NPV evaluation can be undertaken. This evaluation should employ a nominal cost of capital. It is not stated in the information that is prepared by accounts department of Gamma plc that whether 15% cost of capital is in real or nominal terms. Effect on Taxation: it is assumed that there is no tax during the whole life of the project. Practically it is not possible. For the purpose of more accurate evaluation management of Gamma plc should include tax amount in the Investment appraisal methods. For example use after tax cash flows for Net present value calculations. General recommendations on the results As it is previously stated that NPV rule will always prefer on the other methods so we can say that project is financially viable. In addition further investigations should also be made by Gamma plc for the no level of sale in year 1 because this factor directly effected on the results of other investment appraisal methods. Companies own goals and objectives can alter this decision because if the company is thinking to boost up their sales and profit levels on short term basis then the project is unfavorable for Gamma plc, but if the company is planning for the long term success it must be financially viable. Gamma plc should also consider the effect of inflation and taxation because in current economic conditions it is necessary to make account for every change to compete the other competitors at best level. References ASSOCIATION OF CHARTERED CERTIFIED ACCOUNTANTS (GREAT BRITAIN). (2009). Financial management. Wokingham, Berkshire, Kaplan Pub. BPP LEARNING MEDIA. (2010). Acca - f9 financial management: revision kit. [S.l.], Bpp Learning Media. BPP LEARNING MEDIA. (2008). Acca - F9: Financial Management I-learn. Gardners Books. (2008). ACCA, 2008/09. Paper F9, Financial management (FM). Wokingham, Kaplan Publishing. MOTT, G. (1993). Investment appraisal. Pitman. (2010). F9 financial management fm - complete text. [S.l.], Kaplan. STEWART, W. A., & FLANAGAN, J. (1989). Rates of return of projects: a present value return as an alternative to the internal rate of return. Kingswood, N.S.W., University of Western Sydney. VANDENBORRE, R. (1998). Net present value and real options. Leuven, Katholieke Universiteit Leuven, Departement Toegepaste Economische Wetenschappen. BEENHAKKER, H. L. (1996). Investment decision making in the private and public sectors. Westport, Conn, Quorum Books. Read More