Investment Appraisal Techniques - Case Study Example

Student’s Name Professor’s Name Course Date Introduction Several organizations face challenges for the duration of deciding on the viable project to venture in as the shareholders expect higher returns on their investment. This paper prepares a report on Net present value, concept of payback period, , internal rate of return and the accounting rate of return as investment consideration techniques that are suitable for the investing companies. Net Present Value (NPV) NPV denotes the difference between the inflows of cash at the current value and the outflows of cash at the moment value. The concept is useful within the capital budgeting to an evaluation of profitability in a projected development plan. The formula for computing Net Present Value is shown below. In the above formulae, Ct refers to the net cash inflow in the course of period t Co refers to the total initial investment outlays. r denotes the rate of discount rate T is the sum of time periods Advantages The Net present value method is primarily benefitial in that it allows the investors to determine whether the project is worth or not. When the net present value is positive, the concept gives an indication that the incomes that were anticipated and had been made by the project surpass the expected costs. In general, the investment that yields a positive NPV sends a signal to the investors that it is a profitable project. On the other hand, the one with a negative NPV delivers a net loss. The notion is the foundation for the rule of Net Present Value that decrees that only the projects that demonstrate positive Net present value should be considered for investment (Phillips and Burkett 68). The impression of coming up with the value of a development plan remains challenging for the reason that there are different ways to mark the value of impending cash flows. In the present, the value of money is quite higher than the same amount in future due to the time value of money. It is both as a result of earnings that would hypothetically be generated using the money for the duration of intervening as well as the factor of inflation. In fact, a dollar that will be earned in future will not be worth as the one earned now.The discount rate constituent of the Net Present Value formula is a technique to justify this concept. The corporations might have diverse approaches of recognizing the discount rate. However, the primary methods for evaluating the discount rate comprise of taking into account the expected return model of additional investment adoptions with the same level of risk or the expenditures related to the borrowing money required for funding the project. For instance, when a clothing trade wishes to buy an existing store with a present lump-sum value of $500,000, the retail would first approximate the cash flows that will accrue in future through the warehouse and therefore discount the same cash flows (r). If the proprietor were ready to trade the trade for at least $500,000, the acquiring enterprise would possibly agree to take the offer because it presents a positive Net Present Value deal. If the holder made up his mind to vend it for $300,000, the stock exemplifies a net increase of $200,000 for the duration computed investment period computed for. The net gain of this investment-$200,000 , is referred to as the venture’s intrinsic value. On the other hand, if the owner decides not sell for a lesser amount of $500,000, the customer would decide not to accept the deal since the acquisition would indicate a negative NPV. Consequently, it would diminish the whole value of the superior clothing business. Drawbacks One of the challenges related with evaluating an investment’s lucrativeness with NPV is that the concept of NPV relies significantly on various approximations and assumptions. It creates room for the occurrence of inaccuracies, errors, and mistakes. The estimated factors consist of the costs associated with the common projects, the discount rate as well as elements of expected returns. The investment may need unanticipated outflows to embark on the foundation or call for the additional expenses at the end of the project. Also, the estimations of cash inflow together with discount rates possibly will not essentially constitute the risk related to the venture and might assume the extreme capital inflows through the investment period. It can take place as a way of artificially raising the confidence of an investor. In view of these, it becomes necessary for the investor to be accustomed to making up the unforeseen overheads and losses or else for excessively enthusiastic cash inflow predictions. Recommendations It is important to consider the present worth of an investment as a way of predicting its profitability. Net present value creates a hypothetical gauge for this valuation. This gauge relies on approximations and assumptions. It thus recommended for the investor to understand how these approximations and assumptions may affect the investment. There is also an element of risk with the valuations of the venture. There is a possibility that the rate of return on investment could afterward experience a sharp rise or otherwise. One will thus need to be prepared to make up for future costs and losses. Payback Period A payback period refers to the amount of time needed to get back the initial resources put into an investment. An investor using this appraisal means is usually focused on the time it would take for the investment to return the initial capital he/she invested. It is a crucial contributing factor of whether to embark on the situation or project since extended payback periods usually are not needed for investment stations. It overlooks the time value of money which is not common to other ways and means of capital budgeting such as net present value, discounted cash flow and internal rate of return. Payback period remains the primary metric that is often used as a substitute for the net present value (Tunaru 98). It is considerably simpler than Net Present Value, mostly appraising the time needed for the project to yield back the initially invested resources. Therefore, payback periods computed for extensive investments demonstrates higher possibilities of erroneousness because they incorporate more time for the duration of which inflation could come about and twist projected incomes. For example, a firm X invests $10 million in an investment that saves the corporation $2.5 million every single year. The payback period is computed by dividing $10 million by $2.5 million which gives the answer as four. It means that it will take a period of four years to earn back the venture. An alternative project with an outlays of $2 million will not save the firm’s money. However, it will yield the establishment an incremental $1million annually for the subsequent twenty years, which in this case is $20 million. Obviously, the second project possibly will make the firm the twice amount. Nonetheless, it becomes important to ask ourselves the period it will take to get back the investment (Bala 77). The response to this question is $2 million divided by $1 million which is two years. From this two example, the second project takes a smaller amount of time to pay back and also generates the establishment more money and therefore it is better than the first one based merely on the payback. Advantages Most of the finance in several companies should be concerned with capital budgeting. The major models that all financial specialists of corporates learn are the way of valuing diverse, effective projects. They should comprehend the consistent way to conclude the best lucrative project or speculation to carry out. It should be done through with the payback period. Drawbacks Most of the capital budgeting methods incorporate the time value of money. It is the indication that monies in hand in the present day is worth more than its future as it can be devoted and generate money from the investment. For that reason, if one pays an investor tomorrow, it should embrace an opportunity cost (Shapiro 58). This conception dispenses a value to the opportunity cost. On the other hand, the payback period by no means concerns itself with the element of the time value of money. Recommendations The time value of money should remain overlooked in the payback method, computed by calculating the total years it takes to get back the cash spent initially for the investment. For example, if it takes a period of seven years for the deal to earn back the initial capital, then the payback period will be seven years. The analysts should prefer the payback technique for its simplicity and approach it as a supplementary direction in the capital budgeting resolution framework. Internal rate of return (IRR) Internal rate of return is an alternative metric usually used as an NPV substitute. The computations of internal rate of return are done with a similar formula as in NPV but with minor alterations. The calculations of internal rate of return undertake an unbiased Net Present Value denoting a zero value. It is feasible that the discount rate of a project while Net Present Value is zero designates investment’s Internal rate of return (Phillips and Burkett 95). In essence, it signifies the expected rate of progression of the investment. This method is associated with the anticipated returns on an annual basis. It creates room for the abridged assessment of a comprehensive range of sorts and intervals of investments. Advantages Practically, internal rate of return can be used to give the comparison between the projected productivity of a three-year investment and a ten-year investment simply because it gives the idea of the annualized number. For instance, if the two of them have an internal rate of return of 18%, the projects are indefinite compliments that are the same regardless of the duration difference. Nonetheless, the same concept is not correct for NPV. Net Present Value subsists its worth on its own relating the totality of an anticipated investment duration, unlike internal rate of return. If the period of investment is more than a year, then NPV will not incorporate the rate of earnings through the means that allow simple evaluation. From the above example, the ten-year investment would yield a greater NPV than the three-year investment, but it is not necessarily useful information (Wiley 112). It is because the former is three times more than the later and there is a significant amount of speculation chance in the seven years' difference amongst the two projects. It is clear that each and every company looks forward to initiating new ventures that have a high internal rate of return. The point evidence that higher internal rate of returns brings high percentage returns on investments. For that reason, internal rate of return is very beneficial in the grounds of decision-making instrument for circumstances that take account of a distinct project or various projects (Burger 55). When the corporation is gauging one project, it considers the internal rate of return, discards or agrees to take the scheme founded on the affiliation flanked by its internal rate of return and the company's least required return. If the establishment is weighing numerous projects, it contemplates each project’s internal rate of return and selects a combination of projects that promises the uppermost joint IRR. If at least two development plans are mutually exclusive, implying that choosing one plan will prevent the other project being taken, then the corporation does the project that has the highest IRR. Drawbacks The internal rate of return never takes the general scope of a scheme's investment or return into consideration. Even though internal rate of return is a correct point of reference for the administrative decision making, the leaders of organizations consider the magnitude that dollar will yield. For instance, an insignificant project may have a great internal rate of return percentage-wise but then again a low return dollar. On the contrary, a great project may have a less significant IRR nonetheless have a considerable larger dollar profit, making it a smart investment. Recommendations We should not believe that internal rate of return to guarantees the rate of growth that a venture is likely to generate. The positive rate of return which a specified project ends up yielding should be considered to contrasts from the estimated rate. It is because the project that has a considerably greater internal rate of return value than other accessible opportunities would as well deliver a better opportunity of development. The most widely held use of internal rate of return is exhibited in the comparison of the viability of inaugurating new maneuvers with that of intensifying the old ones (Wiley 113). A good example may be based on an energy enterprise using the internal rate of return in determining whether it will be sustainable to establish a new power plant or take the decision of refurbishing and enlarging the existing one. Despite the fact that the two projects are expected to enhance and add value to the firm, there is a possibility of one being more rational decision than the other as approved by internal rate of return. Accounting Rate of Return (ARR) Accounting rate of return refers to a financial ratio which is used in capital budgeting. It computes the gain produced from the net returns of the projected capital investment. The Accounting Rate of Return is a proportion return (Arnold 89). For instance, if ARR = 5%, the project is anticipated to earn five cents out of every dollar invested in every year. If the ARR is equivalent to the needed rate of return or if it is greater than the required, then it will be feasible to accept the project (Brouwers, et al. 93). It will be viable to reject the plan if the ARR is less than the required rate. In the situations of comparing the investments, the greater the ARR, the more it will be attractive. Advantages It is simple to use the ARR in the calculations of an organization’s profits. It is beneficial in the general evaluation of numerous projects since it is an essential computation on how the project is proceedings. Drawbacks This method is founded on profits instead of cash flow. It disregards the cash flow from the investment. Consequently, non-cash items like depreciation can affect the accounting rate of return in profit computations (Tunaru 72). The alteration of depreciation methods may be executed leading to higher profits. The method does not change the risk to long term estimations. In addition, it does take the time value of money into consideration. Recommendations Even though several organizations seems to avoid the method of ARR, it necessary to consider it in the calculations of amortizations and depreciations of assets that are committed to the investments. It should also be adopted in the computations of working capital. Conclusion Having evaluated the techniques of capital investments evaluation, it is clear that each has its flaws and challenges. To begin with, each has calculations that take into account certain assumptions. That said, an investor has to make his decision for an appropriate method. Being an investor, I would take to use the net present value. This method provides remedy for the flaws of using accounting rate of return and payback period. This method accounts for the time value of money as well as all future cash flows in order to determine an investment’s worth. Thus, it is possible to compare the value of the money to be invested with what it will be worth in future. Simply put, an investor is able to know the relationship of his dollar today and the dollar in future. The futuristic accounting may be weakened by unforeseen future happenings. In view of this, one can determine the value by doing calculations over a range of scenarios considering best and worst likely. Works Cited Arnold, Glen. Corporate Financial Management. Pearson, 2013. Bala, Anju. Microsoft Dynamics Nav 2016 Financial Management: Master the World of Financial Management with Microsoft Dynamics Nav 2016. 2017. Brouwers, Rien, et al. Basics of Financial Management: Exercises. Noordhoff uitgevers, 2015. Burger, Robert H. Financial Management of Libraries and Information Centers: A Professional Resource. 2017. Phillips, Patricia P, and Holly Burkett. Data Conversion: Calculating the Monetary Benefits. 2016. Shapiro, Alan C. Multinational Financial Management. J. Wiley, 2014. Tunaru, Radu. Model Risk in Financial Markets: From Financial Engineering to Risk Management. 2015. Wiley. Wiley Cpaexcel Exam Review January 2016 Course Outlines: Business Environment and Concepts. Wiley, 2015. Read More