A Breakdown of Investment Appraisal Methods, Associated Questions and Answeress
LONDON SCHOOL OF COMMERCE. | ASSIGNMENT ON ACCOUNTING AND DECISION MAKING TECHNIQUES| | QUINCY| 4/20/2011| (A) Why is investment appraisal process so important? Answer Capital investment involves the commitment of large amounts of company resources, which will necessitate careful evaluation to be undertaken before a decision is reached. The investment appraisal process helps managers make the right investment decisions as regards what projects to invest in to maximize shareholders wealth in the long and short run.
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Seeing how difficult and extremely expensive it would be to reverse an investment decision, the investment appraisal process equips one with strategic and tactical skill-set to exercise care in making informed initial investment decisions. Also, as projected future benefits and cost are difficult to predict the risk and uncertainty of taking a medium to long-term investment can be high.
The knowledge of Capital investment process can help non-accountants better interpret information and constructively question recommendations received from their accounts so as to make the appropriate investment decision as opposed to just doing what they are told by the accountant. (B) Calculate the payback period for project A. Payback period is defined as the amount of time it takes for a project to pay for itself or the length of time it take to recover the cost of an investment. PROJECT A Initial Investment: The amount of money a business invests in a capital investment project.
It can be sourced from various means such as banks or shareholders funds. It is given as ? 115,000 NO OF YEARS(YR)| NET CASH FLOW (NCF)| CUMMULATIVE NET CASH FLOW(CNCF)| 1| 38,000| 38,000| 2| 42,000| 80,000| 3| 48,000| 128,000| 4| 50,000| 178,000| 5| 70,000| 248,000| Payback period = 2 + 115,000 ? 80,000 48,000 = 2 + 35,000 48,000 = 2years + 0. 7291 ? 12 months of a year. = 2 years 8. 7 month = 2years and 8 months PROJECT B Payback period for project B has a constant net cash flow (NCF) referred to as, Annuity. Taking the annuity factor into consideration payback period (B.
P. B) is calculated as P. B. P = Initial investment = 115,000 Net cash flow 43,000 = 2. 6744 = 2 years and 7 months DECISION If the company were to choose between investing in one of the projects A and B, the company should choose the project with the shortest payback period which is project B. However, if the company has retained earnings to invest in more than one project at a time the can invest in both projects A and B. (C) What are the problems of payback period? Payback period is the amount of time it takes to breakeven on an initial investment.
The returns from a project or investment in a given is usually measured in net cash flow terms. Net cash flow is the difference between cash received and cash paid over a defined period of time. It is associated with the following problems. Payback period measures the rate at which the original investment is recovered in net cash flow terms. This implies that non-cash flow items are not taken into account such as depreciation, losses and Profit from sales of fixed assets. Payback period has difficulty in estimating the amount and timing of instalments due to be paid on the original investment.
Payback period has difficulty in determining an appropriate rate of interest as it is an estimated time frame for a project to recover the initial investment. Also net cash flows received after payback period is ignored. (D) Determine the NPV for each of these projects? PROJECT A INITIAL INVESTMENT = ? 115,000. YEARS(YR)| NET CASH FLOWS(NCF)? | DISCOUNTING FACTOR (DF)11. 5%| NET PRESENT VALUE (NPV)? | YR1| 38,000| 0. 897| 34086| YR2| 42,000| 0. 804| 33768| YR3| 48,000| 0. 721| 34608| YR4| 50,000| 0. 647| 32350| YR5| 70,000| 0. 580| 40600| TOTAL NPV| | | 175412|
LESS INITIAL INVESTMENT| | | 115,000| NET NPV| | | ? 60,412| PROJECT B The net cash flows for each year in this project are constant i. e. Annuity NPV for project B considering Annuity factor is calculated as NET CASH FLOW ? ANNUITY (AF) – INITIAL INVESTMENT. ANNIUTY FACTOR (AF) is calculated as 1 – (1+ R) ^ ? N R WHERE: N =NUMBER OF YEARS AND R = INTEREST RATE = 1 – (1+ 0. 115) ^ ? 5 = 1 – (1. 115) ^ ? 5 = 1? 0. 580 = 0. 42 0. 115 0. 115 0. 115 0. 115 AF =3. 625 NPV = 43,000 ? 3. 625 – 115,000 = 157,036 – 115,000 = ? 42,036 DECISION
The NPV method recognizes the importance of cash received today as opposed to taking the risk future cash payments which are subject to variable factors such as interest rate and inflation. Therefore between projects A and B, the company should accept project A as it has the highest NPV. However, if the company decides to focus employee safety and welfare and other non-financial factors the can accept both project A and B even if project B has a lower NPV. (E) Describe the logic behind the NPV approach. The Net present value (NPV) can be said to be one of the most acceptable methods of capital investment appraisal.
It takes into consideration the timing of net cash flows, profitability of investment or project and returns on initial investment. Usually, when a choice is to be made between projects competing for scarce resources/capital a company is disposed to accepting the one with a higher NPV figure. But sometimes depending on objectives or goals that company’s set out to achieve as regards capital rationing and employee safety and welfare projects with lower or negative NPV can be accepted. (F) Discuss the relationship between NPV and cost capital.
The Net present value in relation to the cost of capital reveals the existence of an inverse relationship between the two concepts. If there is an increase in the cost of capital it would result in a decrease in NPV in almost equal proportion. Hence, companies will be least likely to invest in a project with a high cost of capital because the net present value will be low and would not maximize shareholders wealth. A company that is unable to source cheaper means of getting capital relative to existing competitors stands the risk of losing its market share as it would be unable to expand or acquire fixed assets. G) Calculate the IRR for each project. Should they be accepted? The internal rate of return (IRR) is referred to as project returns in discounted cash flow terms. It attempts to determine the rate of return required to ensure that total NPV equals total initial investment i. e. the cost of capital at which NPV equals zero. For NPV AT 11. 5% cost of capital/interest rate……………… ? 60412 Since IRR is an estimate and not exact we interpolate while constantly increasing the interest rate/cost of capital by 5% using the lowest positive and highest negative NPV figures.
NPV AT 16. 5% cost of capital/interest rate…………………?? Discounted factor (DF) = (1+0. 165) ^N Where N = number of years Initial investment =115,000 NUMBER OF YEARS(YR)| NET CASH FLOW(NCF)? | DISCOUNTED FACTORS(DF)FOR 11. 5%| NET PRESENT VALUE (NPV)? | Yr1| 38,000| 0. 858| 32604| Yr2| 42,000| 0. 737| 30954| Yr3| 48,000| 0. 632| 30336| Yr4| 50,000| 0. 543| 27150| Yr5| 70,000| 0. 466| 32620| TOTAL NPV| | | 153,664| LESS INITIAL INVESTMENT| | | 115,000| NPV AT 16. 5%| | | ? 38,664| NPV AT 21. 5% Discounted factor (DF) = (1+0. 215) ^N Initial investment =115,000
NUMBER OF YEARS(YR)| NET CASH FLOW(NCF)? | DISCOUNTED FACTORS(DF)| NET PRESENT VALUE (NPV)? | YR1| 38,000| 0. 823| 31274| YR2| 42,000| 0. 677| 28434| YR3| 48,000| 0. 558| 26784| YR4| 50. 000| 0. 459| 22950| YR5| 70,000| 0. 378| 26460| TOTAL NPV| | | 135,902| LESS INITIAL INVESTMENT| | | 115,000| NPV AT 21. 5%| | | ? 20,902| NPV AT 26. 5% Discounted factor (DF) = (1+0. 265) ^N Initial investment =115,000 NUMBER OF YEARS(YR)| NET CASH FLOW(NCF)? | DISCOUNTED FACTORS(DF)FOR 11. 5%| NET PRESENT VALUE (NPV)? | YR1| 38,000| 0. 791| 30058| YR2| 42,000| 0. 625| 26250|
YR3| 48,000| 0. 494| 23712| YR4| 50,000| 0. 391| 19550| YR5| 70,000| 0. 309| 21630| TOTAL NPV| | | 121,200| LESS INITIAL INVESTMENT| | | 115,000| NPV AT 26. 5%| | | ? 6,200| NPV AT 31. 5% Discounted factor (DF) = (1+0. 315) ^N Initial investment =115,000 NUMBER OF YEARS(YR)| NET CASH FLOW(NCF)? | DISCOUNTED FACTORS(DF)FOR 11. 5%| NET PRESENT VALUE (NPV)? | YR1| 38,000| 0. 760| 28880| YR2| 42,000| 0. 578| 24276| YR3| 48,000| 0. 439| 21072| YR4| 50,000| 0. 334| 16700| YR5| 70,000| 0. 254| 17780| TOTAL NPV| | | 108,708| LESS INITIAL INVESTMENT| | | 115,000| NPV AT 31. %| | | ? (6,292)| From the NPV analysis we have NPV at26. 5% = 6,200 NPV at 31. 5% = (6,292) IRR = 26. 5% + 6,200 ? 5% 6,200 – (6292) 26. 5% + 6200 ? 5% 6200+6292 26. 5% + 6200 ? 5% 12492 26. 5% +0. 496 ? 5% 26. 5% +2. 48 % = 28. 98% IRR PROJECT B The cash flows for project B are constant for each year i. e. Annuity, taking this into consideration Annuity factor (AF) = 1 – (1+ R) ^ ? N R WHERE: N =NUMBER OF YEARS AND R = INTEREST RATE NPV AT 11. 5%……………… ?42,302 NPV AT 16. %…………..? AF = 16. 5% = 1 – (1 + 0. 165) ^ ? 5 = 1? 0. 466 = 0. 534 = 3. 236 0. 165 0. 165 0. 165 Therefore NPV = (43,000 ? 3. 236) – 115,000 139148 – 115000 = ? 24128 At 21. 5% AF = 1? 0. 378 = 2. 893 0. 215 Therefore NPV = (43000 ? 2. 893) – 115,000 = 124399 – 115,000 = ? 9399 At 26. 5% AF = 1 – (1. 265) ^ ? 5 = 1? 0. 309 = 0. 691 = 2. 608 0. 265 0. 265 0. 265 Therefore NPV = (43,000 ? 2. 608) – 115,000 112144 – 11500 = ? (2856) From the NPV analysis we have
NPV At 21. 5%…………….. 9399 NPV At 26. 5 %……………… ( 2856) Therefore IRR =21. 5% + 9399 ? 5% 9399 ? (2856) = 21. 5% + 9339 ? 5% 9399 + 2856 = 21. 5% + 9339 ? 5% 12255 = 21. 5% + 0. 762 ? 5% = 21. 5% + 3. 81% = 25. 31% Decision From the IRR analysis we can see that projects A and B both have higher returns than cost of capital (11. 5%) so both projects can be accepted. However if the company is faced with a choice between project A and B project A will be the most likely choice as it has higher internal rate of return. H) How a change in the cost of capital does affect the projects IRR? A change in cost of capital does not necessarily affect the project’s IRR directly per say. A direct effect is on the NPV which in turn affects the IRR. The cost of capital is used to calculate the NPV, and the result is further used to calculate the IRR since IRR is a situation where NPV is equal to zero. However, in most cases if the cost of capital increased, net present value decreases and there will be a corresponding decrease in the project’s IRR and vice -versa.
This depends on certain situation. (I) Discuss why the NPV Method is often regarded to be superior to the IRR method? NPV is considered to be a superior method of capital investment appraisal for the following reasons NPV takes into account the time value of money. This implies that NPV takes into consideration that the value of money changes over time influenced by variables such as interest rate and inflation while the internal rate of return does not take note of such considerations.
Also it is easy to compare the NPV of different projects and to reject projects that do not have an acceptable net present value, compared to IRR method that has difficulty in determining two rates within a narrow range, and gives only an approximate rate of return. In complex capital investment situations the IRR method is influenced by different accounting policies and may give misleading results while the NPV calculation is not influenced by different accounting policies. REFERENCE Dyson, J R (2010) Accounting for non-accounting students, eight edition, Pearson educational limited. * Brewster, D. (1997). Business Economics. 1st Edition,London, The Dryden Press BIBLOGRAPHY * Khan, M. Y. (1993). Theory & Problems In Financial Management. Boston: Mcgraw Hill Higher Education. * Douglas R. Et Al (1998) Principles Of Financial Management. Upper Saddle River, NJ, Prentice Hall * Aidan, B. Et Al (1994) Accounting: In A Business Context. 2nd Edition, London: Chapman And Hall (Chapman And Hall Series In “Business In Context”).