I.Investment_Appraisal_Should_Add_Value_to_the_Business_Entity

MBA FOUNDATION PROGRAM ACCOUNTING & DECISION MAKING TECHNICS ASSIGNMENT Group A B0212SZSZ1110 Mustapha BELAROUSSI 17/02/2011 I. Investment appraisal should add value to the business entity' I do agree with the statement that Investment Appraisal add value to the business entity. First of all, any business needs funds to start its activity; it is called capital in business language or investment, which will be used to purchase machines, assets or building for the company. Then, the most important goal for any firm is generating profits. There is a remaining question: why does a company want to make profit' Here are the many reasons: ➢ Survival of the company ➢ Paying the shareholders ➢ Re-investment ➢ Retained profit ➢ Invest in loss projects While starting-up, a company needs to take resolutions for making the capital investment, according to the projects over a period of time, that’s why the company should take the decision for a long-term basis. There are 04 different ways to make an investment on an Investment Appraisal. It is a part of finance: • ARR= Accounting Rate of Return • PBP= Pay Back Period • NPV= Net Present Value • IRR= Internal Rate of Return There are two kinds of investment appraisal which are shown below: Pay Back Period: PBP calculates the time of getting the initial investment back over a period of time. The project with a less PBP is accepted. It is an easier way to calculate the return period. The PBP, NPV and IRR use cash flows and are considered as objective methods. The ARR uses profits, and is considered as a subjective method. To conclude with, businesses have to go through this approach to make an efficient decision and follow on competing in this harsh economic climate. II. What is the payback period of each project' Definition: The payback period is the length of time required to recover the cost of an investment. It is calculated as: - Project A: Y Cash flows Cumulative cash flow Payback period 1 22 22 PBP = 3 + ((125-96)/52) 3.557692 2 31 53 3 43 96 4 52 148 5 71 219 3 years 6 months and 20 days ==> Proposal A: P.B= Year 1 + Year 2 + Year 3 + X months from Year 4 P.B= 3 years +(£125,000 - £96,000)/ £52,000 P.B= 3.55 years ==> P.B= 3years, 6 months and 20 days. -Project B: Y Cash flows Cumulative cash flow Payback period 1 43 43 PBP = 2 + ((125-86)/43) 2.9069767 2 43 86 3 43 129 4 43 172 5 43 215 2 years 10 months and 26 days ==> Proposal B: P.B= £125,000 / £43,000 P.B= 2 years, 10 months and 26 days. Payback method shows clearly that proposal A goes against the company’s policy of three years, so the project A will be rejected. Therefore, project B is acceptable since it matches the period set by the board. III. What are the criticisms of the payback period' Payback period does not take in account the value of any cash flows once the initial investment has been repaid. For example, two projects could both have a payback period of four years, but one might be expected to produce no further return after five years, while the other might continue generating cash indefinitely. Although payback period focuses on relatively short-term cash flows, it fails to take into account the time value of money. In reality, the first is likely to be a riskier and less attractive investment. ➢ The disadvantages of the payback period are: • It ignores the timing of the cash flows within the payback period, the cash flow after the end of payback period and therefore the total project. • It ignores the time value of the money. It means that it does not take into account that one pound today is worth more than one pound in one year time. • It is unable to distinguish between projects with the same payback period. • It may lead to excessive investment is short-term projects. IV. Determine the Net Present Value NPV for each proposal' Definition: The Present Value of an investment’s future net cash flows minus the initial investment. If positive, the investment should be made unless an even better investment exists, otherwise it should not. - Project A: initial investment for both projects is £125,000.00 Y Project A Discount factors Present value 1 22,000.00 0.8929000 19,643.80 2 31,000.00 0.7929000 24,579.90 3 43,000.00 0.7118000 30,607.40 4 52,000.00 0.6355000 33,046.00 5 71,000.00 0.5674000 40,285.40 Cumulative present value 148,162.50 NPV 12% 23,162.50 The project A has a positive NPV of £23,162.50 for a 12% cost of capital. - Project B: initial investment for both projects is £125,000.00 Y Project B Discount factors Present value 1 43,000.00 0.8929000 38,394.70 2 43,000.00 0.7929000 34,094.70 3 43,000.00 0.7118000 30,607.40 4 43,000.00 0.6355000 27,326.50 5 43,000.00 0.5674000 24,398.20 Cumulative present value 154,821.50 NPV 12% 29,821.50 The project B has a positive NPV of £29,821.50 for a 12% cost of capital. Both of the projects could be accepted by AP Ltd. Referring to their positive NPV with 12% cost of capital. But, the project B is the most profitable investment and it permits a higher added value than the project A. V. Describe the logic behind the NPV approach' NPV allows valuing a company’s assets at their correct current value, usually at year-end. The calculation of NPV takes into account the assets original cost, less all accumulated depreciation allowed against that asset in previous tax computations. As an example, one pound today is worth more than one pound in the future. If we are considering a project with future cash flows, we want to roll back the projected amounts at our cost of capital to see if the project is worth pursuing. If the number is positive unless we have limited funds, then we need to choose the projects with the highest numbers until we run out of money. The present value for each year will be as follows: ==> Y1 = 1 / [1 + i] ==> Y2 = 1 / [1 + i] ^ 2 = Y1 / [1 + i] ==> Y3 = 1 / [1 + i] ^ 3 = Y2 / [1 + i] ==> . ==> YN = 1 / [1 + i] ^ N = Y (N - 1) / (1 + i) Total Present Value = Y1 + Y2 + Y3 + ... + YN. The next step is to deduct the initial investment from the total present value: [(Y1 + Y2 + … + YN) - initial investment]. If NPV > 0, Accepted. If NPV < 0, Rejected. If NPV = 0, May accepted or rejected, as explained before. Therefore, NPV is always consistent with wealth maximization of the shareholder’s and it shows a positive benefit towards them. There is positive relation between NPV and shareholders’ wealth. VI. What would happen to the NPV if: 1) The cost of capital increased: NPV decreased: why' Because the cost of capital and the rate of interest are increased, then the present value of the cash inflows is decreased. As we know that the NPV is the difference between Total Net Present Value of the Cash inflows and the initial outlay. TNPV is the multiplicative outcome of Present Value Interest Factor and Cash inflows. ==> PVIF= 1/ (1+Cost of Capital)*Year So, the increase in the Cost of Capital leads to decrease the value of the Present Value Interest Factor and Net Present Value also decreases. 2) The cost of capital decreased: the Net Present Value Increase: why' Because, the cost of capital decreased, the Net Present Value increased, due to the increase in present value of the cash inflows. It is the function of PVIF ==> PVIF=1/(1+r)*T VII. Determine the IRR for each project. Should they be accepted' “The internal rate of return (IRR) method is also based on discounting. It is very similar to the NPV method, except that instead of discounting the expected net cash-flows by a predetermined rate of return, it estimates what rate of return is required in order to ensure that the total NPV equals the total initial cost.”1 ==> IRR = A + [(B / (B + C)) * (D - A)] A = positive rate. B = positive NPV. C = negative NPV with the absolute value. D = range of rates. - Project A: NPV (15%) Y Project A £000 Discount factors Present value 1 22,000.00 0.8695652 19,130.4348 2 31,000.00 0.7561437 23,440.4537 3 43,000.00 0.6575162 28,273.1980 4 52,000.00 0.5717532 29,731.169 5 71,000.00 0.4971767 35,299.5482 Cumulative Present Value 135,874.8034 NPV15% 10,874.8034 ==>NPV (15%) is positive. NPV (20%) Y Project A Discount factors Present value 1 22,000.00 0.8333333 18,333.3333 2 31,000.00 0.6944444 21,527.7778 3 43,000.00 0.5787037 24,884.2593 4 52,000.00 0.4822531 25,077.160 5 71,000.00 0.4018776 28,533.3076 Cumulative Present Value 118,355.8385 NPV 20% -6,6441.615 ==> NPV (20%) is negative. IRR (project A) = 15 + [(10,874.8034 / (10,874.8034 + 6,644.1615)) * 5] ==> IRR (project A) = 18.10372315%. The IRR for the project A has been found superior to the cost of capital, which is equal to 12%. So, the project A should be accepted. Project B: NPV (20%) Years Project B Discount factors Present value 1 43,000.00 0.8333333 35,833.3333 2 43,000.00 0.6944444 29,861.1111 3 43,000.00 0.5787037 24,884.2593 4 43,000.00 0.4822531 20,736.8827 5 43,000.00 0.4018776 17,280.7356 Cumulative Present Value 128,596.3220 NPV 20% 3,596.3220 ==> NPV (20%) is positive. NPV (25%) Y Project B Discount factors Present value 1 43,000.00 0.8000000 34,400.0000 2 43,000.00 0.6400000 27,520.0000 3 43,000.00 0.5120000 22,016.0000 4 43,000.00 0.4096000 17,612.8000 5 43,000.00 0.3276800 14,090.2400 Cumulative Present Value 115,639.0400 NPV 25% -9,360.9600 Once the NPV (25%) has been calculated, the result was found negative. IRR (project A) = 20 + [(3.5963220 / (3.5963220 + 9.3609600)) * 5] ==> IRR (project B) = 21.38776095% As long as IRRs exceed the cost of capital (12%) the project with the higher IRR might appear to be the preferred choice. In the actual appraisal all proposals show an IRR higher than the cost of capital, thus all projects can be accepted. The company has to focus on exclusively one project, which it will be proposal B, because it offers a much higher IRR (21.38%). Summary: Appraisal Technique Proposal Payback Period NPV IRR A £125,000 3years 6 months and 20 days. £23,162.50 18.10% B £125,000 2 years 10 months and 26 days £29,821.50 21.38% VIII. How does a change in the cost of capital affect the project’s IRR' The IRR is the rate of return of a project related to the NPV equal to zero. It is a constant and could not be affected by an increase or a decrease in the cost of capital. Nonetheless, the change in the cost of capital can affect the acceptance of a project. In fact, if the cost of capital increases above the IRR then the project will be rejected, but if the former decrease under the latter, then the project should be accepted. All in all, the fluctuation of the cost of capital does not affect in any terms the IRR itself but related to this one, a project can be jugged as acceptable or refutable. XI. Compare the effectiveness of the NPV method with IRR method: ==> Advantages and Disadvantages of the NPV and IRR Methods: While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages. Advantages: o With NPV it is a direct measure of the dollar contribution to the stockholders. o With IRR it shows the return on the original money invested. Disadvantages: o With NPV: the project size is not measured. o With IRR: at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The multiple IRR problems can also be an issue, as discussed below. The Multiple IRR Problem: A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital). This is known as a non-normal cash flow, and such cash flows will give multiple IRRs. References: • Walther, L.M & Skousen C.J. (2009) Budgeting and Decision Making. • Glen Arnold CORPORATE FINANCIAL MANAGEMENT second edition Prentice Hall Financial Times. • Google Books: INVESTMENT APPRAISAL & FINANCING DECISIONS Third Edition Stephen Lumby. • Dyson, J.R. (2010) Accounting for Non-Accounting Students, (8th edn) FT Prentice Hall. • http://www.allbusiness.com/glossaries/internal-rate-return-irr/4944020-1.html • http://www.investopedia.com/study-guide/cfa-exam/level-1/corporate-finance/cfa13.asp