Coventry City has been identified by an area of the European Union, we need to further regenerate. The City Council has just completed a 12-month consultation process with residents of the city and other interests, such as corporate, government, and plans to evaluate two possible projects. This article will use different methods to analyse these two projects, and decide which one.
For the two projects, we have calculated the Accounting rate of return (ARR), Payback period (PP), net present value (NPV) and Internal rate of return (IRR). It is possible to find business that use variants of these four methods. We are going to assess the effectiveness of each of these methods but we shall see that only one of them (NPV) is a wholly logical approach. The other three all have flaws. According to the appraisal methods, I suggested that the City Council should invest project 2 (Coventry Toll).
Based on the data, the ARR of project 1 is 12.044%, the Payback period is 6 years and 5 months, the NPV is £3,862,722.989 and the IRR is 13.877%. For project 2, the ARR, PP, NPV and IRR are 15.993%, 5 years and 5 months, £12,370,562.703 and 17.640%, respectively. It is easy to compare the two projects with these data. It is obviously to see that project 2 is better. It is going to analyse and evaluate the advantages and disadvantages of each investment appraisal method to support my answer.
ARR
ARR is the accounting rate of return. The ARR is ratio of the accounting profit to the investment in the project, expressed as a percentage. The decision rule is that if the ARR is greater than, or equal to the hurdle rate, and then accept the project. "This method takes the average accounting operating profit that the investment will generate and express it as a percentage of the average investment made over the life of the project."(Peter Atrill, 2012, p278)
Every coin has two sides. On one hand, it is easy to understand and calculate. At the same time, it is liked because it is based on the accounting principles. Another advantage is familiarity. On the other hand, it does not consider the time value of money; the calculation has its flexibility. And the profit is subjective and does not equal cash. Therefore it can be affected by non-cash items such as the depreciation and debts when calculating profits. From these factors, it is shows the ARR are not a excellent method to adjust the project. And the ARR of each project are 12.044% and 15.993%. Usually it should be the higher ARR the better to choose. So from this method, the Coventry Council should choose project 2.
PP
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment.( Peter Atrill, 2012) It is one of the simplest investment appraisal techniques.
The formula of the payback period of the project depends on each cycle from the project's cash flow is uniform or non-uniform. The decision rules of the project is accepted, if the payback period is less than the trumpet payback period is less than the target payback period. Otherwise, do not accept.
The payback period has certain advantages. First of all, it is a very simple calculation. Second, it can be the measures of the risks inherent in a project. Since the cash flows occur in the life of the project is considered to be more uncertain, the payback period for some of the project's cash inflows signs. For companies facing liquidity problems, it provides a good ranking project, the money back early.
The disadvantage of the payback period is: First, the payback period does not consider the time value of money, which is a serious drawback, because it may lead to wrong decisions. Secondly, the cash flow after the deadline will be ignored. Third, during the closing itself is arbitrary.
NPV
The net present value is the present value of cash flows minus investment. (Brealey, Myers, Marcus, 2012) The net present value rule states that managers increase shareholders'' wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive value. For both project, the NPV are all positive. And the NPV of project 2 is much larger than project 1. So I suggested the City Council to accept project 2.
In addition to the value of considering the strengths and weaknesses of the NPV is essential. First, NPV provides the time value of money. Second, calculate the net present value (NPV) of the cash flow and the life of the project's cash flow over the previous. Formation of this, it is obvious NPV consider than the other three methods. Third, the profitability and risk of the project has given high priority. , NPV helps maximize the value of the business.
NPV is a better way, it has a weakness. Under normal circumstances, NPV is difficult to use. Then, NPV cannot provide accurate decisions, the investment amount of the project if the mute is not equal. In addition, it is difficult to calculate the appropriate discount rate. Finally, NPV may not be able to give the correct decision; the project is the inequality of life.
NPV method is a very important in the decision management. The City Council should consider more about these two projects.
IRR
"The internal rate of return of an investment is the discount rate that, when applied to its future cash flows, will produce an NPV of precisely zero. In essence, it represents the yield from an investment opportunity."( Peter Atrill, 2012)
The same with the other methods, the internal rate of return has its own characteristics. Initially, the perfect use of the time value of the monetary theory of time value of money is the interest, it should be very high, because we are sacrificing money time. What is the IRR, but high interest rates, we expect our investment. Therefore, we can say, IRR is the perfect application of the time value of money theory. After this, all cash flows also. This is a good way, we give equal importance to all of the cash flow may not advance or delay of the capital budget. We just need to create the relationship of the different rates, and would like to know in the present value of where the cash inflows equal to the present value of cash outflows. In addition, there have not selected any particular rate of return, the basis of the internal rate of return. Ultimately, there is no need to calculate the cost of capital. In this method, we do not need to calculate the cost of capital, because the case does not calculate the cost of capital, we can check the profitability of any project.
On the other hand, it is difficult to understand IRR. And, for calculating IRR we create one assumption. We think that if we invest out money on this IRR, after receiving profit, we can easily reinvest our investments profit on same IRR. We seem to be unrealistic assumption. What's more, it is not for comparing two mutually exclusive investments -IRR is not good for comparing two projects. Therefore, in this case, it is not important for the City Council to consider the IRR for two projects.(http://www.svtuition.org/2010/05/advantages-and-disadvantages-of.html )
According to the analysis for the four methods, it is displays that project 2 is much better than project 1. So I suggested the City Council to invest in project 2 . although the NPV of project 2 is better, the City Council still need to consider some other factors, for example, the non-financial factors.
Non-financial factors
The great emphasis placed on financial aspects when considering capital budgeting decisions has been questioned by recent literature: see for example Skitmore et. al. (1989), Proctor and Canada (1992), Chen (1995), Lopes & Flavell (1998), Adler (2000),Meredith and Mantel (2000), Mohamed and McCowan (2001), Love et al. (2002). All these authors have been emphasising the need to take both financial and nonfinancial aspects into account when considering capital budgeting decisions.
Investment appraisal is not all about financial factors. There are non-financial factors that plays significant role in making any meaningful investment decision. Although the financial case for making an investment is a vital part of the decision-making process, non-financial factors can also be important.
Climatic issues
Green activities have become more popular in society. Companies not investing in equipment that preserve the environment are seen as a non-responsive and irresponsible by the public who will in turn become customers later. Also the City Council need to consider about this factor.
There is another factor about climate. As we all know, the weather in Coventry is usually rainy and windy. This may affect the work of build projects. It may due to the projects need more time to build. Therefore, it may cost more money to finish the project. For example, you might need to take into account the environmental impact of a potential investment. To some extent, this may be reflected in financial factors: for example, the energy savings offered by new machinery. But other effects - such as the effect on your reputation - will also be important. See our guide to making the case for environmental improvements.
Government
Government regulation is an important factor. There is need to consider the government relevant laws before making investment appraisal. The City Council should be part of the government. They must have considered the government regulation before to build the projects. It should be meeting the requirements of current and future legislation.
Staff motivation
The effect of an investment on the motivation of staff should be considered before furthering in the investment process. If the staffs have a good mood and good environment to do their work, they will be very happy to do. And they will try their best to deal with their work. It may lead the projects finished before the deadline. It is obviously to say that is benefit for the City Council. It may save some money and decrease their cost of capital. For the City Council, before they start the projects they should add staff's wages or improve their working environment to motive the staff. Those will benefits for the projects build.
Not only to consider the good effect for the residents in the Coventry city centre. What else need we consideration is the energy consumption. As we all know highway construction is bound to accelerate the consumption of resources. Transport consumers 4% more energy every year which represents a doubling of energy used every 20 years(Reclaiming city streets for people chaos or quality of life, European commission) We all know that to maintain the roads need to consume energy. Maintenance vehicle consume gasoline, diesel and other. Therefore, the Coventry toll need be considered is how to estimate this part of the energy consumption. For example, the 24km road, the design life is twenty years, how much energy needs to conservation. This series of questions should be considered before project construction.
Conclusion
Due to analysis each investment appraisal method and the non-financial factors, the City Council now should have a clearly decision. In the four appraisal methods, the NPV is the most important one; it is the core of the appraisal method. The City Council should consider more about the NPV. At the same time, the non-financial factors are all need to consider before the City Council decide to invest. Therefore, I suggested the Coventry City Council should choose project 2.
Reference
Payback period in capital budgeting, retrieved from November 19, 2012 from http://www.investopedia.com/walkthrough/corporate-finance/4/
The different between IRR and NPV from November 20, 2012 from http://www.svtuition.org/2010/05/advantages-and-disadvantages-of.html
Accounting rate of return method, retrieved from November 19, 2012 from http://www.accountantnextdoor.com/investment-appraisal-8-non-financial-factors-that-every-accountants-and-managers-should-consider/
Ray Proctor, 2002, Managerial Accounting for Business Decisions, second edition, British, British library cataloguing
Brealey, Myers and Marcus, 2011, Fundamentals of Corporate Finance, seventh edition, British, McGRAW-HILL
Peter Atrill and Eddie McLaney, 2012, Management Accounting for Decision Makers, seventh edition, British, British library cataloguing
Colin Drury, 2012, Management and Cost Accounting, eighth edition, British, Linden Harris.
