The estimation of any investment proposal, using such methods like average rate of return, net present value, payback period, and internal rate of return, investment appraisal is also the essential part of the capital budget.
The meaning of investment appraisal is assessing or measuring. It does not matter that a project is valuable or not. Investment appraisal provides the guidance that when company can invest money in the capital projects as well as this kind of project also add the value to the company. Investment appraisal also increases the value of the business. But in many circumstances when there is no quantifiable advantage in the monetary terms, like government legislation and good will. Mainly the involvement of investment is in financial resources to buy assets like land, building and machine, over a period of time which will give up returns to an organization
Investment appraisal adds the value in to the business entity but it is not the base of making decision to accept the project. Investment appraisal gives you the money figure. But expect investment appraisal there are many other factor which must be consider before accepting the project, like social and ethical issues.
B) Project A of AP Ltd.
It imposes a 3 years maximum payback period.
Payback of A project is given below.
Years N.C.F £ Cumulative N.C.F
£000 £000
1 22 22
2 31 53
3 43 96
4 52 148
5 71 219
Payback = 3 + 29/52
= 3 + 0.6
Pay back of project A is 3 Years and 7.9 Months.
Payback of Project B.
Years N.C.F
£000
1 43
2 43
3 43
4 43
5 43
The Net Cash Flow is same in the Project B so.
Payback = 125/43
= 2.9
So Payback of project B is 2 Year and 10.8 Months.
We compare the both project, so project B is accepted, because the payback of project B is taking less time rather than the payback of project A.
C) Criticism of the payback period:-
The method of payback is not giving you true picture or measure of the profitability of an investment. Normally this method tells to the manager that how many years will be needed to recover the initial investment. Unluckily, this does not mean for all time that shorter payback period tells one investment is more desirable rather than other.
One more criticism of payback period is it does not deem the time value of money. In the future the cash inflows to be received many years which consider similarly with a cash inflow to be receive immediately.
Example:-
Iris Company needs two machines. So company is considering two machines. Machine X and Y, a costs £28000 and will reduce operating cost by £7000 per year. Machine Y costs only £14000 but it will also reduce operating costs by £7000 per year.
Calculation:-
Machine X payback period = £28000/£7000 = 4.0 years
Machine Y payback period = £14000/£7000 = 2.0 years
As we saw in the above example that there is two machines which is iris company is using but the payback period of machine Y is shorter than machine X. So it is consider that machine Y is more preferable than machine X. But if we include one more section or piece this reality will quickly disappear. The life of machine X is 10 years and the life of machine Y is 5 years. So if we buy once time machine X. It has double length of machine Y. So under this circumstances machine X is better than machine Y. Even the payback period of machine Y is shorter than machine X. However the payback method has no natural mechanism for prominence differences in valuable life between investments, these kinds of differences is very important for the company, so it is prove that only relying on payback method can result untrue decisions.
D) Net Present Value of the Projects:-
* Net Present Value of Project A.
N.P.V £ N.C.F £ Discount Rate @ 12% £P.V
£000 £000
1 22 0.893 19.646
2 31 0.797 24.707
3 43 0.712 30.616
4 52 0.636 33.072
5 71 0.567 40.257
.
After adding the P.V 148.298
Less initial investment (125)
.
23.298
So NPV of project A @ 12% is £23298
The project A is accepted because the Net Present Value of the project is positive.
* Net Present Value of Project B.
N.P.V £N.C.F
£000
1 43
2 43
3 43
4 43
5 43
As the project B, the Net Cash Flow values are same so
NPV @ 12% = (43 * 3.605) -125
= 155.015 - 125
= 30.015
NPV @ 12% of project B is £30015
Project B is also accepted because the Net Present Value of the project is not negative.
The cash flow of each project is independent so both projects are accepted. But the company will accept the project is project B because the NPV of project B is higher than the NPV of project A. So project B is acceptable.
E) Logic Behind the N.P.V Approach:-
The idea that triggers the net present values, the technique of investment appraisal is very simple. However an investment is very helpful as long as it creates extra cash than it costs. In other meaning or words, the investment is valuable if the net cash flow is positive.
The technique of NPV formulates single elegance to this approach. It is instead simple calculation however the investment net cash flow is negative or positive, sequentially to take the time value of money in to the accounts, firstly it converts all the cash flow in to present value term.
The Net Present Value analysis, the discount rate represents the minimum acceptable rate of return on the investment.
In a company the net present value gives you the authorization to calculate its assets value at the accurate current value. Basically it is occur at the end of the year when company accounts are prepared.
The evaluation of NPV take the original cost of assets in to the accounts then less the depreciation allowed against the assets in pervious tax computation.
Approaches of N.P.V:-
There are two different types of approaches given below.
1. '' Money (or normal) project cash flows, discounted to PV using the money (or nominal) discount rate
2. Real project cash flows, discounted to PV using the real discount rate.''
F) What would happen to the NPV:-
+NPV
Estimated IRR
0 Cost of capital.
(Actual IRR)
-NPV
As the Above Diagram:-
* The cost of capital increased.
If the cost of capital increased then N.P.V decreased.
* The cost of capital decreased.
When the cost of capital will decrease then value of N.P.V will increase.
G) IRR of the Projects:-
IRR of Project A.
* NPV of project A @ 12%.
N.P.V N.C.F Discount Rate @ 12% £P.V
£000 £000
1 22 0.893 19.646
2 31 0.797 24.707
3 43 0.712 30.616
4 52 0.636 33.072
5 71 0.567 40.257
.
After adding the P.V 148.298
Less initial investment (125)
.
23.298
So NPV of project A @ 12% is £23298
* N.P.V @ 16% of project A.
N.P.V N.C.F Discount Rate @ 16% P.V
£000 £000
1 22 0.862 18.964
2 31 0.743 23.033
3 43 0.641 27.563
4 52 0.552 28.704
5 71 0.476 33.796
.
Adding the P.V 132.060
Less initial Investment (125)
.
7.60
NPV of project A @ 16% is £7060
* NPV of project A @ 20%
N.P.V N.C.F Discounted Rate @ 20% P.V
£000 £000
1 22 0.833 18.326
2 31 0.694 21.514
3 43 0.579 24.897
4 52 0.482 25.064
5 71 0.402 28.542
.
Adding the P.V 118.343
Less initial investment (125)
.
(6.657)
NPV of project A @ 20 % is - £6657
NPV @ 12% = £30015
NPV @ 16% = £7060
NPV @ 20% = - £6657
IRR of project A @ 16%?
= 16% + 7060/7060+6657 (20% - 16%)
= 16% + 7060/13717 (4%)
= 16% + 0.514 (4%)
= 16% + 2.056%
= 18.056%
So the IRR of Project A @ 16% is 18.056%
Therefore project A is accepted.
IRR of project B:-
* Net Present Value of Project B.
N.P.V N.C.F
£000
1 43
2 43
3 43
4 43
5 43
As above the project B, the Net Cash Flow values are same so
NPV @ 12% = (43 * 3.605) -125
= 155.015 - 125
= 30.015
NPV @ 12% of project B is £30015
* NPV of Project B @ 20%.
NPV @ 20% = (43 * 2.991) - 125
= 128.613 - 125
= 3.613
NPV @ 20% of project B is £3613
* NPV of project B @ 25%.
Calculation of Discounted Rate:-
1/1.25 = 0.8
0.8/1.25 = 0.64
0.64/1.25 = 0.512
0.512/1.25 = 0.4096
0.4096/1.25 = 0.32768
Adding the Value = 0.8 + 0.64 + 0.512 + 0.4096 + 0.32768 = 2.68928
NPV @ 25% = (43 * 2.68928) - 125
= 115.63904 - 125
= £(9.36096)
NPV @ 12% = £30015
NPV @ 20% = £3613
NPV @ 25% = -£9360.96
IRR of project B @ 20%?
= 20% + 3613/3613+9360.96 (25% - 20%)
= 20% + 3613/12973.96 (5%)
= 20% + 0.278 (5%)
= 20% + 1.39%
= 21.39%
The IRR of project B @ 20% is 21.39%
Project B is accepted.
As we saw that the project A IRR is 18% and the IRR of project B is 21.39% so both project are accepted but the company will go with the project B. The reason is that project B IRR is greater than project A IRR.
H) Any change in the cost of capital affect the project IRR:-
If the IRR is greater or equal to the cost of capital, IRR is accepted.
However if IRR is less than the cost of capital then IRR is rejected.
I) comparison of NPV with IRR:-
Definition:-
''According to Don Hofstrand the present value of a series of future net cash flows that will result from an investment, minus the amount of the original investment''
Advantage of NPV:-
* The calculation of NPV on the basis of cash flow.
* It takes the time value of money into account.
* NPV will provide the accurate result and will help the company to attain its purpose's of maximising the value of the shares.
Disadvantage of NPV:-
* The NPV concept can be not easy to understand.
* It can be not easy to classify the accurate discount rate or cost of capital.
Definition of IRR:-
''According to M.A Mian IRR is the interest rate received for an investment consisting of payments (negative values) and income (positive values) that occur at regular periods''
It is the discount rate of return or cost of capital at which NPV = 0
Advantage of IRR:-
* The calculation of IRR is base on cash flow as well as it takes the time value of money in to account like NPV.
* IRR is calculated on the basis of ''user friendly'' percentage rate of return.
Disadvantage of IRR:-
* The calculation of IRR is based on percentage so we cannot depend upon to provide the accurate investment guidance when faced with mutually exclusive investments of different sized lay outs.
* In a mutually exclusive project IRR cannot be give accurate investment advice. Because it gives wrong hypothesis regarding the rate at which the project cash flow can be reinvested.
* We cannot rely on the IRR because there are more or multiple IRR like given below diagram.
+NPV
0
-NPV
Bibliography and Reference:-
M.A.Mian (2002)Project Economics and Decision Analysis: Deterministic Models, pennWell corp, Tusla,Okla, p.269.
Acca Book f9
http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_decisions.htm#Example
http://au.answers.yahoo.com/question/index?qid=20080130154317AABCzrE
http://www.investopedia.com/study-guide/cfa-exam/level-1/corporate-finance/cfa13.asp
http://www.agmrc.org/business_development/getting_prepared/valueadded_agriculture/glossaries_of_terms/farm_analysis_terms.cfm
http://au.answers.yahoo.com/question/index?qid=20080130154317AABCzrE
http://www.extension.iastate.edu/agdm/wholefarm/html/c1-05.html
http://www.businessdictionary.com/definition/investment-appraisal.html
