Investment is the key part of the business. All the entities would find it difficult to survive if they did not invest in some form of capital expenditure from time to time rapidly changing technology, innovations and globalization are lead to make more competition in modern businesses context (Bized 2009 1).New assets such as machinery can boost productivity, cut cost and give a competitive edge. Investment in product development, research and development, expertise and new market can open up exciting growth opportunity. Even a project unlikely to generate profit should be subjected to investment appraisal to identify the best way to achieve its aims.
Investment can be
Autonomous-the replacement of worn out capital
Induced-new investment arise from expansion
Reaction to the competitors
Availability of new technology
Definition
A means of assessing whether the investment project is worthwhile or not.(Business dictionary 2009 2)
Investment projects can be the purchase of new pc for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory etc
Used in both public and private sector.
Importance of investment appraisal process
Investments are the most critical aspect for the future of the entity. Investment appraisal normally represent the most important decisions that an entity makes. Investment appraisal has given highest importance in financial management. It is because its impact is upon long term future of the business. Investment decisions should be carefully analyzed in systematic and logical ways. Its purpose is to entity to achieve its long term objectives and its benefits may be spread over many years. All entities would find it difficult to survive if they did not invest in some form of capital expenditure from time to time and they certainly would not be able to grow and develop(G Matt 2006).Successful entities are always looking at ways in which they can change and progress. The senior management will be faced a number of proposals, ranging perhaps from the development of a new product to establishing an entity presence in a new part of the world. The management is therefore faced with the need to decide which proposal to support. Misguided decisions are some big threats for the survival of the business and on the other hand it showed that investment decision is at a high risk. All of the projects will create financial and non financial benefits to entity.
1-http://www.bized.co.uk/timeweb/reference/using_experiments.htm
2-businessdictionary.com
Payback period
In corporate finance, the payback period is a simple measure of the time it takes to recover capital spent on an investment(Investor glossary 2009 1) and then comparing this with the acceptable period. If payback period is less than the acceptable and there are no other constraints , For example capital rationing the project will be accepted. The investment return is measured in terms of net cash flow.Net cash flow is difference between the total of cash received and total amount of cash paid in the same year.(J R Dyson 1992).
Calculation of payback period
Initial outlays =£110,000
Project a Project B
£000 £ 000
Year 1 20 40
2 30 40
3 40 40
4 50 40
5 70 40
For Project A
£000
Annual cash flow Total cash flow
Year1 20 20
Year2 30 50
Year3 40 90
Year4 50 140
Year5 70 210
We are getting initial investment between 3rd and 4th year then
3+20/50=3.4 Years
Which is 3 years and 4.8 months(.4 x 12 months)
For Project B
£000
Annual cash flow Total cash flow
Year1 40 40
Year2 40 80
Year3 40 120
1-http://www.investorglossary.com/payback-period.htm
Year4 40 160
Year5 40 200
In this project we are getting the initial investment between 2nd and 3rd year then
2+30/40=2.75
Which is 2 years and 9 months (.75 x 12months)
Project A has a payback period of 3 years and 4.8 months.
Project B has a payback period of 2 year and 9 months.
In this case if AP Ltd imposes a three years maximum payback period the Project B will be preferred because it is faster than the Project A.
Criticisms of payback period
There are a number of serious drawbacks to the payback method.
It ignores the cash flows after the end of the payback period and therefore the total project return(Business studies online 2009 1).
It ignores the timing of cash flows within the payback period.
It is unable to distinguish between projects with the same payback period.
It ignores the time value of money (a concept incorporated into more sophisticated appraisal Methods). This means that it does not take account of the fact that £1 today is worth more than £1 in One's time. This is because an investor who has £1 today can either consume it immediately or Alternatively can invest it at the prevailing interest rate, say 10%, to get a return of £1.10 in a year's time.
The method is unable to distinguish between projects with the same payback period.
The choice of any cut-off payback period by an organization is arbitrary.
It may lead to excessive investment in short-term projects.
It takes account of the risk of the timing of cash flows but does not take account of the variability of that cash flow.
It is not easy to determine an appropriate rate of interest through payback period.
Net present value (NPV)
The net present value is defined as difference between the present value of the future cash flows from an investment and the amount of investment.(G Matt 2006 )
Calculation of NPV
To calculate NPV for Project A
Initial outlays=£110,000
Cost of capital=12%
1www.businessstudiesonline.co.uk/AsA2BusinessStudies/TheoryNotes/2880/2Hr/PDF/0820Investment20Decisions.pdf
Cash flows Discount rate Present value
Year1 20 0.893 17.8
Year2 30 0.797 23.91
Year3 40 0.712 28.48
Year4 50 0.636 31.80
Year5 70 0.567 39.69
Total present value= 141.74
Net present value (NPV) at 12%= 31740 which is positive so AP ltd should accept the project.
For project B
Annuity
If the cash out flows in every year is same then it can be called as annuity.
NPV at 12%=3.605(40000)-110000.
= 144200-110000
=34200 which is also positive so AP LTDS should accept this project.
Explanation of NPV
In both projects A and B the calculated net present value is positive so both projects will be accepted. It is because when we compare the value of NPV with the initial outlays it is more which means that if AP LTDS accept this project it will increase their entity wealth which also results in the increase of market value of the AP ltd more share holders will come and invest more. Since the project B also results in the positive value of NPV so it should also be accepted because project is giving cash flows more than the initial outlays. The paramount objective of the entity is to create wealth as much as they can. To create wealth, the present value of all future cash inflows must exceed the present value of all anticipated cash outflows. Simply we can say that an investment with a positive net present value increases the owners' wealth.
Logic behind the NPV approach
Any entity wealth is maximized by accepting all projects that offer positive net present values when discounted at the required rate of return for each outlay. If the value of NPV=0 Still entity should accept that project because shareholders can earn cost of capital at the discounted rate. The net present value rule states that managers increase shareholders wealth by accepting those project which are worth more than they cost. Therefore, they should accept all those projects with a positive net value. Managers should undertake all projects up to the point at which marginal return on the investment is equal to the rate of interest on equivalent financial investments in the capital market.(R Pike & Bill Neale 2009)
Goal increase shareholders value
Inputs Annual cash flow Cost of capital
Financial analysis Discount cash flows at the cost of
Capital to find net present value
NPV signal + _
Reject
AcceptDecision outcome
Source:(R Pike & B Neale 2009)
Relationship between NPV and cost of capital.
1.If cost of capital increase
+ NPV
+Cost of capital
0
- NPV
Case 1
If cost of capital increase then according to the relation the npv will tend to get toward zero or decrease
Example
If we increase the cost of capital of both projects say 12% to 15% then
NPV=3.352 x 40000-110000
=23000 which clearly shows decrease in NPV value.
2.If cost of capital decrease
Case 2
If the cost of capital decreases then NPV will increase.
Example
If we decrease the cost of capital say 12% to 10% then
NPV=3.791x40000-110000
=41000 which clearly shows increase in NPV value.
Internal rate of return(IRR)
Project's return in DCF terms is known as IRR.
For project A
NPV at 12%=28420
NPV at 20%
Cash flows Discount rate present value
YEAR1 20 .8333 16.66
YEAR2 30 .6944 20.83
YEAR3 40 .5787 23.14
YEAR4 50 .4822 24.11
YEAR5 70 .4018 28.12
Total present value=112.89
NPV at 20%=112.89-110
=2.89
NPV at 25%
Cash flows Discount rate present value
YEAR1 20 .8000 16
YEAR2 30 .6400 19.20
YEAR3 40 .5120 20.48
YEAR4 50 .4096 20.48
YEAR5 70 .3276 22.93
Total present value=99.09
NPV at 25%=99.09-110
= -10.91
So the IRR would be in between 20% to 25% where NPV=0
IRR=20% + 2.89 x (25% -20%)
2.89+ -10.91
=20% + .2094 x 5%
=21.04%.
For project B
NPV at 20%
Cash flows Discount rate present value
YEAR1 40 .8333 33.33
YEAR2 40 .6944 27.77
YEAR3 40 .5787 23.14
YEAR4 40 .4822 19.28
YEAR5 40 .4018 16.07
Total present value=120.4
NPV at 20%=120.4-110
=10.4
NPV at 25%
Cash flows Discount rate present value
YEAR1 40 .8000 32
YEAR2 40 .6400 25.6
YEAR3 40 .5120 20.48
YEAR4 40 .4096 16.38
YEAR5 40 .3276 13.10
Total present value=107.56
NPV at 25%=107.56-110
= -2.436
So the IRR would be in between 20% to 25% where NPV=0
IRR=20% + 10.4 x (25% -20%)
10.4+ -2.436
=20% + .8102 x 5%
=24.05%.
So IRR for project A is 21.04% and project B is 24.05%.
All the two projects have an IRR greater then the AP Ltd cost of capital which is 12%,so both of the projects should be acceptable(D Watson & A Head 2007). However it is not possible to choose the best project by using internal rate of return method.
Relationship between cost of capital and IRR
The change in cost of capital does not effect the project's IRR because IRR is independent of project's cost of capital. For investment appraisal we compare IRR with the cost of capital ,if IRR is more than the cost of capital we should accept the project. We need cost of capital just to make decisions.
Why NPV is superior to IRR
The NPV method is superior to IRR method in a number of ways which are as under
NPV method is superior to the internal rate of return (IRR) because NPV does not face any problem of multiple rate of return due to irregularities in the pattern of the cash flows.
IRR is just not adequate for longer-term projects with discount rates that are expected to vary.
Also IRR calculation is ineffective in a project with a mixture of multiple positive and negative cash flows.
Another situation that causes problems for users of the IRR method is when the Discount rate of a project is not known.
