Successful companies are always looking at ways in which they can change and develop. The senior management will be faced with a number of different proposals, ranging perhaps from the development of a new product to establishing a company presence in a new part of the world. The company will only have a limited amount of money of its own available and lenders and investors will only be prepared to offer limited amounts. The management is therefore faced with the need to decide which of the proposals to support. (www.bsc.com)
This assignment will examine the investment appraisal which include payback period, NPV and IRR methods and analysis two project to provide an evaluation.
Investment appraisal should add value to the business entity because start the firm we need investment which can investing or buying machines, build a new plant or invest an asset. The goal of business is to gain profit which causes by several reasons such as survival of the company, re-investment, retained profit and invest in loss projects. The company has to determine for making investment refer to the projects over a period of time. Company takes the decision for a long term basis. There are for different methods company uses to make an investment in called Investment Appraisal. It is a part of finance. The types of investment appraisal are Accounting rate of return (ARR), Pay Back Period, Net Present Value(NPV) Internal Rate of Return(IRR)
Project's payback period
The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project. (Watson & Head, 2007)
Project A
Year Net cash flow (£,000) Cumulative Net cash flow (£,000)
0 (10)
1 3 3
2 3 6
3 3 9
4 3 12
5 3 15
Payback Project A = 3+ (10-9÷3)
= 3â…“ years or 3years 4 months
Or Calculate by the annuity method if the net cash flow are same every year.
Payback = Initial investment ÷ Net cash flow which same every year
= 10,000 ÷ 3,000
= 3.33 years or approximately 3 years 4 months
Project B
Year Net cash flow (£,000) Cumulative Net cash flow (£,000)
0 (25)
1 6.5 6.5
2 7.0 13.5
3 7.5 21
4 7.5 28
5 8 36.5
Payback Project B = 3 + (25-21÷7.5)
= 3.53 years or approximately 3 years 6 months
Net Present Value (NPV)
Net present value is done by discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment. The basic discount rate is usually the cost of the firm. Thus inflows that arrive in later years must provide a return that at least equals the cost of financing those returns. (Block, Hirt & Danielsen , 2009)
NPV Project A
Year
Project A
Net cash flow
Cost of capital
Present
12.50%
Value
£ 000
£ 000
£ 000
0
(10)
1
3
0.889
2.667
2
3
0.790
2.370
3
3
0.702
2.106
4
3
0.624
1.872
5
3
0.555
1.665
Total present value
10.680
Less: Initial cost
10
Net present value
0.680
Net Present Value Project A = £680
NPV Project B
Year
Project B
Net cash flow
Cost of capital
Present
12.50%
Value
£ 000
£ 000
£ 000
0
-10
1
6.5
0.889
5.779
2
7
0.790
5.530
3
7.5
0.702
5.265
4
7.5
0.624
4.680
5
8
0.555
4.440
Total present value
25.694
Less: Initial cost
25
Net present value
0.694
Net Present Value Project A = £694
Internal rate of return (IRR)
IRR of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows of a project, produces a net present value of zero. The IRR decision rule is to accept all independent investment projects with an IRR greater than the company's cost of capital or target rate of return. (Watson & Head, 2007)
Project A
NPV at discount rate of 12.5% = 680
We need to find a discount rate that produces a negative NPV.
Try NPV at discount rate of 18%
Year
Project A
Net cash flow
Cost of capital
Present
18 %
Value
£ 000
£ 000
£ 000
0
(10)
1
3
0.847
2.541
2
3
0.718
2.154
3
3
0.609
1.827
4
3
0.516
1.548
5
3
0.437
1.311
Total present value
9.381
Less: Initial cost
10
Net present value
(0.619)
NPV at discount rate of 18% = (619)
IRR project A
IRR =
12.5% + 680 x (18% - 12.5%)
680+619
IRR =
12.5% + 0.523 x 5.5%
IRR =
12.5% + 2.876%
IRR =
15.38%
Project B
NPV at discount rate of 12.5% = 694
We need to find a discount rate that produces a negative NPV.
Try NPV at discount rate of 18%
Year
Project B
Net cash flow
Cost of capital
Present
18 %
Value
£ 000
£ 000
£ 000
0
-10
1
6.5
0.847
5.506
2
7
0.718
5.026
3
7.5
0.609
4.568
4
7.5
0.516
3.870
5
8
0.437
3.496
Total present value
22.466
Less: Initial cost
25
Net present value
(2.534)
NPV at discount rate of 18% = (2534)
IRR project B
IRR =
12.5% + 694 x (18% - 12.5%)
694+2534
IRR =
12.5% + 0.215 x 5.5%
IRR =
12.5% + 1.183%
IRR =
13.683%
A comparison of the Project A and Project B
The organization should select Project A if the company wants to recover the original investment faster because Project A will spends time to get payback faster than Project B by 2 months. Furthermore, the Internal rate of return of Project A is higher than B.
On the other hand, the firm which want high amount of Net present value should select Project B because this project will have higher NPV by £14. Moreover, this project is also have the internal rate of return higher than company's cost of capital. It means both project should invest.
What would happen to the NPV if the cost of capital increased or decreased
Year
Project A
Net cash flow
Cost of capital
Present
Cost of capital
Present
Cost of capital
Present
12.50%
Value
10.00%
Value
15.00%
Value
£ 000
£ 000
£ 000
£ 000
£ 000
£ 000
£ 000
0
-10
1
3
0.889
2.667
0.909
2.727
0.87
2.610
2
3
0.790
2.370
0.826
2.478
0.756
2.268
3
3
0.702
2.106
0.751
2.253
0.658
1.974
4
3
0.624
1.872
0.683
2.049
0.572
1.716
5
3
0.555
1.665
0.621
1.863
0.497
1.491
Total present value
10.680
11.370
10.059
Less: Initial cost
10
10
10
Net present value
0.680
1.370
0.059
Year
Project B
Net cash flow
Cost of capital
Present
Cost of capital
Present
Cost of capital
Present
12.50%
Value
10.00%
Value
15.00%
Value
£ 000
£ 000
£ 000
£ 000
£ 000
£ 000
£ 000
0
-10
1
6.5
0.889
5.779
0.909
5.909
0.87
5.655
2
7
0.790
5.530
0.826
5.782
0.756
5.292
3
7.5
0.702
5.265
0.751
5.633
0.658
4.935
4
7.5
0.624
4.680
0.683
5.123
0.572
4.290
5
8
0.555
4.440
0.621
4.968
0.497
3.976
Total present value
25.694
27.415
24.148
Less: Initial cost
25
25
25
Net present value
0.694
2.415
-0.852
Refer to table project A and B, cost of capital reverse variation to NPV. It means if the cost of capital increase total present value will decrease and affect to NPV when divide by initial cost. On the other hand, when decrease the cost of capital total present value and NPV will increase respectively.
Compare the effectiveness of the NPV with IRR method
The NPV method can tell the collect advice and accommodate non-conventional cash flows about the project while the IRR method might offer many solutions. Moreover, the reinvestment assumption underlying the NPV method is realistic but the IRR is not. Furthermore, the NPV method can easily incorporate change in the discount rate whereas the IRR method is unable to accommodate them. (Watson & Head, 2007)
