One of the most significant long-standing decisions for any business relates to investment. Investment is the purchase or formation of assets with the purpose of making gains in the future. New assets such as machinery can enhance efficiency, cut expenditure and give you a competitive edge in a market. But at the same time, you need to avoid pulling limited financial recourses and create potential to focus other opportunities. Even for a project to generate profit should be subjected to investment appraisal to recognize the best way to reach its aims.
The appraisal of alternative projects is called investment appraisal. Investment appraisal involves an assessment of the levels of expected returns and future cost of the project compared to the amount invested. Companies use methods of investment appraisal in order to evaluate the outcome of projects. These techniques enable them to take more suitable financing decisions, e.g. working capital management, risk, cost of capital, sources of finance etc.
The main objective of the companies is maximization of the shareholder wealth, so they must take reasonable decisions to protect the shareholder funds. Management with the key appraisal skills add value to the decision making and hence in the business. It increases the confidence of the market in the company and the investors will be more willing to invest.
Discounted Cash flow techniques
Discounted cash flow (DCF) study is a techniques used to obtain economic and financial performance for investment projects. DCF analysis is an addition of simple cash flow analysis and takes into account the time value of money and the risk of investing in a project. You can use DCF to judge potential investment.
There are number of methods can be used to analyse the project using discounted cash flow techniques which are as follows;
NPV
IRR
Net Present Value (NPV)
NPV is a investment appraisal techinique based on discounted cash flow (DCF) analysis.
NPV looks at present value of all cash inflows less present value of all cash outflow of project.
It represents the increase in wealth of shareholders of an organization as the result of accepting the project being reviewed.
The main decision rule is that the project should be accepted if it generates the positive NPV.
Advantages of NPV
Strong correlation with shareholders value.
It considers the time value of money.
Risk can be allowed by adjusting the cost of capital.
Shareholders are interested in cash flows and profit maximization.
Cash flows are less subject to manipulation and subjective decisions than accounting profits.
Considers all cash flows of project.
Can be used to compare projects as gives an absolute measure.
Disadvantages/Problems
Difficult to calculate /understand.
It does not allow two projects of different scales to be compared.
It is based on assumptions about cash flow, the timing of that cash flow and the appropriate cost of capital.
Many firms use NPV for investment appraisal and then switch to profit-based measures to motivate managers.
The challenge facing many firms is how to adapt the NPV technique to set targets for mangers and for short-term performance management. These could involve cash flow targets, for example.
IRR
The IRR is the discount rate when the NPV =0.
When presented with uncertainty over the cost of capital, some managers prefer to assess projects by reference to the IRR.
Accept the projects if its IRR>firm's cost of capital.
The IRR has same advantages and limitations as mention above for NPV both based of discounted cash flows.
Annual Net Cash
Flow
Initial Investment
Cost of
Capital
IRR
NPV
1
£ 100,000
£ 4,49,400
14.00%
A
B
NPV= Annual NCF x AF - Initial investment
= 100,000 x 5.216 - 4,49,400
= 5,21,600- 4,49,400
= 72,200
So the NPV for project 1 is 72,200.
B= 72,200.
keeping the cost of capital 19 %
= 100,000 x 4.339 - 4,49,400
= 4,33,900- 4,49,400
= -(15,500)
NPV for project 1 at 19% is -15,500
As we know the value of NPV at IRR is always zero and we have got a positive and negative NPV , so the IRR value should be lies between 14% and 19 %
= 14% + (72,200/72,200+15,500) x (19-14)
=14% + 7200/87,700 x 5
=14% + 0.8232 x 5
=14% + 4.116
= 18.116
IRR for the Project 1 is 18.116 %
Project
Annual Net Cash Flow
Initial Investment
Cost of Capital
IRR
NPV
2
£70,000.00
C
14.00%
20.00%
D
Since ,we have actual IRR figure with us ,so as we know IRR is the value in which NPV is zero.
Let us consider value of Initial investment as X
NPV= Annual NCF x AF - Initial investment
0 = 70,000 x 4.192- X
X= 70,000 x 4.192
X= 2, 93,440
So , Initial Investment for the project 2 is 2,93,440 .
C = 2,93,440.
Now , we will find NPV at 14 %
NPV= Annual NCF x AF - Initial investment
= 70,000 x 5.216- 2,93,440
= 3,65,120 - 2,93,440
= 71,680
So, the NPV for the project 2 is 71,680.
D = 71,680
Project
Annual Net Cash
Flow
Initial Investment
Cost of Capital
IRR
NPV
3
E
£200,000.00
F
14.00%
£35,624.00
Let us consider the annual cash flow as X, since we know at fixed IRR , NPV is always zero.
NPV= Annual NCF x AF - Initial investment
0 = X x 5.216 - 2,00,000
X x 5.216 = 2,00,000
X = 2,00,000 / 5.216
X = 38343.6
So, the annual cash flow for the project 3 is 38343.6
E = 38,343.6
Putting the value of annual cash flow in the NPV formula
NPV= Annual NCF x AF - Initial investment
35,624 = 38343.6 x Y - 2,00,000
38,343.6 x Y = 2,00,000 + 35,624
Y = 2,35,624 / 38343.6
Y= 6.145
So, the value of 6.145 lies on the 10% in the chart. So, the cost of capital for project 3 is 10 %
F = 10 %
Project
Annual Net Cash
Flow
Initial Investment
Cost of Capital
IRR
NPV
4
G
£300,000.00
12.00%
H
£39,000.00
Let us consider the annual cash flow as X
NPV= Annual NCF x AF - Initial investment
39,000 = X x 5.650 - 3,00,000
X x 5.650 = 3,00,000 + 39,000
X = 3,39,000 / 5.650
X = 60,000
So, The value of annual net cash flow for the project 4 is 60,000.
G = 60,000
Keeping the cost of capital at 17 % , NPV will be
= 60,000 x 4.659 - 3,00,000
= 2,79,540 - 3,00,000
= -20,460
As we know the value of NPV at IRR is always zero and we have got a positive and negative negative NPV ,so the IRR value would be lies between the 12 % and 17 % .
= 12 % + ( 60,000 / 60,000 + 20,460 ) * (17-12)
= 12 % + (60,000 / 80,460 x 5)
= 12 + 3,00,000/ 80,460
= 12 + 3.72
= 15.72
So the IRR for the project 4 is 15.72 %.
H= 15.72 %
Analysis
Project 1:
Based on the calculations above, the project 1 looks favorable. It has positive NPV of 72200 and IRR of 18%. The IRR is 4% higher than the cost of capital which means, there should be 4% increase in the cost of capital to make the project to break even. The project has 22% return on the initial investment which is also look encouraging towards acceptance of the project.
Project 2:
The project 2 has a positive NPV of 71680. The project should be accepted if it has positive NPV. Positive NPV shows that the project is financially viable. The project has a IRR of 20% giving a comparative advantage of 2% than the project 1. The project should be accepted if it has IRR greater than the cost of capital which is 14% in this project. The project has a annual cash return of 23% compare to the initial investment.
Project 3:
The project 3 has a positive NPV of 35624 and IRR of 14%. NPV is far less than the above projects. The IRR and the cost of the capital difference is 4%. So if there will be 4% increase in the cost of the capital than the stability of the project will be in danger. If we look at the return on the investment which is 19.2%, it looks reasonable as compare to the investment in that project.
Project 4:
The project has a positive NPV of 39000, IRR of 15.72% and the return on the Capital employed is 20%. The project is not much attractive as compare to the other projects. There is only 3.7% difference which is lowest than the other three projects.
Conclusion:
Based on the analysis above, I come to the conclusion that the project 2 is better as it good for shareholders interest. The project has a positive NPV covering the cost of the project. The difference between the IRR and Cost of Capital is significant than other three projects. Annual cash flow is 23% greater than all three projects, will help the company in solving the cash flow issues.
