Investment appraisal (or Capital budgeting ) is the planning process used to determine a firm's expenditures on assets whose cash flows are expected to extend beyond one year such as new machinery, equipments, etc. It is also the process of identifying, analyzing and selecting investment projects whose cash flows are expected to extend beyond one year such as research and development project.
2- Importance of Investment Appraisal:
Investment decisions are of vital importance to all companies. Getting these decisions right is crucial but, due to a complex and dynamic business environment, this remains a challenging management task. Effective appraisal methods are valuable tools in supporting investment decision-making. As organizations continue to seek a competitive edge, it is increasingly important that management accountants and strategic decision-makers have a sound knowledge of these tools.
Capital expense is a cash outlay for projects or investments that are expected to produce a cash inflow or benefits over a period of time usually exceeding one year. Examples of projects include investments in property, plant, and equipment, research and development projects, large advertising campaigns, or any other project that requires a capital expenditure and generates an expected cash flow. They are potentially large and irreversible outlays. As capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project selection, which is so called capital budgeting. Potentially, there is a wide range of criteria for selecting projects and implementing them. Some shareholders may wish the firm to choose projects that will show immediate increase in cash inflows, and some may want to emphasis long-term growth with little importance on short term. It would be quite difficult to satisfy the differing interests of all the shareholders. Therefore, the ultimate goal is to maximize present value of the firm and it is the reason for firms always carries out discounted cash flow (DCF) and net present value (NPV) to convince investors.
Basically, the importance of capital budgeting are as follow:
Analyze the information
Avoid forecast error
Helps firm to plan its financing
Define the objectives
Present the results
PAYBACK PERIOD:
Payback is the simplest method of looking at the one or more investment projects. The Payback Period method focuses on recovering the cost of investment. It represents the amount of time that it takes for a capital budgeting project to recover its initial cost.
In another definition it refers "the length of time required to recover the cost of an investment".
3.1- Calculation of Payback period:
Year
Project A
Project B
Cash Flow £ (000)
Cumulative Cash Flow £ (000)
Cash Flow £ (000)
1
22
22
43
2
31
53
43
3
43
96
43
4
52
148
43
5
71
219
43
Project A:
Initial Cost of Project = 125,000
Total Cash Flow Received after 3 years = 96,000
Required amount to equal the Cost in 4th year = 125,000-96,000= 29,000
29000/52000*12= 6.7 months
Finally the payback period is about 3 years and 7 months.
Project B:
Here its annuity situation so
Payback = Cost of Project/Annual cash flow
Payback= 125000/43000 = 2.9
Where .9*12= 10.8 months
Finally the payback is about 2 years and 11 months
3.1.1 Recommendation:
AP Ltd imposes a 3 year maximum payback period so Project B should be accepted.
3.1.2 Criticism of Payback period:
Payback Period certainly has the virtue of being easy to compute and easily understandable but beside this it's very simplicity carries weaknesses with it. Following are the major problems associated with this model.
Payback Period ignores the benefits that occur after the Payback Period, and so that it does not measure the total income.
Payback Period ignores the time value of money
It over-emphasizes short run profitability.
Net Present Value:
Net present value is one of the most important capital budgeting techniques. It is used extensively in different fields of capital budgeting. It is normally employed in order to measure the financial performance of projects that have been going on for a longer period of time.
In other words, Net Present Value (NVP) is a method of evaluating the profitability of an investment or project. The Net Present Value of an investment is the present discounted value of cash inflow minus the present discounted value of cash outflows.
The net present value points to the value addition, a particular business undertaking may be making to a company. Normally if the net present value is positive it is assumed that the project would increase the corporate value of the organization. In such cases the company undertakes the particular project.
When the net present value of a project is negative it is understood that the project is least likely to make any value addition to the firm's economic status. Under such circumstances the particular company does not approve the project.
The condition where the net present value of a project is neither negative nor positive is the diciest. It is for sure that the particular project would not add to the company's economic value. In these situations the companies use other techniques to determine the fate of the project.
4.1- Impact of Cost of Capital on NPV:
Cost of Capital has inverse relation with Net Present Value. Increase in Cost of Capital decreases the net present value while decreases in cost of capital increase the net present value.
4.2- Calculation of NPV:
Year
Project A
Project B
NCF
£ (000)
PVIF @ 12%
Present
Value
£ (000)
NCF
£ (000)
1
22
0.893
19.646
43
2
31
0.797
24.707
43
3
43
0.712
30.616
43
4
52
0.636
33.072
43
5
71
0.567
40.257
43
Total
148.298
Less initial cost
125
Net present value(NPV)
23.298
Project A:
NPV @12% Cost of Capital= £ 23298
Project B:
Considering the annuity factor we can calculate NPV for Project B by using following formula:
NPV @12% Cost of Capital = (3.605*43,000)-125,000
NPV @12% Cost of Capital = 155,015 -125,000
NPV @12% Cost of Capital = £ 30,015
4.2.1 Recommendation:
If the NPV of a prospective project is positive, it should be accepted.
If NPV is negative, the project should probably be rejected because cash flows will also be negative.
Project A and Project B both should be accepted as their NPV is positive.
Internal Rate of Return
The Internal Rate of Return, or IRR for short, is a measure of your investment performance, and is expressed as percent return per year. It is essentially equal to the (annualized) interest rate a bank would have to pay you to duplicate the performance of your portfolio.
5.1- Calculation of IRR
IRR of Project A:-
Year
Project A
NCF
£ (000)
PVIF @ 12%
Present
Value @ 12%
£ (000)
PVIF @ 16%
Present
Value @ 16%
£ (000)
PVIF @ 20%
1
22
0.893
19.646
0.862
18.964
0.833
2
31
0.797
24.707
0.743
23.033
0.694
3
43
0.712
30.616
0.641
27.563
0.579
4
52
0.636
33.072
0.552
28.704
0.482
5
71
0.567
40.257
0.476
33.796
0.402
Total present value
148.298
132.060
Less initial cost
125
125
Net present value(NPV)
23.298
7.060
NPV @ 12% = £23298
NPV @ 16% = £7060
NPV @ 20% = - £6657
IRR = positive rate + {(positive NPV/positive NPV+ negative NPV) Ã- range of rates}
= 16% + {(7060/7060+6657) * (20 - 16)%}
= 16% + 2.056%
= 18.056%
IRR of Project A is 18.056%
IRR of Project B:-
Year
Project B
NCF
£ (000)
PVIF @ 12%
PVIF @ 20%
1
43
0.893
0.833
2
43
0.797
0.694
3
43
0.712
0.579
4
43
0.636
0.482
5
43
0.567
0.402
Total
3.605
2.990
NPV of Project B @ 12% = (43000 * 3.605) -125000
= 155015 - 125000
= £ 30015
NPV of Project B @ 20% = (43000 * 2.990) - 125000
= 128570 - 125000
= £ 3570
NPV of project B @ 25% = (43000 * 2.690) - 125000
= 115670 - 125000
= £ -9330
IRR = positive rate + {(positive NPV/positive NPV+ negative NPV) Ã- range of rates}
= 20% + {3570/3570+9330) * (25 - 20)%}
= 20% + 1.38%
= 21.38%
IRR of Project B is 21.39%
5.2- Recommendation
If IRR is greater than Cost of Capital then project is acceptable.
If IRR is less than Cost of Capital then project is not acceptable.
According to above criteria both project A and B should be accepted.
Comparison for Effectiveness of NPV and IRR
Net present value is defined as the measure of the excess or shortfall of cash flows in present value terms once financing charges are met (Wikipedia 2007). This measure implies that all investment appraisal objectives should drive toward a positive net value or there should be a surplus between the values that the capital good will bring over its cost. Practically, it is a measure of what an investment can get you in the long run as opposed to the seemingly large short run cost. The NPV is a mathematical simply understood as the net cash flow at time t over the discount rate at the same time t minus the capital outlay at the beginning of investment time. As we can see, a higher discount rate will decrease the net present value of a capital good. That is why most capital investment appraisals are wary of higher interest rate which increases the discount rate of a good over time.
The internal rate of return is defined as the discount rate that makes the project have a zero net present value (Odellion Research 2006). This definition is equates the NPV to zero and deriving the discount rate. Although the NPV and the IRR are related, they are not equivalent concepts. The IRR's assumption of a zero NPV means that there is no need to evaluate the discount rate. Instead the IRR takes into account the time value of money over the lifetime of the project (Odellion Research 2006). Another objective of the equation is to measure the real world discount rate and compare it with the IRR solution to assess the investment decision.
These two main methods of capital budgeting are correlated with each other. However, they are read differently and are examined in various contexts. In the end the critical factor is valuing the decision of the shareholders while communicating what is the most effective capital good.
