As the rapid change in technology, innovations, globalizations, are bound to make more competition in the modern business context. The business that can compete with this competition and at the same time maintain an edge over its rivals will be able to survive in the market and earn profits.
Businesses will undertake projects which may give sustainable competitive advantage to them. Businesses will have raised finance from various sources which is then invested in assets e.g. plant and machinery.
Investment Appraisal is the evaluation of the attractiveness of an investment proposal by using different methods e.g. NPV, IRR, Payback Period etc.
(B) BACKGROUND
The most common appraisal methods used are the Traditional methods and the Discounted Cash Flows (DCF) methods to analysis and evaluate the investment in financial terms. The traditional methods which are Payback method and Accounting Rate of Return do not consider the time value of money but DCF methods consider the time value of money and they are Net Present Value (NPV) and Internal Rate of Return (IRR).
(C) DISCOUNTED CASH FLOW TECHNIQUES
An investment project is a series of cash inflows and outflows, typically starting with a cash outflow (the initial investment Outlay) followed by cash inflows and cash outflows in the later years. (Götze et al 2008).
(Stickney et al 2009) said that NPV is the discounted or present value of all cash inflows and outflows of a project or an investment at a given discount rate.
I totally agree with the statement that an Investment appraisal does add value to a business which is realized in different ways. (Watson and Head 2007) When a firm is appraising an investment and then gets a positive NPV these will indicate that its getting a return in excess of its cost of capital and will therefore lead to an increase in shareholder wealth.
An increase in the shareholders wealth will increase the value of a company. When the value of a company increases we are bound to see that the share prices of the company to rise and at the end of the day it will benefit the shareholders as the main reason the company is formed is to increase shareholders wealth.
Proposals such as the Shareholder Value Analysis (SVA), The Economic Value Added (EVA) can be used as examples to show how value is added.
SVA is based on the principle that the value of the business is equal to the sum of NPVs of all its activities. And so if the value of the NPVs of any of the business can be increased it would mean greater value for shareholders either to be paid out as dividends or to be reinvested. (Rappaport 1986)
Lets the critically analyse the main discounted cash flow methods which are the Net Present Value (NPV) method and the Internal Rate of Return (IRR).
Lucey (2003) wrote about time value of money whereby costs and income arise at intervals over a period of time and because of these monies spent or received at different times cannot be compared. A discount factor is then used to get the present value of the cash flow.
(Stickney et al 2009) said that the discount rate is the interest rate used to convert future payments to present values.
(Besley and Brighm 2008, p.362) '' The IRR is defined as the discount factor that equates the present value of a projects expected cash flows to the initial amount invested.''
.
(D) NET PRESENT VALUE
Managers have always used the NPV method because it's a logical and practical assessment procedure by which to appraise investment opportunities which will also promote the shareholder wealth maximisation objective.
NPV=Present Value - Initial Outlay
Present value is the sum of the discounted values of the cash flows.
The act of discounting brings cash flows at different points in time to a common valuation basis (their present value) which enables them to be directly compared. (Mclaney 2009)
PV of a cash flow= C â‚“ \,(1 + i)^{-t}
Whereby:
C → Cash flow
i→ discount rate
t→number of periods unitil discount
Deision Criteria ;
NPV˃£ 0 ACCEPPT
NPVË‚£ 0 REJECT
The NPV decision rule simply says that firms should invest when the sum of the present values of future cash inflows exceeds the project outlay
STRENGTHS OF NPV
The NPV method of investment appraisal is said to be superior to all other methods because of the following reasons;
It considers all the cash flows unlike Payback period.
It's an absolute method to calculate project return at present value.
It considers time value of money.
Since it's also based on cash flows it is considered better since they are less objective than profits.
NPV is very useful for ranking different projects as it deals in absolute values rather than percentages( which as in the case of Accounting Rate of Return can give unreliable figures )
NPVs RELATION WITH COST OF CAPITAL
NPV and the cost of capital have an inverse relation and so in summary;
If cost of capital decreases→ NPV INCREASES
If cost of capital increases →NPV DECREASES
(E) INTERNAL RATE OF RETURN (IRR)
Internal Rate of Return is defined as the discount rate that equates the present value of a project expected cash flows to the initial amount investment. (Horne and Wachowicz 2008)
IRR represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at different points in its life.
Sometimes what happens is that people always think that IRR and NPV resemble at the first glance and it would appear as that they are inter changeable which could lead people to assume that they will come to similar conclusions on any particular decisions. Later on with the examples will realize that they are different.
A trial and error method is usually necessary because it's hard to get the exact IRR since it cannot be calculated directly.
IRR FORMULA→
IRR FORMULA = L + NL x (H-L)
NL-NH
L = Lower rate of interest
H = Highest rate of interest
NL= Lower rate of interest net present value
NH= Highest rate of return net present value
Decision Rule
Projects that have an IRR greater than the cost of financing them are acceptable
Projects that have an IRR lower than the cost of financing them should be rejected
N/B
The greater the IRR the more desirable the project
IRRs Relation with Cost of Capital
If cost of capital decreases→ IRR DECREASES
If cost of capital increases →IRR INCREASES
COMPARISONS AND DIFFERENCES BETWEEN NPV & IRR
Both NPV & IRR consider the time value of money.
Both of the appraisal methods consider all cash flows in the project.
Both methods are less objective.
Both method take relevant information into account.
IRR is not directly related to the wealth maximisation criterion while NPV relates directly to shareholders' wealth objective.
IRR does not always give clear signals concerning projects and can be impractical to use while NPV provides clear signals and which are practical to use.
IRR often will not be able to cope with varying costs of finance while NPV will always cope up these is because if financing costs start to alter over its useful life it will bring problems because this rate is normally compared with a required rate of return to make a judgement on the investment. Market interest rates will determine all this factors.
(F) Q.2A
PROJECT 1
Annuity Factor @ 14% for 10 years ................................................ 5.216
Annual Cash Flow for the 10 years ................................................ £ 100,000
Initial Outlay .................................................. £ 449,400
Present Value= Annual Cash Flow x Annuity factor
Net Present Value= Present Value - Initial Investment
= £100,000 C 5.216
= £521,600
B = £521,600 - 449,400 = £72,200
A → IRR IS THE RATE AT WHICH NPV EQUALS TO ZERO
Annuity Factor @ 19% for 10 years .............................................. 4.339
= £100,000 x 4.339
= £433,900
NPV = £433,900 - 449,400 = £ (15,500)
IRR FORMULA = L + NL x (H-L)
NL-NH
L = Lower rate of interest
H = Highest rate of interest
NL= Lower rate of interest net present value
NH= Highest rate of return net present value
= 14% + 72,200 x (19%-14%)
[(72200-(-15500)]
= 14%+ 4.116%
= 18.116
A = 18.12%
PROJECT 2
A → IRR IS THE RATE AT WHICH NPV EQUALS TO ZERO
NPV=0
WHEN Present value - Initial Outlay = 0
Present Value of an annuity 1 i.e.
Where; r = interest rates
N= number of years
Annuity Factor @ 20 % for 10 years ............. = 4.192
Annual Cash Flow ...........................................= £70,000
= £70,000 x 4.192
C = £293,440
So Initial outlay is........................................................... £293440
Annual Cash Flow........................................................... £70,000
Annuity Factor @ 14% for 10 years................................. 5.216
= £70,000 x 5.216
= £365,120
D = £365,120 - 293,440 = £71680
PROJECT 3
A → IRR IS THE RATE AT WHICH NPV EQUALS TO ZERO
NPV=0
WHEN Present value - Initial Outlay = 0
So PV =Initial outlay
IRR= 14%
Annuity Rate @ 14% for 10 years........................................................ 5.216
Initial outlay .......................................................................................... £ 200,000
Annual Cash Flow =
= 38,343.5
E=£ 38,344
38,344 x F = £235,624
F=
Annuity Factor =6.145
6.145= 10%
Cost of capital = 10%
PROJECT 4
Present value= NPV + Initial outlay
= £39,000+ £300,000
PV = £339,000
Annuity Factor @ 12% for 10 years → 5.650
G x 5.650= £339,000
G=
G= £60,000
NPV@ 12% for 10 years → £39,000
Annuity factor @ 17% for 10 years→ 4.659
£60,000 4.659 =£279,540
£279,540-£300,00
NPV =(20,460)
IRR= 12% + ( ) x 17-12
=12% + ( ) x 5
= 15.2795%
H = 15.28%
SUMMARY OF ANSWERS
QUESTION
ANSWER
A
18.12%
B
£ 72,200
C
£ 293,440
D
£ 71,680
E
£ 38,344
F
10%
G
£ 60,000
H
15.28%
(G) Q.2B
We have four mutually exclusive projects in front of us and so the question remains which project should be taken.
According to Lucey (2003) we should accept projects that have a positive Net Present Value and reject projects that have a negative NPV well then so far we should accept all of them lets evaluate them even further .
If the company has two or more investment projects which are mutually exclusive then a company should accept the one with the highest Net Present Value. (Kaplan 2008)
In our case we have Project 1 & 2 have a high NPV and so we have simply eliminated projects 3 & 4 because they have a lower NPV compared to Project 1 and 2.
We clearly can see that project 1 has a NPV of £72,200 and Initial Outlay of £ 449,000 while Project 2 has a NPV OF £ 71,680.
Any rational person would obviously go for project 2 because it does have a high NPV and a lower Initial cost than project 1 but that is not the correct decision.
The Project that should be accepted is Project 1 the reasons for these are;
It has a higher NPV than the others because it has a NPV of £ 72,200
The other reason we rejected project 2 was because of the Shareholders objective. According to (Mclaney 2009) one of the main reasons for businesses is to maximize shareholders wealth and that's exactly what has to be done so the company should take Project 1 because it will lead to increase in shareholders wealth.
Watson and Head (2007) said that the project which has a higher NPV should be accepted since these decision supports the corporate finance objective of maximising shareholder wealth since the Highest NPV leads to increase in the value of a company .
Well if the company had a problem regarding finance as in it dint have £ 449,400 it could have invested in Project 2 but that clearly is not the case in these situation because we are assuming the firm has the necessary funds and so project 1 should be accepted .
(H) CONCLUSION
The Net Present Value method of investment appraisal is sound, superior and a more realistic method while undertaking any investment decision. The reasons for these are that NPV considers all d factors that have to be considered when you are about to invest e.g. Making completely sure that the main objective of the firm is to maximize shareholders wealth had been taken into account and also that the time value of money has been taken into account because it will always tell the investors whether the project is viable or not.
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