Capital investment decisions are those decisions that involve current outlays in return for a stream of benefits in future years. It is obvious that all of the firm's expenditures are made in expectation of realizing future benefits.
These decisions normally represent the most important decisions that an organization makes , since they commit a substantial proportion of a firm's resources to actions that are likely to be irreversible.
Such decisions are applicable to all sectors of society.
Business firms' investment decisions include investment in plant and machinery , research & development , advertising and warehouse facilities etc.
Investment decisions in public sector include new roads , schools , hospitals , airports etc.
Individuals' investment decisions include house-buying and the purchase of consumer durables. ( Drury C. , 2001 , p. 243 )
There may be some investment situations in which there are no benefits quantifiable in money terms but they benefit the organizational development or employee health & safety in the long run. For e.g. the government may require firms to invest in fire detection & alarm systems in all their premises. Even in such cases investment appraisal can help choose between competing systems which have different financial characteristics. ( Mott Graham , 2005 , p. 209 )
The investment appraisal methods help a firm in allocating their funds & resources to the most profitable projects by ranking them on the basis of NPV (Net present value ) , IRR (Internal rate of return ) , PAYBACK period & ARR ( Accounting rate of return ).
QUESTION (B) :
What is the payback period of each project ? If AP Ltd. Imposes a 3 year maximum payback period which of these projects should be accepted ?
ANSWER :
PAYBACK PERIOD FOR PROJECT ( A ) :
Year
Net Cash Flow ( £ 000 )
Cumulative Cash Flow ( £ 000 )
0
( 110 )
1
20
20
2
30
50
3
40
90
4
50
140
5
70
210
Payback ( A ) = 3 + ( 20÷50 ) = 3 + 0.4 = 3.4 yrs = 3 yrs & 4.8 months .
* Payback period for Project ( A ) = 3 years & 4.8 months .
PAYBACK PERIOD FOR PROJECT ( B ) :
Since Project ( B ) is an annuity i.e. constant cash flow per year , the formula is :
Payback period for an Annuity = Initial investment ÷ Constant cash flow per year
Payback ( B ) = 110000 ÷ 40000 = 2.75 yrs = 2 yrs & 9 months .
*Payback period for Project ( B ) = 2 years & 9 months .
Hence according to the Payback period method , the Project ( B ) is better than Project ( A ) since it returns the initial investment in less than 3 years.
Thus if AP Ltd. imposes a 3 year maximum Payback period , the Project ( B ) should be accepted.
QUESTION ( C ) :
What are the criticisms of the payback period ?
ANSWER :
Though the Payback period method is very simple to understand for all levels of management & it helps prevent cash flow or liquidity problems , it has some serious drawbacks as well.
The main disadvantages of the Payback method are :
It completely ignores the time-value of money i.e. in payback period method , there is no difference between the value of a £ 1 now & 1 year later .
It does not count the cash inflows produced after the initial investment has been recovered. Thus ignores the exact profitability of the project.
It is unable to distinguish between projects with same payback period.
Biased against long-term projects that take longer time periods to become lucrative.
Objective not consistent with shareholders' wealth maximization . Infact , managers may use it to get short-term profits in order to secure their jobs.
A project accepted on base of Payback criteria may not have a positive NPV.
Thus , ideally the payback method should be used in conjunction with the NPV method , and the cash flows discounted before the payback period is calculated. ( Drury C. 2001 )
QUESTION ( D ) :
Determine the NPV for each of these projects ? Should they be accepted - explain why ?
ANSWER :
NPV FOR PROJECT ( A ) @ 12 % D.R. :
Year
NCF (£ 000 )
Discount Rate : 12%
Present Value ( £ 000 )
1
20
0.893
17.86
2
30
0.797
23.91
3
40
0.712
28.48
4
50
0.636
31.80
5
70
0.567
39.69
Total PV @ 12% D.R. (£ 000 ) = 141.74
Less initial investment ( £ 000 ) = - 110.00
NPV for ( A ) @ 12% D.R. ( £ 000 ) = 31.74
*Net present value (NPV) for project ( A ) @ 12 % discount rate = £ 31740
NPV FOR PROJECT ( B ) @ 12 % D.R. :
Since Project (B) is an annuity :
NPV for Annuity = Constant cash flow/yr Ã- Cumulative discount rate - Initial investment
NPV for Project ( B ) @ 12 % D.R. ( £ 000 ) = 40 Ã- 3.605 - 110 = 144.2 - 110 = 34.2
*Net present value (NPV) for Project ( B ) @ 12 % discount rate = £ 34200
Since both Projects A & B have positive NPV they should be accepted.
The positive net present value from the investment indicates the increase in the market value of the shareholder's funds which should occur when the stock market becomes aware of the project .The net present value also represents the potential increase in present consumption that the project makes available to the ordinary shareholders , after any funds used have been repaid with interest. ( Drury C. , 2001 , p. 249 )
Even if a Project's NPV is zero & there is no other more suitable project , it could be considered because it covers the discount rate & thus the firm can give dividends to the shareholders . However there is no addition to the firms own funds & present value of the firm remains the same . ( Palan S. , 2009 , lectures )
If the two projects are compared , then the Project ( B ) is more profitable according to the NPV method . Thus the capital should be allocated first to the Project (B) & then if surplus , to Project (A).
QUESTION ( E ) :
Describe the logic behind the NPV approach.
ANSWER :
Net Present value (NPV ) method is a Discounted Cash flow ( DCF ) method i.e. it accounts for the time value of money & cash flows throughout the life of the project.
The process of converting cash to be received in the future into a value at the present time by the use of an interest rate is termed discounting & the resulting present value is the discounted present value. For example , if the interest rate is 10% each £1 invested now will yield £ 1.10 one year from now. Alternatively £1 one year from today is equal to £0.9091 today , its present value because £ 0.9091 , plus 10% interest for one year amounts to £1.
The concept that £1 received in the future is not equal to £1 received today is known as the time value of money & NPV method takes account of this crucial factor. ( Drury C. , 2001, p. 246 )
Strengths of NPV are :
Any project with a positive NPV increases the wealth of the company & thus maximizes the shareholders' wealth.
Takes account of the time value of money & thus the opportunity cost.
Discount rates can be adjusted according to the different level of risks inherent in different projects.
Unlike the payback method , it takes into account events throughout the lifetime of the projects.
Superior to the internal rate of return (IRR) method because it doesn't suffer the problem of multiple rates of return due to irregularities in the pattern of cash flows.
Better than the accounting rate of return (ARR) method because it focuses on cash flows rather than profits & avoids the understatement of returns. ( Palan S. , 2009 , Lecture handouts )
QUESTION ( F ) :
What would happen to the NPV if :
The cost of capital increased
The cost of capital decreased
ANSWER :
Lets consider the Project ( B ) whose NPV @ 12 % = £ 34200
If the cost of capital increases to 25 % :
NPV for (B) @ 25 % D.R. ( £000) = 40 Ã- 2.688 - 110 = 107.52 - 110 = - 2.48
*NPV for Project (B) @ 25 % discount rate = £ - 2480
Thus the NPV for Project(B) decreases with the increase in the cost of capital .
It was positive @ 12% discount rate but becomes negative @ 25% discount rate .
Hence , the NPV of any project would decrease with the increase in the cost of capital.
If the cost of capital decreases to 10 % :
NPV for (B) @ 10 % D.R. (£000) = 40 Ã- 3.791 - 110 = 151.64 - 110 = 41.64
*NPV for Project (B) @ 10 % discount rate = £ 41640
Thus the NPV for Project (B) increases with the decrease in the cost of capital.
Hence , the NPV of any project would increase with the decrease in the cost of capital.
QUESTION ( G ) :
Determine the IRR for each project . Should they be accepted ?
ANSWER :
In order to calculate IRR , first the NPV has to be calculated for the projects in jumps of 5% discount rate to get 2 NPV values i.e. one positive & one negative.
IRR FOR PROJECT (A) :
NPV FOR PROJECT (A) @ 20% & 25% DISCOUNT RATES :
Year
NCF (£000)
D.R. 20%
PV@20%(£000)
D.R. 25%
PV@25%(£000)
1
20
0.833
16.66
0.800
16.00
2
30
0.694
20.82
0.640
19.20
3
40
0.579
23.16
0.512
20.48
4
50
0.482
24.10
0.409
20.45
5
70
0.401
28.14
0.327
22.89
PV @ 20% D.R. = 112.88 & PV @ 25% D.R. = 99.02
Less initial investment = - 110.00 & - 110.00
NPV @ 20 % D.R. (£000) = 2.88 & NPV@ 25% D.R. = - 10.98
NPV for Project (A) @ 20% discount rate = £ 2880
NPV for Project (A) @ 25% discount rate = £ - 10980
Thus the IRR for Project A would be calculated as follows :
IRR = 20% + { 2880 ÷ (2880 + 10980)} Ã- ( 25% - 20% )
= 20% + 0.207 Ã- 5%
= 20% + 1.038%
= 21.038 %
*IRR for Project A = 21.038 %
IRR FOR PROJECT ( B) :
NPV FOR PROJECT (B) @ 20% D.R. (£000) = 40 Ã- 2.991 - 110 = 119.64 - 110 = 9.64
NPV for Project (B) @ 20% discount rate = £ 9640
NPV FOR PROJECT (B) @ 25% D.R. (£000) = 40 Ã- 2.688 - 110 = 107.52 - 110 = - 2.48
NPV for Project (B) @ 25% discount rate = £ - 2480
Thus IRR for Project (B) would be calculated as follows :
IRR = 20% + { 9640 ÷ (9640 + 2480) } Ã- ( 25% - 20%)
= 20% + 0.795 Ã- 5%
= 20% + 3.976%
= 23.976 %
*IRR for Project (B) = 23.976 %
Since the IRR for both projects is greater than the cost of capital or discount rate i.e. 12 % , these projects can be accepted according to the criterion of IRR ( true interest rate earned on an investment ).
Project (B) has a better IRR so it would be preferred over the Project (A).
QUESTION ( H ) :
How does a change in the cost of capital affect the project's IRR ?
ANSWER :
Unlike NPV , IRR doesn't vary with the change in the cost of capital .
IRR represents the true interest rate earned on an investment over the course of its economic life.
It estimates the break-even discount rate i.e. the discount rate at which the NPV of a project is zero.
Thus it shows the discount rate , below which the NPV of a project is positive (thus investment should be made) & above which the NPV of a project is negative (thus investment should be avoided).
QUESTION ( I ) :
Why is the NPV method often regarded to be superior to the IRR method ?
ANSWER :
NPV method is regarded superior to the IRR method because of following reasons :
Unlike IRR , NPV doesn't suffer the problem of multiple rates of return due to irregularities
in the patterns of cash flows.
NPV reinvestment assumption is more practical as it reinvests the cash flows at the cost of capital whereas the IRR reinvests only at a return equal to the IRR of the original project.
In evaluation of mutually exclusive projects the IRR method can incorrectly rank projects because of its reinvestment assumption , thus NPV is recommended for such projects. ( Palan S. , 2009 , lecture notes )
NPV is expressed in monetary units (£) thus gives the bigger picture about the investment whereas IRR is expressed in percentage & comparison of projects in percentage terms can sometimes be misleading , ignoring the size & thus opportunity as well as risk of the investment. ( Drury C. , 2001 , p. 253 )
