Management accounting process, which consists of management decision making according to provided information on the investment in an undertaken project, monitoring the performance of that project and its implementation is called Investment Appraisal. (Weetman, 2009, p.660). Globalization, innovations and rapid technological changes are lead to make modern business environment more competitive. In order to survive in the market, to make profits and to be able to compete within this new business environment; organizations must have strong financial positions as well as flexible structures. To gain feasible competitive advantages in the market an organization should undertake some projects.
Investment appraisals express the most important decision making in an organization, since the organization commits a considerable proportion of its resources to actions that are changeless and without having certain knowledge about future benefits. (Mott, 2005, p.207)
Acquisitions, replacement of machinery, improvements of systems, expansion of business operations, modernization of long term assets can be called as investment. Normally investments such as; plant and machinery replacement, advertising and storing of goods, research and development take more than one year period.
Since these types of investments carry huge cash flows as well as risk associated with them; managers should evaluate projects before they are accepted. When the managers of an organization make plans for the long term, they must be able to answer number of questions including:
Which projects should be undertaken?
What will be the benefits of such project?
How much fixed assets and working capital should be committed to projects?
Where the required finance can be obtained from? (Weetman, 2009, p.660)
While selecting an acceptable projects managers can use different methods in order to correspond different criterions. To evaluate the investments in financial terms, managers can use either Traditional Method or Discounted Cash Flow(DCF) analysis.
In Traditional Methods which consists of Payback method and Accounting Rate of Return(ARR), there are no considerations for the time value of money. But in DCF method considers the time value of money in which reduces the time value of money progressively and it consist with Net Present Value (NPV) approach and Internal Rate of Return (IRR) method.
PAYBACK METHOD
The payback method calculates the length of time needed to recover the initial cash outflow. If there are several alternative projects, the one with the shortest payback time period which minimizes the risk of future uncertainty would be recommended to undertake in an investment decision making. (Proctor,2009)
(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?
FOR PROJECT A:
NET CASH FLOW(NCF) CUMULATIVE NCF
£000 £000
Year 1 20 20
2 30 50
3 40 90
4 50 140
5 70 210
PAYBACK= 3+ Amount still needed .
Total inflow in payback year
PAYBACK= 3+ 110-90 = 3.4 YEARS
140-90
FOR PROJECT B:
NET CASH FLOW(NCF) CUMULATIVE NCF
£000 £000
Year 1 40 40
2 40 80
3 40 120
4 40 160
5 40 200
PAYBACK= 2 + Amount still needed .
Total inflow in payback year
PAYBACK= 2 + 110-80 = 2.75 YEARS
120-80
Because of annuity we can calculate the payback time needed with an other equation which will give us the same solution;
PAYBACK= INITIAL INVESTMENT = 110 = 2.75 YEARS
NCF 40
If the maximum Payback Period of AP Ltd is 3 years; Project B should be accepted.
(c) What are the criticisms of the payback period?
It is the most simple investment appraisal method among the others. And it is used as an indicator of risk. But it has some weaknesses as compared to other methods.
One weakness of this method is that it only concerns about the payback time period and the cash received after payback is completed, is totally ignored. Therefore; even projects with shorter payback period are not as profitable as projects with a longer payback period, they can be accepted. Another weakness is that no attempt is made to relate the total cash earned on the investment to the amount invested. The payback method does not attempt to measure this total profitability over the whole life of the investment and other methods have to be introduced to do this. (Dyson, 2007, p.424)
(d) Determine the NPV for each of these projects? Should they be accepted - explain why?
NPV FOR PROJECT A:
Years
Net cash flow
Discount factor
Present value
£000
12%
£000
1
20
0.893
17.860
2
30
0.797
23.910
3
40
0.712
28.980
4
50
0.636
31.80
5
70
0.567
39.690
_______
Total present value
141.740
Less: Initial cost
110
------------
Net present value
31.740
NPV FOR PROJECT B:
Years
Net cash flow
Discount factor
Present value
£000
12%
£000
1
40
0.893
35.720
2
40
0.797
31.880
3
40
0.712
28.480
4
40
0.636
25.440
5
40
0.567
22.680
_______
Total present value
144.20
Less: Initial cost
110
------------
Net present value
34.20
Both projects should be accepted, since both Net Present Values are positive according to ACCEPT-REJECT decision making techniques.
If we use RANKING decision making techniques;
Project
NPV@ 12% Discount Rate
£000
B
34.20
A
31.740
As it can be seen from the rankings Project B is more preferable with a higher NPV.
(e) Describe the logic behind the NPV approach.
NET PRESENT VALUE METHOD:
Because of the weaknesses of Traditional methods, DCF Discounted Cash Flow method is more superior among investment appraisal techniques. Unlike traditional method, the time value of the money is considered in DCF methods such as; Net Present Value (NPV) and Internal Rate of Return.
Time Value of Money:
If £10 is invested at a interest rate of 10% per year, at the end of the year one the money will grow to £11. Suppose it has been promised for an investor to receive £10 in one year's time and the interest rates are 10%. If the investor does not want to wait one year to receive cash; the money would be £9.091.
This amount can be calculated by using the present value formula which is useful during the calculation of the present value of a sum of £1 that can be received at the end of n years with an interest rate of r% per year;
1
(1+r)n
This process of calculating the present value of the money is called 'discounting'. And the interest rate is called the 'discount rate'. (Weetman, 2009, p.666)
Net Present Value:
The sum total of the present values of all cash flows that come from the project, is called the 'Net Present Value'.
Net present value has some calculation procedure such as;
Make calculations for the annual cash flows
Determine the discount rate
Calculate the discount rate by using the present value formula or PV tables.
Make discounting for future cash flows and calculate annual present values
Sum up all the annual present values to get Net Present Value for the whole project time period.
After calculating the results interpreting must be done in order to decide about the projects. During the decision making;
Accept the project, if NPV is positive.
Reject the project, if NPV is negative.
If there are several projects are being considered for an investment, choose the project with the highest NPV.
The only weakness of this method is that the discount rate (cost of capital) is assumed that it won't be changed over the years with any factors, which is more likely to be not true; especially when longer period of time is involved. (Proctor, 2009, p.190)
(f) What would happen to the NPV if:
(1) The cost of capital increased?
(2) The cost of capital decreased? (8%)
(g) Determine the IRR for each project. Should they be accepted?
THE INTERNAL RATE of RETURN (IRR):
This method is a similar method to the NPV and it is based on discounting as well. But unlike the NPV method, it calculates approximately the rate of return that is needed in order to make sure that total NPV equates the total initial investment cost.
In theory, if the project's calculated internal rate of return is greater than cost of capital, project can be accepted.
IRR of a project can be calculated by the formula below;
IRR= positive rate + ( positive NPV x range of rates )
positive NPV + negative NPV8
*Ignore the negative sign and sum up two values
Advantages of this method:
It focuses on liquidity.
It observes the timing of net cash flow.
It gives a net rate of return on an investment.
NPV FOR PROJECT A:
Years
Net cash flow
Discount factors
Present value
£000
17% 22%
17% 22%
£000 £000
1
20
0.855 0.819
17.10 16.38
2
30
0.731 0.671
21.93 20.13
3
40
0.624 0.550
24.96 22
4
50
0.534 0.451
26.70 22.55
5
70
0.456 0.369
31.92 25.83
_______ ______
Total present value
122.61 106.89
Less: Initial cost
110 110
------------ ---------
Net present value
12.61 (3.11)
IRR= positive rate + -range of rates= = 17%+-5% =21.04%
At 21.01% discount rate the NPV is equal to zero.
NPV FOR PROJECT B:
Years
Net cash flow
Discount factors
Present value
£000
22% 27%
22% 27%
£000 £000
1
40
0.819 0.787
2
40
0.671 0.620
3
40
0.550 0.488
4
40
0.451 0.384
5
40
0.369 0.302
Annuity factor
2.863 2.578
Total present value
114.4 103.12
Less: Initial cost
110 110
------------ ---------
Net present value
4.40 (6.88)
IRR= positive rate + -range of rates= 22%+-5% =24%
Since both project's IRR are bigger then cost of capital; both of them can be accepted.
(h) How does a change in the cost of capital affect the project's IRR?
(i) Why is the NPV method often regarded to be superior to the IRR method?
PROJECT A PROJECT B
£000 £000
Year 1 20 40
2 30 40
3 40 40
4 50 40
5 70 40
