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A Report On Capital Investment Appraisal

I have been appointed to write a report to advice on the continuation of the Landvest 2016 Ltd. Development. Landvest 2016 is a special vehicle created by a group of part-time property developers in the Republic of East Kurazia. A large property developer has subsequently approached Landvest to buy the property, which would result in Landvest not completing the development.

Objectives

To provide spreadsheet models for both the Landvest 2016 Ltd Development and the alternative offer

To identify and discuss the different methods used in the spreadsheet model

To evaluate the project and the risk involved with the different quantitative methods

To identify and discuss the different qualitative risks not captured in the spreadsheet models.

Landvest 2016 Ltd

A discussion of the relative merits of the method that have been used

Four methods for capital investment appraisal will be reviewed in the Landvest 2016 Ltd. spreadsheet model; Net Present Value (NPV), Payback, Accounting Rate of Return (ARR) and Internal Rate of Return (IRR). Capital investment appraisal is ‘how a business decides if a capital investment project is worthwhile. Or, where alternatives exist and which option is likely to be the best’ (Marcourse et al. 2005, p.g. 184).

Net Present Value (NPV) ‘is the value in present days terms of the various cash inflows and outflows expected to arise at different periods in the future’ (T. Lucey, 2002, p.g. 355). The NPV demonstrates the value of an investment or a project for a firm. Please see Appendix A for the NPV formula. The main advantage of the NPV is that it illustrates whether the end result of a project should be accepted or not. If the NPV shows a positive vale then the project might be accepted. On the other hand, if the NPV is a negative value, then the project must be rejected, as it would subtract value from a firm. The ‘NPV is the most widely accepted tool for analysing projects, as it takes into account of the time value of money’ (Brydels, 2008). It also takes into account the opportunity cost of money and the amount and timing of cash flows. Most importantly the NPV helps to increase the wealth for the shareholders in a firm.

However, the NPV has a number of drawbacks which can affect an investment or a project’s end result as it can be a complex method to calculate and it is easily misunderstand by many people. The NPV ignores other features of the business such as qualitative factors e.g. a firms objective, interest rates rising, unemployment and does not ‘take into account of the fact that future returns may be less valuable’ (Bized, 2008).

Payback is a technique frequently used by firms to decide on whether to accept or reject an investment or project. It can be defined as, ‘the time required for the cash inflows from a capital investment project to equal the cash outflows’ (CIMA). Managers can compare the payback period with their investment or project against others and choose which project they should go ahead with. Payback is very easy to calculate and understand. It is ‘more objective based because it uses project cash flows rather than accounting profits (T. Lucey, 2002, p.g. 357). Payback is also a good technique to use for high risk or high tech projects as it demonstrates the quickest payback period which can help to minimise any risks that may occur.

Although, not all risks that may arise are associated with the time it takes for an investment or a project to payback the initial investment. Therefore, the payback method is not an accurate measure of the overall project’s liquidity. The method is too simplistic as it ignores the time value of money and it may lead to managers in a firm to behave in a short- term attitude.

Accounting Rate of Return (ARR) is a technique used by firms to assess the worth of an investment by calculating the yearly percentage return on the sum investment. ‘If the ARR is greater then, or equal to, a hurdle rate then accept the project’ (G. Arnold, 2007, p.g. 87). Please see Appendix B for the ARR formula. The ARR allows managers to compare alternative investments as well as to contrast the percentage rate of return with that available from investing in financial institutions. It is ‘regarded as a useful measure of the likely success of a project because it is based on the familiar accounting measures of profit’ (P. Weetman, 2006, p.g. 267). The ARR shows the profit calculations that are expected over the project life, which is also very useful as it does not ignore the date beyond the cash flow.

However, a major criticism for the ARR is that it ‘fails to take account of the time value of money. There is no allowance for the fact that cash received in one year is more valuable then an identical sum received in three years’ (G. Arnold, 2007, p.g. 88). Also the ARR depends highly ‘on profits which, in turn, includes a subjective accounting estimate of depreciation’ (P. Weetman, 2006, p.g. 267).

Internal Rate of Return (IRR) is ‘ is the discount rate at which the present value of the cash flow generated by the project is equal to the present value of the capital investment, so that the net present value of the project is zero’ (P. Weetman, 2006, p.g. 273). Please see Appendix C for the IRR formula. The higher the IRR, the more profitable it is to undertake an investment or a project for a firm. The IRR allows managers to compare the initial value with a number of projects. Like the NPV, ‘it involves the calculations of the net present value of a potential project’ (Marcouse et al. 2005, p.g. 188). The IRR also demonstrates in a clear and straightforward manner the overall return from an investment or project, which provides uncomplicated decision- making process for firms to determine which investment or project to select.

However, the IRR can be very difficult to calculate especially using Microsoft Excel as it uses estimates. For this reason the IRR is not a useful method in decision making as it provides managers with rough calculations which can give deceptive results for a project.

Landvest 2016 Ltd

Recommendation based on the different quantitative method used to evaluate the project and the risk involved

Using an 18 per cent discount rate provides the project with a positive NPV. This is superior for the company as it indicates that the project will exceed their cost of capital and it would also increase their shareholders value. If they were to sell to the large property developer, the equivalent NPV would be -1871 which is not acceptable. The project produces an IRR of 57.09% which is more than the opportunity cost of the shareholders funds and is therefore to be recommended. Whereas selling to the alternative developer would give a lower IRR of 13.15% which is less than the cost of capital. The project shows a short payback period with one year and six months which also indicates that this project should be accepted as it demonstrates that the company’s capital investment will be paid back more quickly. Shorter payback also means that risks are reduced for the firm as shorter term revenue projections are often more reliable than longer term payback periods. The projects ARR gives a percentage of 49.63% this shows that it is much greater then the cost of capital of 18%, therefore the project should be accepted.

It needs to be emphasised that the NPV values quoted above assume that the project will be completed within five years and that both inflation and property values remain static.

Based on the positive NPV, I would strongly recommend Landvest 2016 Ltd to take on the project as investing into the project would be financially worthwhile. The reason I have based my recommendation mainly on the NPV rate is that it is regarded as technically more sound than the other three methods for making decisions on the final investment of the project. Please see Appendix D to J for the projects spreadsheet models and workings.

Landvest 2016 Ltd

A qualitative discussion of the risks not captured in the model

There are also a number of qualitative factors that have not been captured in the spreadsheet model which may have an affect on the success of Landvest 2016 Ltd’s new development. The following qualitative factors should be considered for Landvest 2016 Ltd: Environmental issues, social issues and the state of the economy.

The environmental issues

There are a number of environmental factors which may have a major affect for Landvest 2016 Ltd. These are firstly, the electricity supply which has been poorly planned by the government. It has been announced that new nuclear power plants will not come into operation for another 10 years. There are already rolling power outages and rationing will also take place. As the project has been estimated to last a minimum of five years, development delays will result from both the rationing and the outages, resulting in overrun and increase costs.

Secondly, developing new property next to the capital city may be result in the development being overrun by squatters. The potential occupation of the development by squatters will hinder sales, have a negative effect on property resale values and result in increase costs.

The social issues

The main factor that could affect the development of the project is the fact that the company Landvest 2016 Ltd is run by a group of part-time developers. The group may not be in full agreement at all time which could result in the decision making process becoming protracted. Furthermore, processes could become totally stalled. It is also not possible to quantify the squatters issue and the ramifications of the development being overrun.

State of the economy

The state of the economy may provide a number of risks for the property development such as inflation and the loss of confidence in the economy. There has been a major concern with the reduction of future property value for Landvest 2016 Ltd. This means that profits are less as costs will remain the same, therefore the return is lower. A reduction in property prices will also lead mean that potential new buyers will stay away. This would lead to a major threat to the company. An increase in inflation and further decreases on property prices will result in lower prices.

Landvest 2016 Ltd

Conclusion

Based on my analysis and discussions above, Landvest 2016 Ltd. should continue to develop the East Kurazia project. This project requires completing in five years. The major obstacle that will prevent the successful completion of this project will be the continual supply of electricity. Further advice should be sought to ensure that shareholders will be satisfied that a continual electricity will be delivered to the development. If electrical supply can not be guaranteed further financial analysis should be completed into the financial viability of Landvest 2016 Ltd. completing the project over a longer time frame against sale to the larger developer.

Landvest 2016 Ltd

Appendices

Landvest 2016 Ltd

Appendix A

The formula for NPV is as follows:

G, Arnold, 2007, p.g. 42

Landvest 2016 Ltd

Appendix B

The formula for ARR is as follows:

ARR= Profit for the year X 100

Asset book value at start of year

G, Arnold, 2007, p.g. 87

Landvest 2016 Ltd

Appendix C

The formula for IRR is as follows:

G, Arnold, 2007, p.g. 58

Landvest 2016 Ltd

Appendix J

Calculations for cash flow

Cash inflows £

Sales 8,000,000

Cash out flows

Professional fees 5,000,000 Yearly deposit (paid into equal annual payments 5,000,000 Legal fees 250,000 City council 1,000,000 Town planners (no fees upfront, but respectively each year) 10,000

Engineers (no fees upfront, but respectively each year) 15,000 Suppliers 2,000,000 Connections specific spot (every year) 200,000 Security

2nd year 20,000 Rising inflation (15%) from the 3rd year 60,000

Inflation rate 15%

TAX rate 35% (12 months in arrears)

Cost of capital 18%

NOTE: written down allowance (WDA) has not been used, as I do not have enough information and therefore depreciation can not be used in cash flow.

Calculations for alternative offer

Cash inflows £

Sales

1st year 1,500,000

The rest after 5 years- 6th year 13,500,000

Cash out flows

Professional fees 5,000,000 Yearly deposit (paid into equal annual payments 5,000,000

Inflation rate 15%

TAX rate 20% (charged in year 7)

Cost of capital 18%

Landvest 2016 Ltd

Reference page

Bized (2008) Net present value [Online]. UK: Available from: http://www.bbc.co.uk/schools/gcsebitesize/business/finance/cashflowrev6.shtml [Accessed 10th January 2009]

Brydels (2008) Net present value [Online]. UK: Available from: http://www.brydels.com/chapter8.html [Accessed 10th January 2009]

CIMA Terminology

G, Arnold. (2007) Corporate Financial Management .London: Prentice Hall

Marcouse et al. (2005) Business Studies. Kent: Hodder & Sloughton

P, Weetman. (2006) Management Accounting. London: Prentice Hall

T, Lucey. (2002) Costing. 6th ed. London: Thomson learning

Landvest 2016 Ltd

Word count

Word count= 1,692

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