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Investment appraisal model

Executive summary

The most company's financial objective is to increase shareholder value in order to invest money into projects which can be evaluated with investment appraisal models.

There are 4 types of models; each of them has its own role and importance to the project analysis which are NPV, IRR, ARR and Payback method. Every model helps managers to make right decisions in order to calculate and take the most successful project.

Investing the project might be risk either medium or serious effect. Risk is possibility of occurrence of negative event which might deviate from expected return. The business might have business risk, financial, risk, project risk and market risk, furthermore the company will face interest rate, exchange rate and commodity price risk.

Choosing the right project, managers firstly need to identify the risk, measure the risk in order to find out how much the risk will affect to the company such as the managers could measure the risk with standard deviation, semi variance and coefficient variance techniques.

In conclusion after measuring the risk, the managers could manage the risk in order to reduce the effect by transferring the risk to insurance company or to third party, mitigate the risk, reduce the probability of occurrence and reduce the magnitude of risk.

1. Introduction

Investment appraisal model provides opportunity for companies that make decisions involving investment in new plant, machinery, buildings, and similar long term assets. Businesses should try to pursue their strategic objectives by trying to maximize value thorough investments that provide an appropriate strategic fit.

Investment appraisal and management is a very vital area for business, expensive and far reaching cost can flow from bad investment. There are a range of standard techniques which allow managers to compare projects by taking into account differing measurement criteria. The methods are net present value, internal rate of return, accounting rate of return and Payback method which help to make right decision in order to increase the wealth of owners. But there are risks in the cash flows from a project and there are risks for the private investor when they purchase the shares. Risk is significant aspect of the financial decision making and is the scope and probability that what is estimated to occur will not actually happen.

2. Financial objective

According to Hawkins (2007) generally objective of the business is to create value for its shareholders while sustaining a sound financial position.

For example The Quaker Oats Company was one of the first firms to adopt this goal: that their objective is to maximize value for shareholders over the long term, ultimately their goal is the goal of all professional investors to maximize value by generating the highest cash flow possible. And also the one of the largest mining company Rio Tinto's core objective is to maximize the long term return to shareholders by finding, mining and processing metal and mineral resources across the globe.

In resulting of examples, basically organization objective is to create value for the shareholders in order to make right decision on investment and to maintain the strategy.

3. Investment appraisal

According to Pike, investment appraisal is to maximize the shareholders wealth, the organization invest money into project which could earn cash return in the future. Investment appraisal models help manager to analyze the return which either can exceed the expectation or cannot reach the target which is mentioned in introduction section, NPV, IRR, ARR and Payback methods.

3.1 Net present value

The use of NPV at Rolls-Royce that Rolls-Royce plc stated, the group continues to focus on all investment to rigorous examination of risks and future cash flows to ensure that they create shareholder value. All major investments require Board approval, has a portfolio of project at different stages of their life cycles. Discounted cash flow analysis of the remaining life of projects is performed on regular basis. From this example, Rolls-Royce obviously using NPV which help them to discounts the future flow of cash to express them at their present value and helps the Rolls-Royce managers to choose the only project with positive NPV based on future cash flows to increase shareholder wealth, gives absolute measure and allow for time of money value. Only it is difficult to predict the cost of capital which has been stated by Pike.

3.2 Internal rate of return

The some examples of large companies who are used IRR; Associated British Ports, UK largest port operator concentrates on project which generates at least 15%.

Brascan, a Canadian Property and energy business, made a bid to acquire Canary Wharf in London; expected return is at least 20% if the bid price was accepted. From these cases IRR could provide them the exact rate of return that the project is expected to achieve and it helps companies to undertake the project, if IRR exceeds the target of rate of return.

As Davies stated that the managers prefer to use IRR which is easily understandable and does not need estimated cost of capital because the result is stated as %. Only problem with IRR is very difficult to make decision for the managers and they need to consider the size of the projects after IRR result. Because it ignores size of the project

3.3 Payback method

According to Anthony, the method is to estimate the number of years which investment outlay will be paid back from the cash inflows and is often used as quick method in of advantage increasing projects where the criteria involve the necessity of quick recovery. The Payback method is easily understood, considers liquidity and looks only at relevant cash flows.

Danger of using payback is ignoring the timing of cash flows, cash flow that occur after payback point and may be tendency to conclude that the shorter the payback period, the better is the project. The SES Global is the largest commercial satellite operator who rents satellite capacity to broadcasters, government, telecommunications and internet service providers. They are planning to launch satellite costs around €250M, the main elements of this cost are €120M, the launch vehicle €80M, insurance €40M and ground equipment €10M. Once the satellite is in orbit, revenues will start. According to the president Romain Bausch, it takes three years to build and average life time is 15 years. They have expected the payback period is around 4-5 years.

3.4 Accounting rate of return

It is a simple measurement form of return on capital employed, based on profits rather than cash flows. According to Davies and Bogzko the method can provide an overview of a new project. But it ignores the time of value of money and no account is taken of the size of the project. For example, during 1970s, Mexican government has changed the four lane road to six narrower lane which enable increase in capacity of road by 50%. But it has been occurred more accident and they changed the road to the previous form that reduced to 33%. But the fact is that the capacity was identical. The confusion arose because each of the two % (50% and 33%) is based on and different bases (6 and 4).

According to the survey within UK companies, in 1993 the payback method appears to have been the most popular method and then NPV and ARR appeared equal, IRR was used at least. Larger companies tended to use DCF (discounted cash flow) methods while smaller companies preferred to use payback. But most companies used more than one method.

In 2000, there has been change occurred, the increase popularity in DCF methods with IRR and NPV are being most popular methods. Larger companies continued to use DCF methods, with IRR being slightly more popular than NPV. The majority of companies used more than method, for small straightforward investments use the simple techniques and NPV and IRR on larger strategic projects.

4. Analysis of investment risk

4.1 Concept of risk

The business objective is to maximize the shareholders value in order to invest in a new project which has uncertainty of loss or success. There is fundamental relationship exists between risk and return, the example, In 1986 Eurotunnel has been authorized to run a twin rail tunnel between France and Britain. The project was such highly risky venture that shareholders would not get any dividend at least for 8 years and has expected internal rate of return 14%. According to McGuigan (2006) the rate of investment and risk of return has a positive relationship: the greater the risk, greater the expected return which can be linked with Eurotunnel's risky decision and expectation of higher return.

During the project launch, the company has found, the project has been underestimated and traffic has consistently fallen short of expectations, partly because of unforeseen competition from low cost airlines. Project has also entirely funded with private money, it caused financial risk which is increase in borrowing with heavy debt and variability in net earnings. The company was suffering to lurch from one debt to another debt until the company has restructured and named Groupe Eurotunnel SA that helped the business to cut the €9.2 billion debt to €4.16 billion by repaying banks in form of shares.

Share price of Eurotunnel was too low and most of shareholder in France bought a share during 1987. They have suffered a lot with market risk, seeing share price falling from 900p to 20p.

Following restructuring also enabled the company to make profit of $1.57 million for 2007, its first annual net profit, less than year after the company almost sank in a debt that cause business risk, variability in a profit within the company. However the result leaves out an outstanding gain of €3.3 billion from restructuring agreement that halved Eurotunnel's debt and saved it from bankruptcy. In resulting of this example, Eurotunnel was a risk taker company rather than risk averse which prefers high return in exchange for taking high risk.

Risk averse investors prefer low risk and low return investment. For instance Mike Cool, managing director of Carefree plc, business with market value of £30 million and has opportunity to relocate the premises. There is probability of 50% increasing value by £12 million or decreasing value by £10 million. Calculating in a way (0.5*£12m)+(0.5*-£10m)=£1m, although the investment proposal offers £1 million, he rejected to undertake the project.

4.2 Measurement of risk

When the company invests money into a new project such as developing new products, risk is the possibility that actual cash flows will be different from the forecasted returns. Risk measurement helps especially to the risk averse investors to assess the project risk using expected value and standard deviation. There are 3 statistical measures: the standard deviation, semi variance and coefficient of variance.

Here is example, Snowglo plc who is trying choose less risk project.

4.2.1 Standard deviation

Market efficiency

Probability

Outcome £ project A

Outcome project B

Strong

0.2

700

550

Normal

0.5

400

400

Weak

0.3

200

300

Market efficiency

Probability

(a)

Outcome

(b)

Expected

Value (a*b)

Deviation

(X-b)

Squared

Deviation

Variance

(a*d²)

Strong

0.2

700

140

300

90000

18000

Project A

Normal

0.5

400

200

0

0

0

Weak

0.3

200

60

-200

40000

12000

X=400

Standard deviation=√30000=173.2

Strong

0.2

550

110

150

22500

4500

Project B

Normal

0.5

400

200

0

0

0

Weak

0.3

300

90

-100

10000

3000

X=400

Standard deviation=√7500=86.6

The standard deviation could give exact dispersion figure of how much one project is riskier than another. In this example the project B is twice less riskier than project A.

4.2.2 Semi variance

Semi variance is the most suitable measure for the downside risk which is deviation below expected outcome, mainly considered in the decision process. Downside risk relates to only “weak” state of economy. For example:

SVa=0.3(200-400) ²=£12000

SVb=0.3(300-400) ²=£3000

Again project B seems to have less risk. In both cases the semi variance accounts for 40% of the project variance. (15000*100/37500)=40%

4.2.3 Coefficient of variance

Coefficient variance gives opportunity to compare the different projects with different expected returns. Consider for example of project A and B.

Standard deviation

(a)Expected return

(b)Coefficient variance

(a/b)Project A

173.2

400

0.43

Project B

86.6

400

0.22

4.3 Financial Risk Management

Risk management is fundamental aspect for the modern companies. Many years ago companies has been dealt with the insurance against fire, theft and other occurrences. According to Brigham and Ehrhardt, recently the scope of risk management has been broadened to control cost of petroleum by purchasing oil futures, protection against interest rate and exchange rate through the outside control.

Firstly a company should identify the risk, measure the effect of each risk and then need to decide how each risk should be handled.

There are few techniques to make better decision process for managing the risk efficiently such as transfer a risk to the insurance company, transfer the function that produces risk to a third party, purchase a derivative contract to hedge risks, reducing interest rate and exchange rate and commodity risk in order to reduce the volatility of cash flow and decrease the bankruptcy, reduce the probability of adverse event occurrence, reduce the scale of adverse event loss and avoid the risk in such a way to manage the risks effectively.

5. Conclusion

In a conclusion, the financial objective of the company is to increase the shareholders value by investing money into projects. Before the choice of project, managers analyze the project return in the future by using investment appraisal model which are NPV, IRR, ARR and Payback Method. But investing the project is not safe track to make money, there is probability of negative effects that might be different from the expected return.

In order to make right decision, the company top managers should identify the risk and then measure the risk by finding out standard deviation, semi variance and coefficient variance which will help to choose and see the risk effects if they likely to have less risk.

After measuring the risk, the company could also do transfer the risk to insurance company or third party, reduce the probability of risk in order to stop the action, reduce the magnitude of the risk and avoid the risk as nearly as possible.

6. Reference

Anthony, N. R., Hawkins, F.D. & Merchant, A.K. (2007) Accounting Text and Cases, (12th edition), McGraw Hill Education UK Ltd, England

Pike, R., Neale, B. (2009) Corporate Finance and Investment Decisions and Strategies, (6th edition), FT Prentice Hall, England University of Sunderland, (2007) Financial Management, England

Davies, T., Boczko, T. & Chen, J. (2008) Strategic Corporate Finance, McGraw Hill Education UK Ltd, England

Ryan, B. (2008) Finance and Accounting for Business, (2nd edition), Cengage Learning EMEA, England

McLaney, E. & Atrill, P. (2008) Accounting an Introduction, (4th edition), Pearson Education Ltd, England

Harrison, I. (2004) Advanced Accounting for A2, (1st edition), Hodder & Stoughton, England

Rio Tinto's financial objective is available online at www.riotinto.com/annualreport2008/marketsandstrategy/core-objectives/index.html (accessed 25/09/09)

Collins, J. &Hussey, R. (2007) Business Accounting, Palgrave Macmillan, USA

Merna, T.& Thani, F.(2008) Corporate Risk Management, (2nd edition), John Wiley & Sons, Ltd, England

Ross, A. S. Westerfield, W. R. & Jordan, D. B. (2008) Corporate Finance Fundamentals, (8th edition), McGraw Hill International Edition, USA

Brigham.F. E. & Ehrhardt.C.M (2002) Financial Management practice and theory, (10rth edition), Thomson Learning Inc, USA1

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