Accounting And Decision Making Techniques Accounting Essay

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In this project we can see how company can choose their investment where they can get a good return, basically investment appraisal is a way through which the company have to decide that the investment for a project will be beneficial or not. Investment appraisal plays a key role in an organization to see the financial positions of company. Through this project we can see the various method of investment appraisal such as NPV method, playback method and IRR method. This project also shows that what will happen to NPV if cost of capital increases or if cost of capital decreases. As well as it also shows the logic and effect behind the NPV approach. (a) 'Investment appraisal should add value to the business organisation'. Do you agree? Critically analyze the main discount cash flow techniques available to management? An investment appraisal is the process in which one can assess whether or not to investment in a project is the worthwhile. It is a tool for both private and public sector organisations. Businesses invest is to increase their profits by improving their operations, to match the supply and to demand, to reduce the manufacturing costs and to increase the productivity and efficiency.

For "not for profit "organisations the incentive to invest is driven by the need to improve the efficiency, effectiveness and economy of the organisation to provide "value for money" It is essential that managers with responsibility for investments have an understanding of the methodologies and theories behind investment appraisal. Investment is the spending of money for the future gain. A firm engages in investment if it spends money now hoping to obtain a greater return in the future. "An investment appraisal refers to the quantitative techniques that are used by firms to decide whether or not to go ahead with an investment. Where investment projects are mutually exclusive, the techniques can be used to rank projects to select the most attractive ones" (Horner.D, 2005) It is the process by which several investment proposals can be analysed, which are compared and ranked with one another and to come out with the best investment based decisions are of prime and importance proposals are to ensure that business uses appropriate methods and techniques for evaluation the projects and chooses the one which is best for the investor. There are different methods or techniques used in practice by business to evaluate the investment proposals, which can be distinguished into two categories named discount and non-discount techniques. On-discount techniques are the payback period and the average rate of return. Discounting techniques are the net present value and internal rate of return.

Investment appraisal is one of the methods to evaluate whether investment is worthwhile or not. It is all about assessing these income flows against the cost of the investment. Investment appraisal is evaluation of the potential profitability of a proposed investment, so to a good return or investment one should plan their fund properly. Investment appraisal is used in both private and public sector.

Any successful company is always looking for a new way by which they can change and expand their businesses for which there are few considerations which can be followed.


Key considerations in making investment decision are:

  1. What is the scale of the investment - can the company afford it?

  2. How long will it take before the investment starts to yield returns?

  3. How long will it take to pay the investment?

  4. What are the expected profits gained from the investment?

  5. Could the money which is being ploughed into the investment and yield higher returns and elsewhere? (thetimes100[1])

Investment appraisal methodology

Typical methodologies for investment appraisal include:

  1. Payback period

  2. Accounting rate of return

  3. Net present value

  4. Internal rate of return(IRR)

  5. Profitability index

  6. Discounted cash flow

  7. Risk assessment

Business cases and investment appraisal

Successful organisations need to be sure that they have made the best decision when it comes to major capital investments or strategic changes.

Organisations need to ensure that all the relevant options which are been weighed up and the best one selected. People need to know whether their decision is -or remains-affordable and provides value for money and that the benefits will outweigh the costs.

Preparing a strong business case address these issues and demonstrates that public money is being spent wisely.

Tribal has more than 100 management consultants dedicated to central government work, spread over 40 offices across the United Kingdom. Many of our staff who have worked within the public sector and are nationally recognised leaders in their field.

We have delivered in business cases for a range in government departments and agencies, including the education sector.

Our services include:

  • Preparation of business case as a whole or just the parts where help is needed

  • Specialist business modelling

  • Project management (from strategy to implementation and review)

  • "Critical friend" services where we offer independent and frank assessments of business cases, audit models and assessments, and help navigate the OGC gateway review process.

Discount cash flow

Discount cash flow(DCF) is the sum of a series of future cash transactions, on a preset value basis.DCF analysis is a capital budgeting technique used to quantify and assess the receipts and disbursements from a particular activity project or business venture in terms of constant dollars at the outset, considering risk-return relationships and timing of cash flows. Under DCF, each successive year's cash flow is discounted to a greater extent than the prior year, due to the fact that it is received further out in time. Discounted cash flow analysis is utilized in a wide Varity of business and financial applications (mortgage loans are probably the most common example).

Assumptions of Discount Cash Flow Analysis

According to Ronald W. Hilton, author of managerial accounting, there are two primary methods of discounted cash flow analysis: net-present-value method (NPV) and internal-rate-of-return (IRR) method principal assumptions of their methods are as follows:

    All cash flow is treated as though they occur at the end of the year.
  • DCF methods treat cash flows associated with investment projects as though they were known with certainty, whereas risk adjustments can be made in an NPV analysis to account-in part-for cash flow uncertainties.

  • Both methods assume that all cash inflows are reinvested in other projects that earn monies for the company.

  • DCF analysis assumes a perfect capital market.

Hilton admitted that "in practice there four assumptions rarely are satisfied. Nevertheless, discounted cash flow models provided are effectively and widely used method of investment analysis. The improved decision making that would result for using more complicated models seldom are worth the additional cost of information and analysis."

DETERMINING DISCOUNT RATES:

An important element of discounted cash flow analysis is the determination of the proper discount rate that should be applied to bring the cash flow back to their present value .Generally, the discount rate should be determined in accordance with the following factors:

  • Riskiness of the business or project-the higher the risk, the higher the required rate of return.

  • Sizes of the company-studies indicate that returns are also related inversely to the size of the entity. That is, a larger company will not provide lower rates of return than a smaller company are otherwise have similar nature.

  • Time horizon-generally, yield curve are upward sloping (longer term instruments command a higher interest rate); therefore , cash flows to be received over longer periods may require a slight premium in interest, or discount, rate.

  • Debt/equity ratio-the leverage of the company drives the mix of debt and equity rates in the overall cost of capital equation. This is a factor that can be of considerable for importance, since rates of return on debt and equity within a company which can vary considerably.

  • Real or normal basis-market rates of interest or return are on a normal basis. If the cash flow projections are done on a real basis (non-inflation adjusted), then the discount rate should be calculated using an after-tax cost of debt in the cost of capital equation.

2) AP Ltd. Is trying to evaluate 4 new projects. Assume all the 4 projects have a useful life of 10 years. The projects are mutually exclusive and some of their details are as follows':

Assume-All the 4 project have a useful life of 10 years.

Project Annual Net Cash Flow Initial Investment Cost of capital IRR NPV

Project Annual Net Cash Flow Initial Investment Cost of capital IRR NPV
1 £100,000 £449,000 14% A B
2 £70,000 C 14% 20% D
3 E £200,000 F 14% £35,624
4> G £300,000 12% H £39,000

Net present value of = (Annual cash flow * Cumulative discounted value)

   - Initial Investment

Project 1 (B)

                           = (£100,000*5.216) - £449,000

                            = £512,600 - £ 449,000

                          B= £72,600

Net present value of = (Annual cash flow * Cumulative discounted value)

       - Initial Investment

Project 1 (B) @18%

= (£100,000*4.494) - £449,000

                            = £449,400 - £ 449,000

                           = £400

Discounted rate assume as 19%

Net present value of   = (Annual cash flow * Cumulative discounted value)

                            - Initial Investment

Project 1 (B) @ 19%

                            = (£100,000*4.339) - £449,000

                            = £433,900 - £ 449,000

                            = -£15,100

NPV @ 18% = £400

NPV @ 19% = -£ 15,100

IRR of project 1 (A) = 18% + NPV @18% / (NPV @18% + (- NPV @ 19%)) * (19%-18%)

                            = 18% + [£400/ (£400 + £15,100)]*(1%)

                            = 18% + .0258 * 1%

                         A = 18.0258%

Net present value of = (Annual cash flow * Cumulative discounted value)

                            - Initial Investment

Project 2

                0 = (£ 70,000*4.192) - Initial Investment (C)

Initial investment (C) = (£ 70,000*4.192)

                            C = £293,440

Net present value of = (Annual cash flow * Cumulative discounted value)

                            - Initial Investment

Project 2 @ 14 %( D)

                            = (£70,000*5.216) - £293,440

                            = £365,120 - £293,440

                        D = £ 71,680

Net present value of = (Annual cash flow * Cumulative discounted value) - Initial Investment

Project 3@ 14%

                            0= (Annual cash flow * 5.216) - £200,000

Annual cash flow (E) = £200,000/5.216

                            E = £38,343.56

Net present value of = (Annual cash flow * Cumulative discounted value)

                             - Initial Investment

Project 3

                                   £35,624 = (£38343.56 * Cumulative discounted value)

- £200,000

Cumulative discounted value = (£35,624 + £ 200,000)/ £38343.56

                                            = £235,624/£38343.56

                                            = 6.1451

According to the cumulative discounted rate table

                         Cost of capital (F) = 10%

Net present value of = (Annual cash flow * Cumulative discounted value)

                                - Initial Investment

Project 4 @ 12%

                                   £39,000 = (Annual cash flow *5.650) - £300,000

                Annual cash flow (G) = (£39,000+£ 300,000)/5.650

                                                 = £339,000/5.650

                                              G = £60,000

Net present value of = (Annual cash flow * Cumulative discounted value)

                                                             - Initial Investment Project 4 @ 15%

                                                                = (£60,000*5.019) - £300,000

                                                                = £1140

Cumulative discounted = 4.833 (using the cumulative discounted table)

Value for 10 years @ 16%

Net present value of = (Annual cash flow * Cumulative discounted value)

                                                                - Initial Investment

Project 4 @ 16%

                                                                = (£60,000*4.833) - £300,000

                                                                = -£10020 NPV @ 15% = £1140

NPV @ 16% = -£10020

IRR for project 4 (H) = 15% + {NPV@15%/ [NPV@ 15% -(NPV@16%)]}

                                                                *(16% - 15%)

                                                                = 15% + [£1140/ (£1140+£10020)]*1%

                                                                = 15% + 0.102*1%

                                                             H = 15.102%

B) Which project would you choose? Explain the reasons for your choice.........

I will select the project which has the high NPV. Because NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a project which is positive, it should be accepted. However, if the NPV is negative, the project should probably be rejected because the cash flows will also be negative...

For example, if the retail clothing business wants to purchase a existing store, he would first be estimate the future cash flows that store would generate, and then the discount those cash flows into one lump sum present value amount ,say $565,000.if the owner of the store who is willing to sell the business for less than $565,000. The purchasing the company would likely to accept the offer as it shows a positive NPV investment. Conversely, if the owner would not sell for less than the value $565,000.the purchaser would not purchase the store, because the investment would show a negative NPV at this time and would, therefore he reducer's the overall value of the clothing company.


References

  1. Glen Arnold, 2008; Corporate financial management

  2. Modern financial techniques: W. L. Silber, 2000

  3. http://www.financialmodelingguide.com/valuation-concepts/net-present-value/ ; Assessed on 18/11/2009

  4. http://www.thetimes100.co.uk/downloads/theory/investment_appraisal.pdf; Assessed on 18/11/2009

  5. http://www.businessdictionary.com/definition/investment-appraisal.html

  6. Accetta, Gregory J. "Testing the Reasonableness of Discounted Cash Flow Analysis." Appraisal Journal. January 1998.

  7. Bangs, David H., Jr., with Robert Gruber. Finance: Mastering Your Small Business. Upstart, 1996.

  8. Chen, Richard C. "A Discounted Cash Flow Analysis for Financing Alternatives." National Public Accountant. July 1998.

  9. Financial Accounting Standards Board. Statements of Financial Accounting Concepts. Irwin, 1987.

  10. Hilton, Ronald W. Managerial Accounting. McGraw-Hill, 1991.

  11. Woelfel, C.J. Financial Statement Analysis. Probus, 1994.

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