Capital investment appraisal

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A capital investment appraisal is a process that evaluates the attractiveness of capital expenditure proposals. There are different methods of investment appraisals these include internal rate of return, net present value, payback period and accounting rate of return. Each of the methods has different bases such as profits or cash flows. Furthermore all the methods have different strengths and weakness which will be intensely analysed throughout the assignment.

Accounting rate of return is a method of appraisal which expresses the return of the investment as a percentage of the cost of the capital investment. The businesses that use this method typically set a minimum threshold rate that must be equalled or exceed by annual rate of return.

Accounting rate of return is a method based on profits. The profits are open to manipulation because the profit figure depends on many subjective estimates such as depreciation, the valuation of stock and provisions for doubtful debt. This makes profit based methods less reliable than cash flow appraisal methods and therefore limits the effectiveness of accounting rate of return. Profit based appraisal methods such as accounting rate of return are less reliable than other appraisal methods which basis are cash flows because cash is measurable and can't be as easily manipulated as profits so are more objective.

Payback period is another investment appraisal. Payback calculates how long it will take for the business to recover the initial investment. This method is based on projected future cash flows from the project. This type of method using cash flows is more reliable than profit based methods such as ARR, this is because profit is subjective because of estimates about depreciation, stock valuation and doubtful debt. However payback takes no account of cash flows after the payback point has been reached. This could be quite disastrous for a firm because they may choose a project with the quickest payback but cash flows may subside or even stop after this period so may have been better to take a longer term approach and choose the other project which may have produced longer and larger cash flows in the future. Furthermore future cash flows are hard to predict with uncertainty increasing the further into the future. These cash flows can also be manipulated by the people who prepare them if they favour one project over another. Also the accuracy of the cash flow figures will depend on the experience of the person producing them because the more experience the person has they tend to have dealt with similar situations and tend to know what the likely cash flow will be. A limitation of the payback period method is that it takes no account of the time value of money so is less accurate than discounted cash flow methods such as IRR and NPV.

Discounting cash flows takes into account the time value of money. This is useful because a £1 today is worth more than £1 in a year. This is because of a few factors, firstly because rising inflation means that you can't buy as much with the same money in the future as you can now. Secondly if you were to put your money in the bank today you would earn interest on the money so would receive more in the future.

Discounted payback is a method of capital investment appraisal which uses discounted cash flows to calculate the payback period of a capital investment. This method recognises the time value of money which the normal payback method doesn't. However one of the main advantages of the normal payback period diminishes. This is because discounting the cash flows is more complex than the simple payback period, it is because payback is so simple that it is widely used so discounted payback is not as prominent.

Net present value is a method of capital investment appraisal which is based on discounted cash flows, the net present value is the sum of all cash flows caused by the project. The main advantage of using net present values is that it takes into account the time vale of money. This means you can evaluate the future cash flows if you were to get the money today. Another advantage of this method compared to ARR is that it is based on discounted cash flows which are more reliable than profit based methods which ARR is based on. Furthermore if you compare net present value to payback period, net present value takes into account cash flows after payback has happened which is best in taking a longer term view of a project and gives a more accurate picture of the project as a whole rather than just the cash flows up until the capital costs are recovered.

One of the main limitations of NPV is that all cash flows are assumed to happen on the last day of the year, when in actual fact it happens throughout the year not just at the end. Another limitation of this method is that the cost of capital is assumed to stay the same over the lifetime of the project. However the further into the future of the project the less likely the cost of capital will remain the same.

To decide whether a project would be accepted using net present values are that if the net present value is positive then the project will be accepted, if negative the project will be rejected. If there is a choice between different projects the one with the highest NPV will be chosen if this method was the only appraisal method used.

Internal rate of return is the final method of capital investment appraisal and is the most difficult to be implemented. The IRR is the annual rate of return that a project is expected to produce, this is calculated using discounted cash flows which allows for the time value of money. This method is expressed as a percentage which is determined by calculating the discount rate that gives a NPV of zero. For a project to be accepted using IRR the cash generated from the project must at least be equal to the cost of financing the project.

One of the main advantages of IRR is that it shows how much room there is for mistakes on projected cash flows, this is because it calculates the NPV of a project to zero.

A disadvantage of IRR is that it can be quite hard to calculate and requires a lot of trial and error. This means it will take longer to calculate which may be a problem if a firm needs to make a quick decision on a project to secure its future.

One of the main limitations of IRR is that it doesn't measure actual money like net present value does, it is a relative method so you only know the percentage whereas in real money terms a project with a lower percentage could produce the highest profit. Another limitation of this method is that it could be accepted at 0% as this doesn't account for any risk involved which is inevitable with any capital investment, furthermore it doesn't take into account the approximation of the IRR calculations.

Each of the methods of investment appraisals have advantages and disadvantages which have been outlined above, it does not mean that one method is better than the other but could be used in conjunction with each other to gain a consensus of which project is best. However qualitative factors have to be taken into consideration, these could include experience that staff have with dealing with investment appraisals because the more understanding the more likely the forecasted figures are going to be more accurate. Other qualitative factors may be the clients that they are targeting, whether they are risky or just a continuation of current business operations. This is because risky clients may be lucrative if they pay but if they don't then the firm could lose a lot of money.

The payback period of project 1 is a longer than project 2, however the difference in the payback between the two projects is only small at only 5.6 months. If this was the only investment appraisal used then project 2 would be approved regardless of the cash flow after the payback period. Project 2 will have the least risk associated with it according to the payback period because this project pays back quicker so can start making profit sooner.

From the investment appraisals that I have used I would recommend project 2, however qualitative information has to also be taken into account. Looking at the information provided about both proposals, project 2 seems to have the least risk associated with it, this is because the project is just doing what they already do in a different part of the country. This has many benefits, one is that they already have the knowledge of the industry so will not have to hire new staff, this knowledge also means it is less risky because they have experience in that area. Another benefit of this project is that it will expand their client base throughout the country, so will not just rely on business continuing coming from one part of the country so will be more resilient to changes in the local areas. Project 1 may have the most risk associated with it but will diversity their service and may lead to future business deals if this project is successful. Overall I would recommend that the firm should decide to invest in project 2.

It will be a 3 years 4.6 months payback period of the 7 million capital investment

I would recommend project 3, even though this project seems the riskiest from the description of the project. This is because the firm have no experience in foreign markets, with this firm having no experience abroad this may mean the accuracy of the forecasted cash flow figures may be doubtful. This is because unknown events may occur which may have been predicted if they had experience in the country. Furthermore the firm may find barriers to entry entering into a new country such as language barriers which may cause delays or confusion, also there may be cultural working differences in Germany compared to practices in England.

Project 3 has the highest Net Present Value with an NPV of 5.06, this is 3.49 larger then project 1 and 2.34 larger than project 2 which shows that project 3's cash flows are larger in value in today's money terms than project 1 and 2 which takes into account the time value of money.

Looking at the internal rate of return of all the projects project 3 has a far superior IRR with 24.5% which is 6.1% larger than project one and 9.7% larger than project 2. This shows that project 3 provides a better return on the investment of the project in percentage terms.

Finally looking at the payback period of each of the projects project 3 has the shortest payback period with 11 months for the initial 1million payment. So if the investment isn't a success then the firm may decide not to continue with the purchase of the property. So it will only take 11 months to recoup the initial investment so provides a smaller risk if the investment goes wrong. The payback period for the whole investment of 7 million pound it will take 3 years 4.6 months which is shorter than project 1 with 4 years and 6 months which is 1 year 1.4 months longer than project 3 and is also shorter than project 2 which has a payback period of 3 years 8 months which is 3.4 months longer than project 3. However most of project 3's revenue is expected in years 4 and 5 which may be problematic because the further into the future you try to predict cash flows the harder it is, this is because the future is difficult to calculate, it may be even harder to predict these cash flows with no experience in the country.

Other factors in the recommendation for project 3 are that future business in Germany is potentially very lucrative. With the firm gaining a foothold in Germany with project 3 which will expand the firm's current client base, this could increase profits even after the initial 5 year period. Furthermore this project will make the firm more resilient to changes in England's economy such as if there was a recession as they will be able to rely on the German side of the operations more.