Archer’s Organic Foods plc is a producer and distributor of organic foods. The company is looking to expand the business by acquiring a farm in the North of England. This report analyses the financial viability of two farms by using a number of investment appraisal methods. The two farms differ in their initial investments, sales and costs. The freehold of option 1 farm will be acquired at the beginning of the project. The farm in option 2 will be taken on a 10-year lease with deposit and annual rent payments. The report makes a recommendation on the final selection of a farm by evaluating the results, strengths and weaknesses of four investment appraisal methods.
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The four investment appraisal methods used in this report are the Accounting Rate of Return (ARR), payback period, Net Present Value (NPV) and Internal Rate of Return (IRR). The results of the four investment appraisal methods may not be similar because of differences in their approaches and calculations. Hence, it is beneficial to use more than one investment appraisal method and understand the benefits and limitations of each method before making a final decision.
II. Investment appraisal methods
The four investment appraisal methods can be classified into two main categories. The ARR and payback period are non-discounting methods whereas the NPV and IRR are discounting methods. The ARR method measures the accounting profit rate by dividing the average income by the average investment (Hansen and Mowen, 2007, p. 568). The method is simple to use but has major limitations. It ignores the time value of money which is a major drawback in case of projects with long lives. Also, a benchmark rate is required for comparison.
The payback period calculates the time required to recover initial investment from the operating cash flows of a project (Brigham and Houston, 2007, p. 373). Shorter payback period projects are preferred as they generate cash equal to initial investment in a shorter duration and this can be viewed as a proxy of risk.
However, the payback period method ignores the time value of money (Kinney & Raiborn, 2011, p. 655). It also ignores the cash flows after the payback period which could result in a selection of a project that adds less value.
The NPV method calculates the net value of a project by discounting the cash flows at a rate which reflects the risks of those cash flows. The discounting of the future cash flows is a major advantage of the NPV method over the non-discounting methods. This is very important for valuing the two alternatives as cash flows are spread over 10 years.
The drawback of the NPV method is that it assumes constant gearing to maintain same cost of capital. This rarely happens as cash inflows over the period change the gearing. A company will have to issue debt regularly to maintain same gearing (Delaney, 2008, p. 37). This is difficult to do due to administrative issues and costs. It is also not easy to calculate cost of capital that is used for discounting cash flows (Howe, 1992, p. 34). Finally, the NPV method is not useful on its own when a company faces capital rationing. The profitability index may have to be used along with the NPV to evaluate investments in a capital rationing scenario.
IRR method also discounts the future cash flows and gives the cost of capital at which the NPV would be zero. This gives an idea about the margin of safety that is available in terms of possible decline in the rate of return before it equals cost of capital. The limitation of the IRR method is that it can give two IRRs for same set of cash flows if the pattern of cash inflows and outflows reverses more than once during the life of a project (Brigham and Daves, 2009, p. 421). It also assumes that cash inflows during the life of a project will be reinvested at the IRR which may not be true as the firm may not have similar opportunities to invest in.
The investment appraisal methods have their pros and cons and it is useful to use more than one method to get a better picture.
III. Results of investment analysis
The first option is the freehold acquisition of a farm at £1,500,000. The calculations and results of the investment appraisal methods of option 1 are shown in appendix I. It is assumed that the farm will be sold for £1,500,000 at the end of 10 years. It implies that the average investment over the period will be £1,500,000.
ARR = Average profit / Average investment = £313,000 / £1,500,000 = 20.83%
The cumulative cash flows turn positive for the first time in year 6.
Payback period = 5 + (245,000/360,000) = 5.68 years.
The NPV of option 1 is £739,000 and the IRR is 19.43%.
The second option is to lease a farm for 10 years. A down payment of £300,000 will be made at the beginning of the 10-year period. It is assumed that the down payment will be returned at the end of 10 years. The average investment will be £300,000. The calculations and results of the investment appraisal methods of option 2 are shown in appendix II.
ARR = Average profit / Average investment = £190,000 / £300,000 = 63.33%
The cash flows are adjusted to reflect the fact that annual rents will be paid in advance. The rent for year 1 will be paid at the beginning and hence shown in year 0. The rent for year 10 will be paid at the end of year 9 and hence £150,000 cash is added back to the profits of year 10.
The cumulative cash flows turn positive for the first time in year 5.
Payback period = 4 + (160,000/190,000) = 4.84 years.
The NPV of option 2 is £623,000 and the IRR is 27.48%.
IV. Analysis of results
The ARR of option 1 is 20.83%. There is no benchmark available for comparison but it is significantly more than the cost of capital of 12% and hence the ARR method approves investment in option 1. The payback period is 5.68 years. Though the payback period is significantly lower than the 10-year life of the project, it does not meet the 5-year cut-off period set by the finance director. Hence, the investment in option 1 is not approved under the payback period method.
The NPV of option 1 is very high and positive £739,000. Purchase of the farm will increase the net value of the firm by £739,000 over a period of 10 years and hence the investment is approved under the NPV method. Finally, the IRR of 19.43% is also higher than the cost of capital of 12% which again approves the purchase of firm.
The ARR of option 2 is 63.33% which is substantially higher than the cost of capital of 12% and hence the ARR method approves investment in option 2. The payback period is 4.84 years and it meets the 5-year cut-off period set by the finance director. The investment in option 2 is also approved under the payback period method.
The NPV of option 2 is positive £623,000. Option 2 is also approved under the NPV method. Finally, the IRR of 27.48% is also higher than the cost of capital of 12% which again approves the purchase of firm.
Option 2 is preferred over option 1 by the ARR, payback period and IRR methods. However, the option 1 is preferred over option 2 by the NPV method because the NPV of option 1 is more than that of option 2.
The difference results under the various investment appraisal methods are not unexpected. The ARR and payback period methods do not discount the future cash flows. This is a major drawback in this case as cash flows are spread over a long life of 10 years. Also, the cost of capital is a high 12% and not discounting the cash flows does not reflect the risk of the investment. In view of the above arguments, the results of the ARR and payback period methods should be viewed with caution.
The NPV method favours option 1 as its NPV is £116,000 higher than the NPV of option 2. However, option 1 uses higher initial investment and this is reflected in its IRR which is lower than that of option 2.
The company should opt for option 1 as it adds the maximum net value to shareholders. However, if funding is restricted than option 1 should be preferred because it adds higher net value per unit of investment. The net value per unit investment is £2.08 for option 2 as compared to £0.49 for option 1.
In addition to the above analysis, the investment decision should take into account few other but important points into consideration. Firstly, in the analysis of option 1, it was assumed that the farm will be sold for £1,500,000 after 10 years. However, the prices of land and farms have increased in the recent years. The table below shows the sensitivity of the NPV to the changes in price of the farm.
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An annual farm price inflation of 6% over a 10-year period would substantially increase the NPV to £1,121,000. This is a significant jump. Even if the annual farm price inflation is -2%, the NPV is still positive. On the other hand, the changes in farm prices would not have any impact on the NPV of option 2. The possible significant benefit from purchase of a farm should also be included in final decision making.
Secondly, the evaluations are also sensitive to changes in cash flows. Projections are rarely met in practice (Arya et al., 1988, p. 499). It is difficult to accurately predict cash flows over a 10-year period because of a number of factors. The demand may change due to economic-wide changes. The costs of raw materials and labour may rise faster than anticipated. Adverse weather may also play havoc on the production. Hence, it is beneficial to do a sensitivity analysis of cash flows. It is assumed that the variable costs will move in direct proportion to the changes in revenues. The tables below show the sensitivity of the NPVs to changes in sales and variable costs.
The above tables show that option 2 is more sensitive to the changes in sales and variable costs. At 80% of the base case sales and variables costs, the NPV of option 1 is significant positive but that of option 2 is marginally positive. The option 2 will turn into a negative NPV investment if actual cash flows are just less than 80% of the projected cash flows.
Thirdly, the NPV is also sensitive to changes in the cost of capital. The tables below show the sensitivity of the NPVs of two options to changes in the cost of capital. Option 1 is more sensitive to changes in the cost of capital. The company should analyse the likely increases in the cost of capital over 10 years before making a final decision.
In addition to the above-discussed points, the company should also analyse some of the key non-financial matters to ensure that the investment will yield positive results. It should analyse whether there would be local demand for organic foods in case of each option. Organic foods are sold at a premium to inorganic foods. The buying power of consumers is linked to the general overall economic conditions. The UK economy is passing through a tough phase with consumers concerned about government cuts in public expenditure. This may make it difficult for the company to sell its produce in the local region.
The company should also consider the resources that would be involved in effective monitoring of the farm in the North as opposed to current operations in the South. Monitoring and control is important for success of an investment and long-distance could hamper it.
The results of four investment appraisal methods did not match and there is no unanimous choice. Option 2 is preferred on the basis of the ARR, payback period and IRR methods. Option 1 is the preferred option because of its higher NPV and the possibility to gain from an increase in farm prices.
The NPVs of two options are also sensitive to a number of factors like cost of capital and changes in sales and variable costs. The NPV of option 2 is more sensitive to changes in cash flows whereas the NPV of option 1 is more sensitive to changes in the cost of capital.
The recommended option is option 1 because of its higher NPV and also the potential to reap even higher benefits due to increase in value of farm over 10 years. If the project does not meet sales expectations, the company will have the option to sell the farm and exit early in option 1. On the other hand, the company will end up paying lease rent for 10 years in option 2.
Arya, A., Fellingham, J.C., and Glover, J.C., 1988. Capital budgeting: Some exceptions to the net present value rule. Issues in accounting education, Vol. 13, No. 3, pp. 499-508.
Brigham, E.F., and Daves, P.R., 2009. Intermediate Financial Management. 10 edn. South-Western Cengage Learning.
Brigham, E.F., and Houston, J.F., 2007. Fundamentals of financial management. 11 edn, Thomson Higher Education.
Delaney, C.J., Rich, S.P., and Rose, J.T., 2008. Financing costs and NPV analysis in finance and real estate. Journal of Real Estate Portfolio Management, Vol. 14, Issue 1, pp. 35-40.
Hansen, D.R., and Mowen, M.M., 2007. Managerial accounting, 8 edn. Thomson South-Western.
Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice & Education, Vol. 2, Issue 1, pp. 31-35.
Kinney, M.R., & Raiborn, C.A., 2011. Cost Accounting – Foundations and Evolutions. 8 edn, South-Western Cengage Learning, Mason.
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