Irr Is Straightforward And Simple Accounting Essay

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Table 1.2 (Results are expressed in number of years and remaining computed as number of days and ranked in order of best proposal according to payback)

Workings:

Formula 1.0

Payback = Cost of Project

Annual Cash inflow

Proposal 1(Research and Development)

(Inflows on proposal (1) does not start till year 3, hence the payback period will begin in year 3)

Payback (first phase) 50,000.00 = 1.37 (1yr, 37% *365 days) = 1 year and 135days

36,500.00

This project needs 1 year and 135days to payback initial investment. Since only 6months after year 2(£36,500) is expected, £13,500 of the initial investment will still be locked up in the investment.

Payback (full phase) 50,000.00 = 1.37 (1yr, 37% *365 days) = 3rd year and 135days

73,000.00

Proposal 2(Mainframe Computer System)

Payback (first phase) 90,000.00 = 1.36 (1yr, 36% *365 days) = 1yr and 131days

66,000.00

Payback (full phase) 180,000.00 = 2.73 (2yr, 73% *365 days) = 2yrs and 266days

66,000.00

Proposal 3 (Extra Warehouse Space)

Payback (first phase) 100,000.00 = 1yr

145,000.00

Payback (full phase) 200,000.00 = 1.38 (1yr, 38% *365 days) = 1yr and 139days

145,000.00

Proposal 4 (Staff Training System)

Payback (first phase) 20,000.00 = 1.25 (1yr, 50% *365 days) = 1yr and 91days

16,000.00

Payback (full phase) 40,000.00 = 2.5 (2yrs, 50% *365 days) = 2yrs and 183days

16,000.00

Proposal 5(Quality Assurance Scheme)

Payback (first phase) 35,000.00 = 1yr

35,000.00

Payback (full phase) 70,000.00 = 1yr

70,000.00

NET PRESENT VALUE (NPV)

Phase

Proposal

1

2

3

4

5

1st

NPV (DCF10%)

£-21,201.5

£50,613

£151,720

£14,088

£114,135

Ranking

5th

3rd

1st

4th

2nd

1&2

NPV (DCF10%)

£50,015

£70,206

£51,720

£20,656

£195,370

Ranking

4th

2nd

3rd

5th

1stTable 1.3 (Results are expressed in amounts (values) and ranked in order of best proposal according to highest amount)

Workings:

Formula 1.1

NPV = PV of net inflow - initial outlay

(For the purpose of these proposals all PVs are calculated using the annuity factor for full phase)

Annuity Factor = [1-1(1+r)^n]/r DF = [1/(1+r)^n] rate = 10%

Annuity for 2yrs = [1-1(1+0.1)^2]/.1 = 1.736

Annuity for 5yrs = [1-1(1+0.1)^5]/.1 = 3.791

Discount factor year 2.5 = [1/(1+0.1)^2.5] = 0.7885

Proposal 1(Research and Development)

NPV (first phase) = £([36,500*0.789] - 50,000)

= £-21,201.5

Note: (Proposal 1 is a delayed annuity, beginning from year 3. Our computation is based on 5yrs - 2yrs annuity factor.)

NPV (full phase) = £([73,000*(3.791 - 1.736)] - 100,000)

= £50,015

Proposal 2(Mainframe Computer System

NPV (first phase) = £( [66,000*1.736]+[33,000*0.789) - 90,000)

= £50,613

NPV (full phase) = £( [66,000*3.791] - 180,000)

= £70,206

Proposal 3(Extra Warehouse Space)

NPV (first phase) = £( [145,000*1.736] - 100,000)

= £151,720

NPV (full phase) = £( [145,000*1.736] - 200,000)

= £51,720

Proposal 4(Staff Training System)

NPV (first phase) = £( [(16,000*1.736) +(8,000*0.789)] - 20,000)

= £14,088

NPV (full phase) = £( [16,000*3.791] - 40,000)

= £20,656

Proposal 5(Quality Assurance Scheme)

NPV (first phase) = £( [(70,000*1.736)+(35000*0.789)] -35,000)

= £114,135

NPV (full phase) = £( [70,000*3.791] - 70,000)

= £195,370

INTERNAL RATE OF RETURN (IRR)

Proposal

1

2

3

4

5

IRR- first phase

-

47%

117%

67%

197%

Ranking

5th

4th

2nd

3rd

1st

IRR- phase 1&2

23%

26%

29%

29%

99%

Ranking

4th

3rd

2nd

2nd

1stTable 1.4 (Results are expressed in rates (percentages of reinvestment) and ranked in order of best proposal according to highest rate)

NB: in practice IRRs that are more than 10% of the company's cost of capital are unrealistic and hence there may be significant distortion in project estimates. (McKinsey & Co, 2004)

Workings:

Formula 1.2

IRR = L + [(NPVL/NPVL-NPVH)(H-L)]

N.B :(L - LOWER RATE, H - HIGHER RATE)

Rate = 25% - 200%

Annuity for 2yrs = 25% (1.440), 30%(1.361), 50%(1.111), 90%(0.803), 100%(0.750) 120%(0.661), 200%(0.444)

Annuity for 5yrs = 25%(2.689), 30%(2.436), 50%(1.737 ), 90%(0.969), 100%(0.969), 120%(0.817), 200%(0.498)

Disc factor year 2.5 = 25%(0.572), 30%(0.519), 50%(0.363), 90%(0.201), 100%(0.177), 120%(0.139), 200%(0.0641)

Proposal 1(Research and Development)

NPV (first phase): NPV will remain negative irrespective of rate used because the net inflow without discounting is lesser than the initial outlay.

Hence no IRR

Note: (Proposal 1 is a delayed annuity, beginning from year 3. Our computation is based on 5yrs - 2yrs annuity factor.)

2nd NPV (full phase 25%) = £ ([73,000*(2.689 - 1.440)] - 100,000)

= £-8,823

IRR (full phase 25%) = 10%+ [(50,015/(50,015+8,823)(25-10)]

22.7% approx. 23%

Proposal 2(Mainframe Computer System)

2nd NPV (first phase 50%) = £ ([66,000*1.111]+[33,000*0.363) - 90,000)

= £-4,595

IRR (first phase) = 10%+ [(50,613/(50,613+4,595)(50-10)]

46.7% approx. 47%

2nd NPV (full phase 30%) = £ ([66,000*2.436] - 180,000)

= £-19,224

IRR (full phase) = 10%+ [(70,206/(70,206+19,224)(30-10)]

25.7% approx. 26%

Proposal 3(Extra Warehouse Space)

2nd NPV (first phase 120%) = £( [145,000*0.661] - 100,000)

= £-4,155

IRR(first phase) = 10%+ [(151,720/(151,720+4,155)(120-10)]

117.07% approx 117%

2nd NPV (full phase 30%) = £([145,000*1.361] - 200,000)

= £-2,655

IRR (full phase) = 10%+ [(51,720/(51,720+2,655)(30-10)]

29.02% approx. 29%

Proposal 4(Staff Training System)

2nd NPV (first phase 90%) = £( [(16,000*0.803) +(8,000*0.201)] - 20,000)

= £-5,544

IRR (first phase) = 10%+ [(14,088/(14,088+5,544)(90-10)]

67.41% approx. 67%

2nd NPV (full phase 30%) = £( [16,000*2.436] - 40,000)

= £-1,024

IRR (full phase) = 10%+ [(20,656/(20,656+1,024)(30-10)]

29.06% approx. 29%

Proposal 5(Quality Assurance Scheme)

NPV (first phase 200%) = £( [(70,000*0.444)+(35000*0.064)] -35,000)

= £-1,680

IRR (first phase) = 10%+ [(114,135/(114,135+1,680)(200-10)]

197.24% approx. 197%

2nd NPV (full phase 100%) = £( [70,000*0.969] - 70,000)

= £-2,170

IRR (full phase) = 10%+ [(195,370/(195,370+2,170)(100-10)]

99.01% approx. 99%

QUESTION 2

Introduction

The problems most managers face during investment decisions on multiple investment possibilities, is their ability to make the best and profitability choice under capital constraints. However, when resources are limited, directors can employ profitability index (PI) as a tool for selecting among various project combinations and alternatives.

Profitability index enable Directors to identify the relationship between the cost and benefits of a project. A good indicator is a profitability index that is greater than one. Proposals should therefore be ranked according to their profitability index, and top-ranked proposal should be undertaken until the entire funds are used up. For this purpose, we are carrying out an assessment on the five proposals of directors for a profitable order of using up limited funds.

Assessment Results

Proposal

1

2

3

4

5

PI ratio- first phase

-42%

56%

152%

70%

326%

Ranking

5th

4th

2nd

3rd

1st

PI ratio phase 1&2

50%

39%

26%

52%

279%

Ranking

3rd

4th

5th

2nd

1stTable 1.5 (Assessment results are expressed in rates (percentages of reinvestment) and ranked in order of best proposal according to highest rate)

Workings (assessments):

Formula 1.3

PI ratio = present value of cash flows (NPV) / Total initial investment.

Proposal 1(Research and Development)

PI (first phase) = £(-21,201.5/ 50,000)

= -42% (not profitable at all)

PI (full phase) = £(50,015/ 100,000)

= 50%/0.50

Proposal 2(Mainframe Computer System

PI (first phase) = £(50,613/ 90,000)

= 56%/0.56

PI (full phase) = £( 70,206/ 180,000)

= 39%/0.39

Proposal 3(Extra Warehouse Space)

PI (first phase) = £( 151,720/ 100,000)

= 152%/1.52

PI (full phase) = £( 51,720/ 200,000)

= 26%/0.26

Proposal 4(Staff Training System)

PI (first phase) = £( 14,088/ 20,000)

= 70%/0.70

PI (full phase) = £( 20,656/ 40,000)

= 52%/0.52

Proposal 5(Quality Assurance Scheme)

PI (first phase) = £( 114,135/35,000)

= 326% /3.26

PI (full phase) = £( 195,370/ 70,000)

= 279%

Recommendation - Ranking

Based on the results of our assessment using the profitability indexes on the first phase, Proposal 5 has a PI of 3.26 and proposal 3 has a PI of 1.52. These projects are the profitable proposals that are recommended to be taken. The other three projects have a PI that falls below the acceptable indicator of any number greater than 1.

On the other hand, if directors should decide go on board for full phase of the proposals, then only proposal 5 is acceptable with a PI 2.79.

Nevertheless, the cost involved in pursuing the two acceptable proposals (£35,000+£100,000) based on phase one and the only acceptable proposal (£70,000) on the full phase will not exhaust the available funds of £300,000.

We therefore recommend that on which ever conclusion directors' draw i.e. whether to do full phase or not, they could follow the PI ranks as given on table 1.5 to fully utilise the available funds.

QUESTION 3

Introduction

Investment appraisal is the process of evaluating a project for its economic viability. Many methods of investment appraisal exist - ranging from payback period, NPV, IRR and others. As important as capital budgeting is, investment decisions should not be based purely on financial, but also, other non-financial or qualitative factors that plays significant role in making any meaningful investment decision.

These factors include;

Government Regulations: Directors must always consider the implications of government actions and inactions on any project they want to execute. This includes relevant laws and regulations such licensing to operate, social and environmental regulations before making investment appraisal.

For example, it is likely that proposal 1 and proposal 5 may be subjected to certain government regulations.

Competitors' action. There is need for the directors to consider the companies major competitors actions before making investment decisions. Does a market exist already? Are there any fierce competition? Can the product penetrate the market in order to earn estimated inflows?

Directors must assess all proposals on this ground to be certain of estimated inflows.

Customers' satisfaction: Customers are always the "King", and in order for companies to maximise it objective (that is profit maximisation) it must satisfy it customers. The satisfaction that customers will get from an investment is a non-financial factor to consider before making any investment.

In this case, will the proposed investment meet customers' expectation and preferences?

Availability of manpower. The company needs to make sure that there are enough people with high skills and expertise to operate the equipment to be invested in. Directors must consider if staffs can handle the changes brought about by the investment, whether they be should be trained to use the new technology.

The financial implications of manpower appears to have been considered in proposal 4, however directors must consider all proposals for non-financial purposes.

Impact on existing products. Director must consider the repercussions of developing a new product have on existing products. Will product run alongside old products? What happens to existing market for existing products? Will impact be detrimental to existing products or are the company diversifying?

Directors are proposal to develop new products in the case of project 1 which may have possible impacts on existing products.

Availability of new technology. Recent technologies developed in the area of each proposal must be considered. In addition, directors must assess how technologies in each proposal are frequently changed and how it could impact on the investment proposed. Because if Directors are not able to keep up with competition products may be rendered obsolete and hence unable to meet expected inflows.

Probably Directors have considered the financial implications on proposal 4 but again qualitative factors must be considered on all other proposals.

Conclusion

It is very crucial for directors to consider qualitative/non- financial factors of an investment proposal because such factors are more likely to alter the outcome of the decision.

To achieve an excellent decision, Directors needs to evaluate their external environment as well as their internal environments (PEST and SWOT analysis) in relation to the proposals and measure how much they could work to the advantage or disadvantage of the company.

QUESTION 4

Introduction

A number of researches have shown that, in practice, the IRR method is more popular than the NPV approach. The IRR is a discount rate that makes the present value of estimated cash flows equal to the initial investment.

Merits and Demerits of IRR

IRR is straightforward and simple. In other words, the IRR method is easy and understandable. Investors with non-financial background can easily appreciate the implications of the IRR on a project.

Based on it simplicity, Managers and Investors are able to judge the value of their investment against a companies required rate of return and/or interest rates.

It uses cash flows and recognizes the time value of money, like the NPV, which happens to be a step ahead of the ARR and the payback period method, both of which ignore the time value of money.

However, IRR method often tends to give unrealistic rates of return. Supposing a company's cost of capital is 10% and the calculated IRR is 40%. It does not mean that directors should immediately accept the project because of the assumption that the company has the opportunity to reinvest future cash flows at 40%. Realistically, it is often impossible for company's to reinvest at rate of 40%. Hence unless the IRR is reasonable, it should not be used as a basis for accepting and rejecting a project.

Again, the IRR method may give different rates of return. This makes it difficult for directors to decide on which rate to use or to choose a favorable rate that boost investors' confidence in the project. Regardless of how popular the IRR method is in the business world, it may be a complicated technique to practice.

Merits and Demerits of NPV

NPV take into consideration time value of money because it is based on discounted cash flow, recognized that £1 in the future is worth less than £1 today.

Because it considers real cash flows, it is less subject to manipulation and subjective decisions unlike the net profit. For example, net profit is influenced by accounting policies on stock valuation, depreciation and overhead apportionment. Regardless of changes in any of these, the cash flows will remain unchanged.

NPV take the cost of raising finance via the discounting process. As shareholders are interested in cash flows and profit maximization, a positive NPV therefore reflects the increase in shareholder wealth that should occur if the project is undertaken.

However, in practice it may be difficult to determine the discount rate. This should relate to the cost of finance (or cost of capital, as it is usually known), but calculating the cost that makes up the different elements of finance (e.g. share capital and loans) is difficult.

The NPV deals in absolute figures and does not place preference on the size of the project. Supposing there are two mutually exclusive project, NPV would recommend acceptance of a £1 million project with a NPV of £1250 over a £1000 project with a NPV of £500.

Conclusion

Most probably, the IRR method is favoured and widely used in practice because non-financial executives, who include CEOs, Shareholders and board members, can easily relate to percentages and has no difficulty embracing the concept of the project.

Nonetheless, NPV tends to be a superior method, because results are valued in amounts thus a positive NPV indicates addition to shareholder's wealth and hence considered as financially worthwhile.

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