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Almost all businesses require constant investment for survival and growth, particularly manufacturing concerns. Even service industry requires investment to train its staff, introduce new services and improve their performance. New assets and skills can improve the business performance and can be the basis of a competitive advantage for the business as well.
According to Ansoff's Matrix a business might decide to grow its current operation in any one of the four ways (shown below). The business has to invest when they are developing a new product, entering new markets or both at the same time.
This investment can be a new product, a new service or a new capability. A business would like to expand and stretch itself endlessly but the limited financial and human resources constraint that growth. The business has to thoroughly investigate the pro and cons of a deal before it can actually invest in that. Depending on the size of a business the investment can range from buying a photocopier to an investment of hundreds of thousands of pounds in expanding the business into a new market.
The main reason of investing is to expand the business to maximize profits. It can also be done to meet the growing demand of a popular product. Other reasons might be to achieve a certain capability to get a competitive advantage over industry competitors.
In a NFP the reason for investment can be to get greater efficiency, reduced costs and improved performance.
Other reasons of investments may be
Focusing to get improved quality
Improving company's brand recognition and answering any corporate social responsibility matters
Faster decision making
Although profit maximization and cost reduction are at the heart of any investment, the fit of investment in present business should also be carefully analysed. Any investment should not be treated as a single entity. Its effect on the whole business should be determined as well.
Once the investment is agreed by the management usually the finance department should evaluate its effectiveness by checking the perceived results by different appraisal techniques.
Some Typical Methods used for investment appraisals are
Annual Rate of Return
Net Present Value
Internal Rate of Return
I am going to discuss a project that our organisation ( The Professionals' Academy of Commerce Khyber Campus ) undertook that help helped the organisation to
improve its image
generate greater profits
gain competitive advantage
acquire new capabilities
diversifying the business
A little introduction of the company.
The Professional Academy of Commerce is a multi campus Chartered Accountancy institute in Pakistan. It is affiliated with Association of Chartered Certified Accountants and Institute of Chartered Accountant of Pakistan. It provides chartered accountancy courses only. It is the oldest institution for providing chartered accountancy education in Pakistan. It has been offering its services since 1987. The total number of students studying here is more than 7,000. For more details and company background please visit www.pac.edu.pk
Reason for selecting this project over other investment option.
There were many reason that compelled the organisation to take this project instead of other investment options.
Low investment , High Return
The initial investment required was quite low and the returns are very high. The whole cost of investment was recovered in less than one year. As the building and other facilities are available so there is no additional cost of renting a special place or building any new rooms etc
Having a functional computer lab could open up many avenues which were not yet available then. The organisation could benefit from internet, local area network etc to improve their communication internally and externally.
Extension of Services
Although the main purpose of the investment was to prepare a centre where CAT and ACCA computer based examinations could be held. The facility was also used for hosting examination of other academic bodies that needed an up to date computer lab. The facility could also be used for PIPFA ( Pakistan Institute of Public Finance and Audit ), ICAP ( Institute of Chartered Accountants of Pakistan ) computer based examinations.
What did we do ?
An important part of the education are the examination. In chartered accountancy field the exams are very tough and through. The exams are held in two formats.
Paper Based Examination that are held twice a year in June and December of every Year.
Computer Based Examinations that are held round the year approximately 24 times a year. Twice every month.
The computer based examination are held at different centers all over Pakistan. For that to take place the institute has to have a fully equipped Computer Lab that has to be approved by ACCA.
The assignment discuses the investment involved in setting up of computer lab for computer based examinations and its annual returns.
The Investment Cost
Purchase of 20 Computers Work Station Systems
Purchase of a Computer Server
Cost of Setting up Network, Installation, Laying Cables, Connectors etc
Purchase of Software for 21 Systems
Uninterrupted Power Supply Units for 21 Systems
Other Misc Costs
Repairs And Maintenance Costs
Total costs of the project for four years = 1,344,000
The useful life of project is estimated for four years, after which the first six items were to be re-purchased, which make up most of the cost of investment.
The Yearly Return
On average 55 students appeared for examination every month. The total number of students appearing was approximately 1200. We approximated 10% increase in examinees every subsequent year.
Paid to ACCA and The British Council
Total Number of exams in year 1
Total Number of exams in year 2 (5% Growth)
Total Number of exams in year 3 (5% Growth)
Total Number of exams in year 4 (5% Growth)
Return expected in First Year = 660 * 2750
Return expected in Second Year = 693 * 2750
Return expected in Third Year = 798 * 2750
Return expected in Fourth Year = 878 * 2750
Total returns in Four Years = 8,329,750.00
The Payback Period Investment Appraisal Technique
It is the simplest investment appraisal technique. It only takes into account the time it requires to get the actual investment back. This technique is usually adopted by small businesses.
When there are more than two investment options available normally the option with smaller payback time is opted for.
According to this investment appraisal technique the time required to regenerate the invested amount is.( if annual returns are constant )
Payback Period = Cost of Investment / Annual Cash Inflow
But this is not our case as annual cash Inflows are different for each year
The first years return is 1,815,000 and the total investment is 1,344,000.00 Hence the complete cost of investment will be covered in the first year alone.
More specifically the monthly return in first year is 1,815,000 / 12 = 151,250.00 The total cost can be recovered in approximately nine months only. So the payback period of the investment is quite small.
Advantages of Using Payback Technique
It is simple and easy to understand
It is quick and does not require complex calculations
Disadvantages of Payback Period Technique
It does not account for the time value of money
It also neglects any cash that is earned after the original payback period.
Annual Rate of Return Appraisal Technique
This appraisal technique calculates the yearly net return in terms of percentage according to the initial investment made.
The formula for finding the Annual rate of return is
ARR= Net Return Per Year * 100 / Initial Investment
The total return of the project is Rs. 8,329,750.00
The yearly return is Rs. 8,329,750.00 /4 = 2,082,437.5
ARR = 2,082,437.5 *100 / 1344,000.00
ARR = 154.9 %
As discussed in payback period the ARR also shows that the total cost will be recovered in first year only.
If there are more than one investment options available the one with higher ARR is selected.
Advantages of Using ARR Technique
It shows the annual returns of the project in simple terms.
Unlike Payback period which ignores the financial returns and focuses on the time only. The ARR provides a method of comparing the returns of one investment option with another. So in a sense it reflects the opportunity cost.
It is quite easy to calculate and understand.
Disadvantages of ARR
It does not take into account the time value of the money like Payback period.
It is slightly more complicated than payback
Discounting Future Cashflow
Time Value of Money.
Money now is worth more than same money if received in future.
If the cash is readily at hand you can invest it somewhere and get returns on it. Like putting a £100,000.00 now in bank and earn interest on it or invest in some profitable project etc.
If you do not have the money right now but you will get in near future, and you have to make an investment right now you will need to get a loan and pay it back with interest later. This will reduce your money.
The future is unpredictable and contains many risks, like inflation, lower returns, etc. So the sooner the money is invested and the sooner returns are received, the better it is for the investor.
Say if a person is to receive £100 in a year's time. And the discount rate is at 10 percent. What he thinks as 100 will actually be 90.91.
This calculated as
Future Value = Present Value / ( 1 + r )n
Where r is the discounting rate.
N is the number of year after which return is expected
Discounting Future cashflows point outs exactly what to expect in reality. It eliminates the exaggerated profit return that might seem higher at the moment but will not have same value in future.
Net Present Value
" 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 prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. " (Ref: Investopedia)
Project returns are often assessed by using net present value rather than payback or Annual rate of return. The NPV appraisal technique finds out the present value of all expected future cashflows at a given discount rate. The general rule of thumb is that the higher the NPV of a project is the better it is.
In our case taking the discount rate at 10 %, the Cashflows are
Year No Inflow / ( Outflow ) Discount Rate Present Value
0 -1,344,000.00 1 -1,344,000.00
1 1,815,000.00 0.909 1,649,835.00
2 1,905,750.00 0.826 1,574,149.50
3 2,194,500.00 0.751 1,648,069.50
4 2,414,500.00 0.683 1,649,103.50
Net present value is calculated by adding all the future cashflows present value.
Net Present Value = -1,344,000.00 + 1,649,835.00 + 1,574,149.50 + 1,648,069.50 + 1,649,103.50
NPV = 5,177,157.5
A compact form of the formula is
NPV = âˆ‘ [ Ct / ( 1 + r ) t ] - C0
Ct is the inflow of year
C0 is the initial investment i-e cash outflow
R is the discounting rate.
If we ignore the discounting rate the profit is
Profit = 1,815,000.00 + 1,905,750.00 + 2,194,500.00 + 2,414,500.00 - 1,344,000.00
Profit = 6,985,750.00
The difference between the NPV deducted profit and normal profit is
Diff = 6,985,750.00 - 5,177,157.5
Diff = 1,808,592.50
This difference is the time value for money deduction that Net Present Value has calculated. The real profit that will be enjoyed in four years is Rs. 5,177,157.5 NOT Rs. 6,985,750.00
Internal Rate of Return
Internal rate of return method is used to measure profitability of an investment in capital budgeting. IRR is the discounting rate which the NPV of future cash flows will be zero. IRR method is used to see the comparison of different investment options and the one with higher IRR is favoured.
In order to calculated IRR we have two calculate two NPVs.
An NPV at a lower discount rate where the result of NPV is positive
An NPV at a higher discount rate at which the NPV's result is negative.
After finding these two IRR can be found out using the following formula
IRR = LDRÂ + [NPVlowÂ * ( HDR - LDR ) / ( NPVÂlow - NPVhigh )]
LDR = Lower Discount Rate
HDR = Higher Discount Rate
NPVlow = NPV calculated at Lower Discount Rate
NPVhigh = NPV calculated at Higher Discount Rate
(REF : From MFRP Lecture Slides)
Calculating negative NPV first, in order to calculate IRR
As the returns of the project are very high, the NPV gets negative at 140% discounting rate. The chances of this happening are extremely rare.
NPV at 140% = -25,370.00
IRR = 10% + [5,177,157.5 * (140-10) / 5,177,157.5 - (-25,370.00)]
IRR = 139.37% which is very very high and is highly acceptable.
In the light of discussion made NPV and IRR are better approaches to follow as they take into account the time value of money. Although Payback and IRR are much simpler but they can be misleading by not taking inflation and other factors.
IRR and NPV take into consideration the inflation and interest rates which may fluctuate in future and affect our returns.
So for the sake of simplicity and ease of understanding payback and ARR should be calculated but are not to be relied upon heavily.
meeting the requirements of current and future legislation
matching industry standards and good practice
improving staff morale, making it easier to recruit and retain employees
improving relationships with suppliers and customers
improving your business reputation and relationships with the local community
developing the capabilities of your business, for example by building skills and experience in new areas or strengthening management systems
anticipating and dealing with future threats, for example by protecting intellectual property against potential competition
Apart from financial factors the following non financial factors should also be considered when using these appraisal techniques.
( The above extract is from www.businesslink.gov.uk )