Strategic financial management investment appraisal

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Introduction:-

Investment appraisal is a method by way of which a company can confirm whether an investment plan is worthwhile to invest in or not. Investment plan could be the procurement of a new computer in a small firm, a new piece of machinery in a manufacturing firm, an entire new factory, etc; so basically in means to invest the funds of the business in a manner whereby the firm's reputation would stand stronger. Both public and private sector industries need to invest their funds so as to move forward with the time and prosper in a wholesome way.

There is no one particular way by which a company or even the decision makers may choose to assess and compare the different proposals in front of the company and so many factors need to be taken into consideration which making such decisions. According to Bott[1] some of these factors are as mentioned below:-

  • The extent to which the proposals are consistent in consideration with the companies' long term plans.
  • The risk factor if the company were to invest in such a proposal.
  • The availability of the resources required for the company to invest in such a proposal including finances.
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To analyze all of these factors, various method have been propounded through the years by various different persons. These methods of investment appraisal are as given below:-

(Source: Biz/Ed, 2007)[2]

Part 1:- NPV (Net Present Value)

NPV or Net Present Value is one of the most commonly used methods of investment appraisal until today.

(Source: Biz/Ed, 2007)[3]

According to Mott[4] the NPV approach is based on the 'time value of money' concept. That means that it is better to have £90 today than to have £100 say ten years from now. If you have it now, you could invest it, and you would have more than the original £100 ten years from now. This might seem very basic but in reality the NPV approach also considers the risk factor and so if the investment is of low risk then the investor would prefer to get more returns at a later stage. According to the discount rate the investor must take his decision on the basis that he can get a better rate of return from his investment from other sources or no. This decision has to be made very carefully by the investor as once an investment is blocked in for a particular number of years the investor would not get the same rate or return if he would want to exit and reinvest his money in any other source.

Calculation of NPV:-

Project ‘A':-

Year

Net Cash Flow

Discount Factor @ 10%

Present Value

0

-200

1

-200

1

200

0.909

181.8

2

800

0.826

660.8

3

-800

0.751

-600.8

TOTAL PRESENT VALUE = 241.8

Note: - Year 0 is the year of investment and generally not taken into consideration while calculation of NPV but in this case since the figure is negative we would have to take it into consideration and consider that the investment is either taken as an overdraft or a loan.

NET PRESENT VALUE=TOTAL PRESENT VALUE-INITIAL INVESTMENT

Therefore,

NPV = 241.8 - 200

NPV = 241.8 - 200

NPV = 41.8

PROJECT ‘B':-

Year

Net Cash Flow

Discount Factor @ 10%

Present Value

0

-150

1

-150

1

50

0.909

45.45

2

100

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0.826

82.6

3

150

0.751

112.65

TOTAL PRESENT VALUE = 240.7

Note: - Year 0 is the year of investment and generally not taken into consideration while calculation of NPV but in this case since the figure is negative we would have to take it into consideration and consider that the investment is either taken as an overdraft or a loan.

NET PRESENT VALUE=TOTAL PRESENT VALUE-INITIAL INVESTMENT

Therefore,

NPV = 240.7 - 150)

NPV = 240.7 + 150

NPV = 90.7

Note: - Since the initial investments of both the projects are different the decision makers most take into consideration the profitability index of both projects before taking any decision on the basis on only the NPV; and hence the calculation of the profitability index is any mentioned below. Also since for this calculation initial investment is required and this is negative which would indicate a loss while calculation and also because the initial investment can never be a negative value since it is year 0, the initial investment is considered to be positive and the calculation is as shown :-

Profitability Index

PROFITABILITY INDEX=NPV+INITIAL INVESTMENT INITIAL INVESTMENT

PROJECT ‘A':-

PROFITABILITY INDEX = 41.8+200200

PROFITABILITY INDEX = 241.8200

PROFITABILITY INDEX = 1.209

PROJECT ‘B':-

PROFITABILITY INDEX = 40.7+150150

PROFITABILITY INDEX = 190.7150

PROFITABILITY INDEX = 1.605

Selection of project:-

Scenario 1:- Which project should the firm undertake if it is not financially constrained?

If FIRMEX Corporation (PLC) is not financially constrained and has ample funds to invest then it could invest in both the projects as both the projects tend to yield a profit in the future. Although project ‘B' has a higher yield at a lower initial investment project ‘A' also has a profit and so in the scenario where the company is not financially constrained; according to me FIRMEX Corporation (PLC) should first invest in project ‘B' and later it could decide it further investment is wanted for the company it could invest in project ‘A'.

Scenario 2:- Suppose the company lacks the capital to undertake both projects Which of the two projects then should the company select?

If FIRMEX Corporation (PLC) has a cash crush and still wants to invest in one of these given 2 projects then in that scenario according to me FIRMEX Corporation (PLC) must invest only in project ‘B' since the profitability index is higher and the initial investment requirement is lower than that of project ‘A'. In such a way not much money is needed to be invested and the return is higher, so investing in project ‘B' according to me seems to be a better bet in this scenario for FIRMEX Corporation (PLC).

Part 2:- IRR (Internal Rate of Return)

Internal rate of return is a rate of return which is used in capital budgeting to measure and compare the profitability of investment. IRR is also called as discount cash flow rate. This means that all cash flow from investment is depend of time value of money. Thus the higher the IRR the better it is considered for investment.

(Source: Biz/Ed, 2007)[5]

Calculation of IRR:-

Project ‘A':-

Year

Net Cash Flow

Discount Rate @ 10%

Present Value

Discount Rate @ 20%

Present Value

Discount Rate @ 30%

Present Value

0

-200

1

-200

1

-200

1

-200

1

200

0.909

181.8

0.833

166.6

0.769

153.8

2

800

0.826

660.8

0.694

555.2

0.592

473.6

3

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-800

0.751

-600.8

0.579

-463.2

0.455

-364

NPV when discount rate is 10% = 41.8

NPV when discount rate is 20% = 58.6

NPV when discount rate is 30% = 63.4

Note:- As we can observe, as we go on increasing the discount factor the NPV goes on reducing; but to get the NPV to 0 i.e. the point of IRR, we have to consider the discount factor to be either 0% or 100% and hence this project has multiple IRR's and the method of IRR is not suitable for calculations and decision making in such a project. Lets just see what happens when we consider the discount factor to be 100% and 0%:-

Year

Net Cash Flow

Discount Rate @ 0%

Present Value

Discount Rate @ 100%

Present Value

0

-200

1

-200

1

-200

1

200

1

200

1

200

2

800

1

800

1

800

3

-800

1

-800

1

-800

Total Present Value @ 0% = 0

Total Present Value @ 100% = 0

Hence, IRR cannot be calculated for this project in such a method.

Project ‘B':-

Year

Net Cash Flow

Discount Rate @ 10%

Present Value

Discount Rate @ 20%

Present Value

Discount Rate @ 30%

Present Value

Discount Rate @ 40%

Present Value

0

-150

1

-150

1

-150

1

-150

1

-150

1

50

0.909

45.45

0.833

41.65

0.769

38.45

0.714

35.7

2

100

0.826

82.6

0.694

69

0.592

59.2

0.510

51

3

150

0.751

112.65

0.579

87

0.455

68.25

0.364

54.6

NPV when discount rate is 10% = 90.7

NPV when discount rate is 20% = 47.65

NPV when discount rate is 30% = 15.9

NPV when discount rate is 40% = -8.7

IRR=PERCENT OF LOWER NPV AMOUNT OF LOWER NPVSUM OF LOWER AND HIGHER NPVX DIFFERENCE IN PERCENT OF

BOTH NPV's

Therefore,

IRR = 30% +15.924.6×10%

IRR = 30% + 6.46%

IRR = 36.46%

IRR results:-

According to the results that can be seen for FIRMEX Corporation (PLC) from the IRR method of investment appraisal we can say that the IRR results confirm the previous results that were brought by the NPV and profitability index. Although in project ‘A' the IRR cannot be calculated with accuracy but still getting a rough estimate in mind; we say that even according to the IRR values, any decision maker would prefer to invest in project ‘B' rather than in project ‘A'. Hence we say easily say that project ‘B' adds more value for FIRMEX Corporation (PLC) than project ‘A'.

Conclusion:-

PROJECT A

PROJECT B

NPV

41.8

90.7

PROFITABILITY INDEX

1.209

1.605

IRR

0/100%

36.46%

From the above given analysis and all previous calculations shown we can confidently conclude to say that project ‘B' is going to be more profitable for FIRMEX Corporation (PLC) because it has got very good results for the future at a lower level of investment and that the company can make a good profit from the project ‘B' that is higher than the percent of profitability that FIRMEX Corporation (PLC) can get from project ‘A'; so it is suggested that FIRMEX Corporation (PLC) invests in project B at 10 % cost of capital to get a valued outcome and greater future standing.

References:-

Professional issues in Information Technology; Frank Bott; Yps-publishing

Biz/Ed ; Business Education journal ; 2007

Accounting for non accountants ; 6th edition ; Graham Mott ; 2005

Burzin R Merchant

0506KMKM1009

[1] Professional issues in Information Technology; Frank Bott; Yps-publishing;

[2] Biz/Ed ; Business Education journal ; 2007

[3] Biz/Ed ; Business Education journal ; 2007

[4] Accounting for non accountants ; 6th edition ; Graham Mott ; 2005

[5] Biz/Ed ; Business Education journal ; 2007