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Evaluation of the attractiveness of an investment proposal, using method s as average rate of return, internal rate of return (IRR), net present value(NPV), or payback period. Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily.
Investment appraisal means the investment therefore assumes that investment will yield future will yield future income streams. Investment appraisal is all about assessing the income streams against the cost the investment. It is to make a more informed decision, more sophisticated techniques to be used and important of time value of money. It is degree of simplicity required and degree of accuracy required and extent to which future cash flow can be measured accurately and necessity of factoring effects of inflation.
As project B has shorter payback period (less than 3 year) than that of project A (more than 3 year), project B should be accepted. criticisms of the payback period?
Payback refers the number of years accepted to take to recover the cost of initial investment. Following are the criticisms of the payback period it lacks objectify and ignores the time value of money, it ignores the time profile of the net cash inflows, and any time pattern in the net investment outlays , it take no account of the total profitability over the whole life of the investment, cash received after payback completed is totally ignored. So, it focuses on breaking even rather than on profitability, It lacks objectivity and ignores the time value of money, no effort is made to relate the total cash earned on the invested to the amount invested.Net Present Value
The net present value method determines whether a project rate of return is equal to, higher than, or lowers than the desired rate of return. All cash flow from a project is discounted to their present value using the company desired rate of return. Subtracting the total present value of all cash out flow of an investment project from the total present value of all cash out flows of an investment project from the total present value (NPV). Net present value, allows you to a companies at their correct current value, usually at year end when the accounts are prepared. The calculation of net present value takes into accounts original cost less all accumulated depreciation allowed against that asset in previous tax computations. Using this concept of the time value of money, you can determine the net present value (NPV) for a particular investment as the sum of the annual cash flows discounted for any delay in receiving them, minus the investment outlay. The Net Present Value is the present value of the net cash inflows less the project's initial investment outlay.
The main NPV decision rules -
- Project with positive NPV should be accepted.
- Project with negative NPV should be rejected..
In addition to, project B will probably be chosen in preference to project A as it has a higher NPV.
Describe the logic behind the NPV approach
NPV method recognizes that cash received today is preferable to cash receivable sometime in the future. There is more risk in having to wait for future cash receipts, and while a smaller sum may be obtained now, at least it is available for other purposes (could be reinvested future for years and compound into a higher value).
This method is calculated based on the widespread acceptance of Discounted Cash Flows (DCF) method. DCF method recognizes that the value of money is subject to a time preference, that is, that £1 today is preferred to £1 in the future unless the delay in receiving £1 in the future is compensated by an interest factor, expressed as a discount rate.
In simple terms, the DCF method attempts to evaluate an investment proposal by comparing the net cash flows accruing over the life of the investment at their present value with the value of funds about to be invested. Thus by comparing like with like it is possible to calculate the rate of return on the investment in a realistic manner.(ref:)INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investment. It also called the discounted cash flow rate of return or simply the rate of return. IRR is discounted rate of return derived based on the condition that net present value for an investment is 0. IRR is then compared to the company's discounted rate of return. If IRR is higher than the project's discounted rate of returns, then the investment is deemed to be worthwhile for the company or investor. The discounted rate of return for the company is determined by the investors themselves. Discounted rate of return is derived based on a number of factors. One of them is the consideration of risk. If the investor is evaluating a more risky investment, he is likely to have a higher rate of return. This is to compensate the risk that he is taking on this project. Another factor that could influence the discounted rate of return is the general market rate of return.
Determine the IRR for each project. Should they be accepted?
The interest rate which, when used as the discount rate for a series of cash flows, gives a net present value of zero. In other word, IRR is a cost of capital at which NPV = 0.
For the calculation of IRR the first step is to select two discount factors, and then calculate the net present value of the project using both factors. One of the factors should produce a positive NPV, and the other a negative NPV. Suppose, two discount factors are 20% & 22%.
In both cases IRR are greater than cost of capital. So both projects should be accepted as NPV here is positive.
How does a change in the cost of capital affect the project's IRR?
Without modification, IRR does not account for changing the cost of capital.
NPV =0 = -110000 + 40000/(1+ IRR) +40000 /(1 + IRR)2....... NPV =0 when IRR = 23.8%
Solving for NPV using MIRR, we will replace the IRR with our MIRR = cost of capital of 12%:
NPV = -110000 + 40000/(1+ .12) + 40000/(1 + .12)2......... NPV =34200whenMIRR = 12%
So any change (modified or replaced with MIRR) in the cost of capital, where NPV=0, would lead to a change in the NPV, but not the IRR.
So any change in the cost of capital does not influence the IRR.
Why is the NPV method often regarded to be superior to the IRR method?
arriving at a particular decision and making a comment regarding the superiority of NPV or IRR, Let's proceed on with a comparison between these two renowned methods of capital investment Before appraisals
- In case of calculating the IRR, the main difficulty arises for selecting two discount rates with a range as narrow as possible will give a positive and negative NPV. Using a trial-and-error method unless a computer may be a time consuming matter.
- The major limitation of IRR is it's one single discount rate whereas each cash flow of NPV can be discounted with multiple discount rates without any problem.
- NPV method emphasises on cash flows rather than on profitability because cash flows making the positive NPV results in the maximization of the shareholders' wealth.
- The advantage of the NPV method is the simplicity with which the results are stated. As it is shown in calculation above, with the NPV method, the expected results are expressed in terms of pounds which directly reflect the increased wealth position. The internal rate of return, on the other hand, produces a result which is shown as a percentage, and this result has to be compared with a minimum required rate of return before a decision may be made. ( M W E Glautier & B Underdown, 2007)
- Where a project is financed with raising a loan, the IRR method envisages that the cash surpluses will be reinvested at the IRR discounting rate, whereas the NPV method envisages that they will be reinvested at the minimum acceptable rate of return used in that method. Thus, the advantage of the NPV method is that it makes more realistic assumptions about reinvestment opportunities. ( M W E Glautier & B Underdown, 2007)
- If there is an irregularities in cash flows over subsequent years due to the market conditions, a multiple rate of returns used to make the project break even produce multiple IRRs. In case of mutually exclusive projects, IRR can give some misleading results as well. In both cases NPV is free from such problems.