Use of investment appraisal techniques

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Content page

1.0 Introduction……………………………………………………………..…………..4

2.1 Capital budgeting…………………………………………………………………...5

2.2 Capital rationing…………………………………………………………………….6

3.0 Task1………………………………………………………………………………...6

3.1 Net present value…………………………………………………………………….7

3.2 Capital rationing……………………………………………………………………..7

3.3 financing options…………………………………………………………………….7

3.4 Analysis……………………………………………………………………………...7

4.0 Task2………………………………………………………………………………...8

4.1 Significance of the WACC…………………………………………………………..8

4.2 Calculations of WACC………………………………………………………………9

5.0 Conclusion…………………………………………………………………………..11

6.0 References…………………………………………………………………………...12

1.0 Introduction

The report is used for enterprises to deal with different situations. To study how to analyze the finance data to solve the problem. Give some advice to CAMRY LIMTED and Zen Limited. The major purpose of this report is a better understanding of all kinds of investment appraisal technique, and used to make investment decision. Then we can offer advice to the companies. To let the companies make more profit.

2.1 Capital budget

Capital budgeting, or investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures.[1] One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.Many formal methods are used in capital budgeting, including the techniques such as:

Accounting rate of return

Payback period

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annuity

Real options valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period. In this study, capital budgeting is used in Camry limited of in investment decision making, to propose the optimal capital renewal program for Camry Limited, so as to improve the efficiency of factories.

2.2 Capital rationing

The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.

Companies may want to implement capital rationing in situations where past returns of investment were lower than expected. For example, suppose ABC Corp. has a cost of capital of 10% but that the company has undertaken too many projects, many of which are incomplete. This causes the company's actual return on investment to drop well below the 10% level. As a result, management decides to place a cap on the number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new projects would give the company more time and resources to complete existing projects. In this study the capital rationing is used for Zen Limited.

3.0 TASK1

3.1 Net present value (NPV)

NPV of on 6% and 7% of funds showing in the following table:

NPV

6% of Funds

7% of funds

Moulding Equipment

177280

--

Extrusion Equipment

150400

616000

Packing Equipment

666800

82940

3.2 Capital rationing

Stated a limited funds 3500000 for capital renewal, therefore there is not sufficient funds to invest in as many as three machines. Meanwhile, these funds must take full use to improve the efficiency of its factory. Table 2 shows the ranking, NPV and P1 of these three equipments.

locations

ranking

NPV

PI

Packing Equipment

1st

666800

22.23%

Extrusion Equipment

2nd

18800

3.76%

Moulding Equipment

reject

(177280)

---

3.3 Financing options

There are two alternative financing options, and calculations of NPV for each option are shown in the following table:

Financing options

NPV

Purchase

306584

Lease

239901

difference

66683

3.4 Analysis

According to the above table 1, it shows the results of NPV of moulding equipment is (177280). The figure is negative, so the proposals of purchase Moulding equipment is rejected and Camry Limited cannot go for negative NPV. But, the results of NPV of both Packing and Extrusion are positive, so these two purchase proposals are acceptable, and then Camry should go for the positive NPV.

On the one hand, through comparing the capital cost of these two equipments, easily find that it is necessary to purchase Packing equipment. Firstly, the reason is that the cost of Extrusion equipment is already over the limited capital renewal funds. Besides, the NPV of Packing equipment is higher than Extrusion equipment, but it does not exess the limited capital renewal funds. From the above, the Camry limited should purchase the Packing equipment. Firstly, it will take 3000000 and then the remaining funds of 500000 could invest in Extrusion equipment.

Based on the above data, table 3 show that both financing options of purchase and lease give positive NPV. Therefore, academically speaking, no matter purchase the machine or lease the machine, there two financing options are acceptable. However, from a practical viewpoint, must choose one of financing option to implement. Net present value of purchase option is higher than lease option is higher than lease options, and the difference is 66683. In conclusion, it is strongly suggested that Camry limited should purchase this machine, so as to increase its capacity and reduce the capital cost.

4.0 Task2

4.1 Significance of the WACC

Weighted average cost of capital is the most popular method to value the business, widely used both on the enterprise value assessment and evaluation of investment projects and it is one of the important parameters and evaluation of investment projects and it is one of the important parameters and appropriate discounting rate to evaluate the value of capital investment. Because a lot of enterprise’s capital structure is more complex, there are variety sources of finance in these company. Moreover, calculating the WACC needs to find cost of equity (Ke), cost of preference (Kp), cost of debt (Kd), calculation of cash flows and internal rate of return (IRR) . To find Out the cheapest source of funds available by evaluating WACC, and it is helpful to study the impact that a new sources of capital has on the WACC, and to count the market value of the company. This report will show the calculation of present WACC of Zen Limited.

4.2 Calculations of WACC

Weighted Average Cost of Capital (WACC)

Debentures

WACC MV % of Funds

Ordinary shares (ex div) 12000000 50.21

Preference share (ex div) 6400000 26.78

Debentures at MV 5500000 23.01

Total 20700000 1000

and, each has a different cost as follows:

WACC % cost of Funds

Ordinary shares(ex div) 36.00

Preference shares (ex div) 6.25

Debentures at MV 4.53

The WACC represents the overall cost of financing your company. It is calculated by determining the cost of each source of finance and weighting same using the market value of each separate source as weights.

As Zen Limited upon the task of raising finance the WACC is of great significance for the following reasons: the WACC can be applied as the discount rate used to appraise the capital investment in the U.K.(and others) to determine whether or not to invest.

If the finance raised costs less than the present WACC then the overall WACC will be reduced and can improve the company’s value of shareholders wealth

Zen Limited can consider the cost of all potential sources of finance relative to the present WACC in order to make the financing decision

The WACC of Zen Limit is 20.73%. This has been calculated as follows:

WACC Note MV %Cost Weighting %weight weighted

Ordinary share(ex div) 1 12000000 36.00 1200/2070 50.21 18.07

Preference share (ex div) 2 6400000 6.25 320/2070 26.78 1.674

Debentures at MV 3 5500000 4.30% 5500/2070 23.01 0.99

Weighted average cost of capital 23900000 100 20.73%

5.0 Conclusion

According to the different situation of different companies, this report uses a variety of techniques such as capital budgeting, capital rationing and weighted average cost of capital, to provide advice and assistance to the company in decision to investment. According o the analysis of alternative proposals, the result suggested that Camry Limited should buy the machine rather than lease the machine. In addition, the result of the calculation of weighted average cost of capital show Zen Limited is able to enter the U.K Market.

6.0 Reference

Websites

http://www.investopedia.com/terms/c/

http://en.wikipedia.org/wiki/

Books

5. Carter and N.J. Macdonald, D.C. B. Cheng (1997) Chapter 6: Investment decisions-Capital budgeting, Chapter objectives, basic finance for marketers [online]. Available at: http://www.fao.org/docrep/w4343e/w4343e07.htm#chapter6investment decisions capital budgeting ( Acessed:1th November 2014)

Charles T. Horngenen (2013) Chaper 29: Capital Budgeting [Online] Available at: http://dosen. Narotama.ac.id/wp-content/up-content/uploads/2013/02/chapter-29-captial-Budgeting.pdf(Accessed:18th October 2014).

WORD COUNT: 1544

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