Why is investment appraisal process so important

Investment decisions are of critical importance to all companies, since they determine both their potential to succeed and their ultimate cost structure. Investments usually implicate high initial cash outflows and thus tie up substantial funds. Sound investment decisions are crucial, therefore. Yet, according to a highly complex and fastly changing business environment they remain a challenging management task.

A capital investment appraisal is used to make sure value for money with regard to developing an estate strategy and capital project. It is not an indication of loss or profit for the company as a whole but rather a comparision of costs with regard to those areas of the estate where there is an opportunity or a demand for change. (Baum T., Mudambi R., 1999).

Capital investment decisions are the important criteria to be used by an organization in order to apply its corporate strategy. Because of this, it has to include strategical decisions, marketing decisions and human recources implications that are an overall business review. These decisions include; expansion, cost reduction, market development, acquisitions and disposals, lease or buy. It is possible to evaluate the validity of the opportunities for an investment appraisal by comparing the expected benefits with the anticipated costs as its purpose. ( Kind J, 1999 p.122)

(b) What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback period which of these projects should be accepted?

Payback for Project A

Years

Net cash flow

Cumulative net

cash flow

£000

£000

0

(110)

(110)

1

20

20

2

30

50

3

40

90

4

50

140

5

70

210

Total 3+=3.4 years

Payback for Project B

Years

Net cash flow

£000

0

(110)

1

40

2

40

3

40

4

40

5

40

Total = 2.7 years

c) What are the criticisms of the payback period?

Payback is a type of measurement that indicate the necessary period of time required for the recovery of the initial investment.

There is a necessity of clarification that the payback can not be used as an only decision criterion because it does not include any profits or cash flows occurring after the payback period. Second, payback gives equal weight to all cashflows before the cutoff period, despite the fact that the more distant cashflows arc less valuable.( Mott, 2005, p 217.)

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It is a compulsory for a company to determine a proper end time for the investment in order to use payback method. Too many short-lived projects will be chosen by the company rather than long term ones in case of using the same date without taking into account the project life.

Also it can be considered as an effective auxiliary investment appraisal tool since some possible risks that may arise from an investment project can be indicated by payback. As paralel to this, it might be thought as an important factor for the consideration of the economic life of a project as a consecuence of a sensitivity analysis. (Götze U, 2008, p.46)

Although it has weaknesses, payback will be used as one of the main decision making tecniques because the simplicity is the keynote of this investment appraisal method. And also it has short term perspective that leads decision making. In case of consideration of more complex projects,we should use advanced analysis like Net Present Value method and think carrefully what might be at risk. ( Dyson, 2007, p.422)

(d) Determine the NPV for each of these projects? Should they be accepted – explain why?

NPV for Project A

Years

Net cash flow

Discount factor

Present value

£000

12%

£000

1

20

0.893

17.86

2

30

0.797

23.91

3

40

0.712

28.98

4

50

0.636

31.8

5

70

0.567

39.69

_______

Total present value

141.74

Less: Initial cost

110

————

Net present value

31.74

NPV for Project B

Years

Net cash flow

Discount factor

Present value

£000

12%

£000

1

40

0.893

35.72

2

40

0.797

31.88

3

40

0.712

28.48

4

40

0.636

25.44

5

40

0.567

22.68

_______

Total present value

144.2

Less: Initial cost

110

————

Net present value

34.2

Both projects should be accepted, since both Net Present Values are positive according to ACCEPT-REJECT decision making techniques.

If we use RANKING decision making techniques;

Project

NPV@ 12% Discount Rate

£000

B

34.20

A

31.740

As it can be seen from the rankings Project B is more preferable with a higher NPV.

(e) Describe the logic behind the NPV approach.

NET PRESENT VALUE METHOD

One of the most widely known and used technique of financial analysis is Net Present Value method. It is a comparision of the value of money now and that of the future. A pound today is precious more than a pound in the future, because the buying power of the future money is eroded by the effect of inflation.

Importance of Time Value of Money in Financial Management;

The time value of money is the fundamental for financial management because it is the aid of determining present value in today’s paund of the future net cash flow of a project. Therefore you can obtain a comparision of that sum of money with necessary amount of money to carry out the project.

Any of financial decisions must not be taken in case of the equality of inflows and outflows because of uncertain future conditions. In order to purchase assets the inflow must be above the outflow. If the purpose is to raise the funds then outflow must be kept more than the inflow. And it is required that the inflow and outflow can be matched. In order to make effective financial decision, the flows expected in the future must be adjusted on the purpose of being compared with the current ones.( Ramagopal, 2008, p.221)

The procedure of Net Present Value Calculation;

Net present value method can be used to examine the profitability of all investment projects.

If the net present value > 0 The project is feasible

If the net present value < 0 The project is not feasible

If the NPV is greater than the cost, the project will be gainful for the company. In the case of having more than one project, you should calculate Net present value of all, and the superior one that has the most difference between Net present value and cost must be chosen. Project that its net present value is bigger than zero, are considered to raise the value of the company. (Mott, 2005, p216)

The advantages of this method;

It puts forward the value of 1 pound of today is more than that of 1 pound in the future. Because the return of todays investment will be received earlier than any of the future investments.

The estimated cash flows and the opportunity cost of capital are examined by this method.

In order to calculate the net present value for the whole project, the current values of the cash inflows and outflows could be added since present values are todays value. ( Kind J, 1999 p.127)

The weakness of the model is that cash flows are accepted to be seen on the last day of the year depending on discounting once a year. On the other hand the assumption of the constant cost of capital during the whole life time of the project can be considered as the another weakness of the method. (Proctor, 2009, p.192)

(f) What would happen to the NPV if:

(1) The cost of capital increased?

If the cost of capital increases, discount rates decrease, which means that present values of cashflows also decrease. As a result, NPV will also decrease, because there will be a decrease in the sum of total present values of cash flow

(2) The cost of capital decreased?

Decreasing the cost of capital will increase discounting rates, which means an increase in total present value of cashflows. Depending on this increase, NPV which includes the sum of total present values of cashflows will inevitanly increase.

(g) Determine the IRR for each project. Should they be accepted?

The net present value is most popularly alternated with internal rate of return (IRR). IRR is defined as the discount rate or cost of capital at point where the benefits are balanced with its costs, the net present value is equal to zero and so, can be considered as break even rate. It can be used as measure of capital efficiency.

Advantages of IRR

Liquidity is considered in this method.

It emphasize timing of net cash flow.

The exact % return on investment is given

NPV FOR PROJECT A:

Years

Net cash flow

Discount factors

Present value

£000

17% 22%

17% 22%

£000 £000

1

20

0.855 0.82

17.1 16.4

2

30

0.731 0.672

21.93 20.16

3

40

0.624 0.55

24.96 22

4

50

0.534 0.451

26.7 22.55

5

70

0.456 0.37

31.92 25.9

_______ ______

Total present value

122.61 107.01

Less: Initial cost

110 110

———— ———

Net present value

12.61 (2.99)

IRR= positive rate + -range of rates= = 17%+-5% =21.04%

At 21.01% discount rate the NPV is equal to zero.

NPV FOR PROJECT B:

Years

Net cash flow

Discount factors

Present value

£000

22% 27%

22% 27%

£000 £000

1

40

0.82 0.787

2.863 2.581

2

40

0.672 0.620

3

40

0.55 0.488

4

40

0.451 0.384

5

40

0.37 0.302

_______ ______

Total present value

Less: Initial cost

110 110

———— ———

Net present value

4.52 (6.76)

IRR= positive rate + -range of rates= 22%+-5% =24%

Since both project’s IRR are bigger then cost of capital; both of them can be accepted.

(h) How does a change in the cost of capital affect the project’s IRR?

The IRR value of the project is not affected by a change in the cost of capital. The point that must be taken into account here is that IRR value must not be below cost of capital for the safety of the investment.

(i) Why is the NPV method often regarded to be superior to the IRR method?

The NPV calculation will usually always provide a more accurate indication of whether or not a project should be undertaken or not.However, since IRR is a percentage, and NPV is shown in money, it is more appealing for a manager to show someone a particular rate of return, as opposed to money amounts.