School of Business and Law

Investment Appraisal

Sub: ADMT
Lecturer: S. Palan
Student: Bora ASLAN
Student ID: B0164KEKE0810

London city
2010

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CONTENTS

1. INTRODUCTION (p. 3)

2. INITIAL INFORMATION (p. 3)

3. STATEMENT (p. 4)

4. CONCLUSION (p. 11)

5. REFERENCES (p. 12)

6. BIBLIOGRAPHY (p.12)

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1. INTRODUCTION

This report has been prepared to provide information about investment appraisal of two
thought projects that can be undertaken; as well as to recommend the more beneficial
project.

2. INITIAL INFORMATION

 There are two proposed projects that can be undertaken.

 Projects’ expected lives are 5 years.
 AP Ltd. is planning to invest £110,000 for either project A or project B.
 The cost of capital is fixed at 12%
 The cash inflows that are expected to be, are as shown below.

PROJECT A(£) PROJECT B(£)

Year 1 20,000 40,000
2 30,000 40,000
3 40,000 40,000
4 50,000 40,000
5 70,000 40,000

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3.STATEMENT

(a) Why is the investment appraisal process so important?

Management accounting process, which consists of management decision making

according to provided knowledge on the investment in an undertaken project, monitoring
the performance of that project and its implementation is called Investment Appraisal.
(Weetman, 2009, p.660)

Globalization, innovations and rapid technological changes made modern business

environment more competitive. In order to continue to exist in the market, to make profits
and to be able to compete within this new business environment; organizations must have
strong financial positions as well as flexible structures. To gain feasible competitive
advantages in the market an organization should undertake some projects.

Investment appraisals express the most important decision making in an organization,

since the organization commits a considerable proportion of its resources to actions that
are changeless and without having certain knowledge about future benefits. (Mott, 2005,
p.207)

Acquisitions, replacement of machinery, improvements and modernization of systems,

business operations expansion can be called as investment. Normally investments such
as; plant and machinery replacement, advertising and storing of goods, research and
development require longer than one year period.

Since these types of investments bring a considerable amount of cash inflows as well as
risk correlated to them; managers should evaluate projects before they are accepted.
When the managers of an organization make plans for the long term, they must be able to
answer number of questions including:

1) Which projects should be undertaken?

2) What will be the benefits of such project?
3) How much fixed assets and working capital should be committed to projects?
4) Where the required finance can be obtained from? (Weetman, 2009, p.660)

While selecting an acceptable project, managers can use different methods in order to
correspond different criterions. To evaluate the investments in monetary terms, managers
can use either Traditional Method or Discounted Cash Flow(DCF) analysis.

In Traditional Methods which consists of Payback method and Accounting Rate of

Return (ARR), there are no considerations for the change in the value of money over the
time. But DCF methods, which contain Net Present Value (NPV) and Internal Rate of
Return (IRR) method, consider the time value of money. In These methods, the value of
money reduces more and more with time.

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PAYBACK METHOD

The payback method gauges the time-span needed to recover the initial cash outflow. If
there are numerous different projects, the one which has the quickest time period of
payback, which minimizes the risk of future uncertainty would be recommended to
undertake in an investment decision making. (Proctor,2009)

(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?

FOR PROJECT A:

NET CASH FLOW(NCF) CUMULATIVE NCF

£000 £000
Year 1 20 20
2 30 50
3 40 90
4 50 140
5 70 210

PAYBACK= 3+ Amount still needed .

Total inflow in payback year

PAYBACK= 3+ 110-90 = 3.4 YEARS

140-90

FOR PROJECT B:

NET CASH FLOW(NCF) CUMULATIVE NCF

£000 £000
Year 1 40 40
2 40 80
3 40 120
4 40 160
5 40 200

PAYBACK= 2 + Amount still needed .

Total inflow in payback year

PAYBACK= 2 + 110-80 = 2.75 YEARS = 2 YEARS 9 MONTHS

120-80

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Because of annuity we can calculate the payback time needed with an other equation
which will give us the same solution;

PAYBACK= INITIAL INVESTMENT = 110 = 2.75 YEARS

NCF 40

If the maximum Payback Period of AP Ltd is 3 years; Project B should be accepted.

(c) What are the criticisms of the payback period?

It is the most simple investment appraisal method among the others. And it is used as an
indicator of risk. But it has some weaknesses as compared to other methods.

One weakness of this method is that it only concerns about the payback time period and
and it ignores the cash received after the payback period. Another weakness is that the
Payback method does not try to calculate project’s total profit over the whole expected
life of the money invested. Therefore; projects with shorter payback period can be
accepted although they are not as gainful as projects, which have longer time period of
payback. (Dyson, 2007, p.424)

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

NPV CALCULATIONS FOR PROJECT A:

Years Net cash flow Discount factor Present value

£000 12% £000
1 20 0.8931 17.862
2 30 0.7971 23.913
3 40 0.7121 28.984
4 50 0.6361 31.805
5 70 0.5671 39.697
_______
Total present value 142.261
Less: Initial investment 110
------------
Net present value 32.261

NPV CALCULATIONS FOR PROJECT B:

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 Years Net cash flow Discount factor Present value
£000 12% £000
1 40 0.8931 35.724
2 40 0.7971 31.884
3 40 0.7121 28.484
4 40 0.6361 25.444
5 40 0.5671 22.684
_______
Total present value 144.22
Less: Initial investment 110
------------
Net present value 34.22

Both projects should be undertaken, 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 34.22
A 31.261

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:

Because of the weaknesses of Traditional methods, DCF Discounted Cash Flow method
is more superior among investment appraisal techniques. Unlike traditional method, the
time value of the money is considered in DCF methods such as; Net Present Value (NPV)
and Internal Rate of Return.

Time Value of Money:

If £10 is invested at a interest rate of 10% per year, at the end of the year one the money
will grow to £11. Suppose it has been promised for an investor to receive £10 in one
year’s time and the interest rates are 10%. If the investor does not want to wait one year
to receive cash; the money would be £9.091.

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This amount can be calculated by the usage of the present value formula, which is useful
during the calculation of the present value of a sum of £1 that can be received at the
ending of n years with an interest rate of r% per year;

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(1+r)n

The process, which aims to calculate the present value of the money, is known as
‘discounting’. And the interest rate can be called either ‘discount rate’ or ‘cost of
capital’. (Weetman, 2009, p.666)

Net Present Value:

The sum total of the present values of all cash flows that come from the project, is called
the ‘Net Present Value’.

Net present value has some calculation procedure such as;

1. Make calculations for the annual cash flows
2. Determine the discount rate
3. Calculate the discount rate by using the present value formula or PV tables.
4. Make discounting for future cash flows and calculate annual present values
5. Sum up all the annual present values to get Net Present Value for the whole
project time period.

After calculating the results interpreting must be done in order to decide about the
projects. During the decision making;
1. Accept the project, if the project has a positive NPV; which means that project is
profitable.
2. Reject the project, if the project has a negative NPV; which means that there is a
loss.
3. If there are several projects are being considered for an investment, choose the
project with the highest NPV.

The only weakness of this method is that the discount rate (cost of capital) is assumed
that it won’t be changed over the years with any factors, which is more likely to be not
true; especially when longer period of time is involved. (Proctor, 2009, p.190)

(f) What would happen to the NPV if:

(1) The cost of capital increased?

If the cost of the capital rises, discount factors decreases; which causes a decrease in
present values of cash inflows. Since NPV is the sum of present values of cash inflows
minus initial investment cost, NPV decreases as well.

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 (2) The cost of capital decreased?

NPV rises with a reduction in cost of capital.

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

THE INTERNAL RATE of RETURN (IRR):

This method is a similar method to the NPV and it is based on discounting as well. But
unlike the NPV method, it calculates approximately the rate of return that is needed in
order to make sure that total NPV equates the total initial investment cost.

In theory, if the project’s calculated internal rate of return is higher than the cost of
capital, project can be accepted.

IRR of a project can be calculated by the formula below;

IRR= positive rate + ( positive NPV x range of rates )

positive NPV + negative NPV8
*
Ignore the negative sign and sum up two values

Advantages of this method:

 It focuses on liquidity.
 It observes the timing of net cash flow.
 It gives a net rate of return on an investment.

IRR CALCULATIONS FOR PROJECT A:

Years Net cash flow Discount factors Present value

£000 17% 22% 17% 22%
£000 £000

1 20 0.855 0.819 17.10 16.38

2 30 0.731 0.671 21.93 20.13
3 40 0.624 0.550 24.96 22
4 50 0.534 0.451 26.70 22.55
5 70 0.456 0.369 31.92 25.83
_______
______
Total present value 122.61 106.89
Less: Initial investment 110 110
------------
---------
Net present value 12.61 (3.11)

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IRR= positive rate + ×range of

rates= = 17%+ ×5% =21.01%

At 21.01% discount rate the NPV is approximately zero.

IRR CALCULATIONS FOR PROJECT B:

Years Net cash Discount factors Present value

flow
£000 22% 27% 22% 27%
£000 £000

1 40 0.819 0.787
2 40 0.671 0.620
3 40 0.550 0.488
4 40 0.451 0.384
5 40 0.369 0.302

Annuity factor 2.863 2.578

Total present value 114.4 103.12
Less: Initial investment 110 110
------------ ---------
Net present value 4.40 (6.88)

IRR= positive rate + ×range of

rates= 22%+ ×5% =23.95%

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?

If there is a change in cost of capital IRR does not change. However, managers should
evaluate the results again to accept the project. Since the IRR must be still greater than or
same as the new cost of capital.

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

While dealing a simple investment appraisal projects, in general both NPV and IRR
methods result the similar decision. But in some cases there may be a conflict between
these two results.

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When there is a conflict NPV method often regarded to be superior than the IRR method.

Because; NPV results are expressed in pounds, which can directly show the financial
position. IRR results are shown as a proportion, and these results must be put side by side
with a minimum rate of return previous to the evaluation can be done. In another word;
Comparing two projects IRR’s is meaningless unless referred to the initial outlays.
(Gaultier and Underdown, 2001, p.493)

Another reason for preferring NPV rather than IRR is that, IRR method provides only a
fairly accurate rate of return, which can be false in some complex investment appraisal
situations. (Dyson, 2007, p.433)

The most important reason is that; in some situations multiple rate of returns can be
found due to irregular pattern of cash inflow.

4.CONCLUSION

Based on information above both projects are profitable and can be undertaken. But; with
higher positive NPV, IRR and shorter payback period it can be said that project B is more
favorable.

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5.REFERENCES

 Dyson, J.R. (2007), Accounting for non-accounting students, (6th Edn), Pearson
education. (p.424-433)
 Gaultier, M.W.E. and Underdown, B (2001), Accounting Theory and Practice,
(7th Edn), Prentice Hall. (p.493)
 Mott, G (2005), Accounting for Non-Accountants, (6th Edn), Kogan Page. (p.205)
 Proctor, R (2009), Managerial accounting for business decisions, (3rd Edn),
Pearson Education. (p.190)
 Weetman, P (2009), Financial & Management Accounting: An Introduction, (5th
Edn), Prentice Hall. (p.660-666)

6.BIBLIOGRAPHY

 Lucey, T (2002) Quantative techniques, South-Western Cengage Learning.

 Mclaney, E.J. and Atrill P. (2010) Accounting: an introduction (5th edn) Pearson
Education.
 Wood, Frank and Sangster, Alan (2007) Business Accounting 2, (10th edn)
Prentice Hall.

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