Should An Investment Appraisal Add Value To Businesses Finance Essay - Free Essay Example

Sample details Pages: 7 Words: 2113 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? One of the key areas of long-term decision-making that firms must tackle is that of investment the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining fund. Investment appraisal in the nutshell is one the main stages of capital budgeting cycle. However in this analysis, attention will be taken on how investment appraisal adds value to a business and the reasons for and against how it adds value to a business from different points of view and as well school of thoughts. Its essential to know that analysing investment appraisals without examining the methods attached to it will be a fault, so the discounted cashflow techniques which are Net present value and internal rate of return will be taken into consideration. But I presume that a little bit of payback and accounting rate of return will also be analysed. Don’t waste time! Our writers will create an original "Should An Investment Appraisal Add Value To Businesses Finance Essay" essay for you Create order When we analysis investment appraisal it is considered that even when the projects that are unlikely to generate profits, it should be subjected to investment appraisal, by so doing, the best ways of achieving the projects aims are identified. According to Glautier and Underdown (2007), in the analysis of investment appraisal, many important facts are uncertain therefore making it a prime problem, there is then the need in trying to reduce the field of uncertainty before a decision is made. There is the problem of making sure that all the known facts are correctly assessed and quantified. Both known and uncertain facts are estimated in cash terms, and the methods of investment appraisal focus on cash flows. Glautier and Underdown postulated that there is selection of investment projects is always a question of considering which of the several competing alternatives in the best from the business organisation point of view. By quantifying the cash inflows and the cash outlays which are involved in the various alternatives hence appraising the investment, a decision is made by selecting the alternative which is preferred by the business organisation hence adding value to their business. Glautier and Underdown, in their example concerning a Wall Street Finance Ltd was offering the opportunity of selecting two investments, each of which will yield 500,000 yearly. Investment A requires a total cash outlay of 5,000,000 hence it promises a rate of return of 10 per cent. Investment B requires a total cash outlay of 50,000,000 and therefore offers a rate of return of 1 per cent per annum.In this situation Wall Street Finance Ltd has to do an appraisal on the investment, therefore a good appraisal of the project will normally choose project A, therefore adding value to its business organisation. However according to Jon C and Roger S (2007), investment appraisal methods such as the pay back and accounting rate of return rather brought down the business organisation and making faulty decisions. This he illustrated using a case study of Ressembler Group where individual managers were more concerned with meeting short term targets wherein some managers used the level of revenue and with little attention to cost while others completely used the payback method. In this situation the managers were more interested to see how long it takes the cash proceeds to equal the initial outlay. In cases like this, a business will need to consider its strategic requirements and the way managers understand them. So investment appraisal may help to find the cheapest way to provide (say) a new staff restaurant, even though such a project may be unlikely to earn profits for the company. According to a survey I made concerning a small business that before opening a restaurant had a problem in the choice of location so he only had to appraise the in which area he invest considering the three locations. In the scenario, he had to take many things into consideration such labour, market, transport. After looking at the possibilities he came out with a good decision hence he did appraise his business efficiently thereby adding value to it. However, another person business had his business to open and considered that as an investment so he was left with two possibilities and had to appraise them. According to his possibilities, project A had a rate of return of 5 per cent and he had to invest 100,000 in order to obtain 500,000. Project B had a rate of return of 2 per cent and he had to invest 200,000 in order to obtain 400,000.Normally he had to accept project A but unfortunately his minimum acceptable rate of return was 10 per cent hence his appraisal had failed and the failed. There are two discounted cash flow techniques which are net present value(NPV) and internal rate of return(IRR), they are the best methods of investment appraisal because they take into consideration the time value of money meanwhile the rest ignore it. Its essential to acknowledge that according to NPV method, it recognizes that cash received today is preferable to cash receivable sometime in future. It is reasoned out that there is more risk in having to wait for future cash receipts while a smaller sum may be obtained now; at least it is available for other purposes. For instance it can be invested and the subsequent rate of return may then compensate for the smaller received now or at least equal to it. Practically, 91 received now assuming a rate of interest of 10 percent is just beneficial as receiving 100 in a years time. This principle is behind the NPV method of investment appraisal. Using the NPV method, if NPV is less than one then the profit not profitable but if it is more than one then its profitable. Also if NPV is equal to zero then its recommended to use the IRR method to determine whether a project is profitable or not. The NPV is important because it uses net cash flows thereby emphasizing on the importance of liquidity and its also easy to compare the NPV of different projects and to reject projects that do not have acceptable NPV. One of the weaknesses of the NPV is that it incurs some difficulties in estimating the initial cost of the project and the time periods in which instalments must be paid back. However, a business will not necessarily accept a project simply because it has a positive NPV, because they are many non-financial factors that must be allowed for. Moreover, in some cases projects with a negative NPV may go ahead perhaps they are concerned with employee safety and welfare. It has been earlier said when a project has an NPV equal to zero we use the IRR to determine whether the project is profitable or not. This takes us to the idea of IRR which is analysed subsequently. The IRR is a discounted cash flow method very similar to NPV. However, instead of discounting the expected cash flows by a predetermined rate of return, the IRR rather seeks to respond to the question of what rate of return will be required in order to ensure that the total NPV equals the initial cost. According to Dyson (2005), a rate of return that was lower than the entitys required rate of return would be rejected. In practice however, the IRR would only be one factor to be taken into account in deciding whether to go ahead with a project. One of the essential facts considered when calculating the IRR is selecting two discount factors which must taken arbitrarily and within a narrow range, one must produce a positive NPV and the other produce a negative. Dyson (2005) shows two ways how the IRR is similar to the NPV. These ways include; the initial cost of the project has to be estimated as well as the future net cash flows arising from the project, also the net cash flows are then discounted to their net present value using discount tables. However, the main difference between the two methods is that the IRR method requires a rate of return to be estimated in order to give an NPV equal to the initial cost of investment. Consequently, the IRR has a disadvantage of being not easy to understand and also difficult to determine which two suitable rates to adopt. But this method gives a clear percentage return on an investment, it also emphasis on liquidity. Though the discounted cash flows techniques are useful in management, some aspects of the discounted payback and the accounting rate of return methods are valuable. At least in management the payback method helps to estimate how long it would take before a project begins to pay for itself. For instance, if a company had to spend 500,000 on purchase of non-currents assets for the business, the payback method helps to determine how many years the business will take to recover this 500,000. As we already know this method does not take into account the time value of money hence making not the best in comparing the profitability of different projects. The Accounting rate of return (ARR) helps management to compare the profit of a project with the capital invested in it. So in like manner this method helps the business to determine its profit in areal which makes it useful. This is mostly applicable when short term projects are considered. In a final analysis, though sometimes investment appraisal does not add value to a business but I think generally the reasons that investment appraisal adds value to a business out wares the later. So in a final conclusion 80 per cent of investment appraisal adds value to a business organisation. In like manner discounted cash flows methods are very essential in management unlike the payback and ARR which does not because it ignores the time value of money. 2) AP Ltd is trying to evaluate 4 new projects. Assume all the 4 projects have a useful life of 10 years. The projects are mutually exclusive and some of their details are as follows: Project Annual Net cash flow Initial Investment Cost of capital IRR NPV 1 100,000 449,400 14% A B 2 70,000 C 14% 20% D 3 E 200,000 F 14% 35,900 4 G 300,000 12% H 39,000 Required: Calculate A, B, C, D, E, F, G and H in the above. Show all calculations Which project would you choose? Explain the reasons for your choice Solutions: Project 1 When NPV=O: IRR O= (100000) AF-449400 449400= (100000) AF AF= 4.5% NPV= (100000) 5.216- 449400 = 72200 Project 2 When NPV= 0: IRR 0= (70000)4.192 I I= 293440 NPV= (70000) 5.216 -293440 NPV= 71680 Project 3 When NPV= 0: IRR 0= ACF (5.216)- 200000 ACF= 38343.6 NPV= ACF (AF)- I 35900= 38343.6X 200000 X= 6.152 then from tables Cost of capital= 10% Project 4 NPV= ACF (AF) -I 39000= ACF (5.650) 300000 339000= ACF (5.650) ACF= 60000 BUT When NPV= 0: IRR 0= 60000X- 300000 IRR= 5% New complete table answered Project Annual Net cash flow Initial Investment Cost of capital IRR NPV 1 100,000 449,400 14% 4.5% 72200 2 70,000 293440 14% 20% 71680 3 38343.6 200,000 10% 14% 35,900 4 60000 300,000 12% 5% 39,000 In choosing a project amongst a group, there are two very important aspects which has to be taken into consideration; these are the internal rate of return and the net present value. If I wanted to decide taking only considering the NPV, I think project one will be the most valuable but the question now is in terms of the IRR it will be misleading to accept this project because it is far lower that the cost of capital. Also, looking at the initial investment the owner had to invest a huge sum as a start to the project. But according the IRR which I think is the best measure in assessing project profitability. So to me I will accept project two because its got a percentage higher that the cost of capital and from that point of consideration we can already conclude that the project will be a profitable one even though its NPV is not the highest but a good and acceptable NPV. In a final analysis, the NPV is a better measure to determine whether a project is good. In that light, project one will best amongst the project to undertake any kind of investment. Investment appraisal adds value to the business for the above mentioned reasons most importantly the NPV and IRR are good methods to be used in investment appraisal. Reference: Dyson J. R. (2005). Accounting for non- accountants. (6th edition) The Prentice Hall, Glautier M.W.E. and Underdown B. (2007). Accounting theory and practice. (7th edition) The Prentice Hall. Jon C. and Rogers S. (2007). Quantitative Methods for Business Decisions, (5th edition) Chairman and Hall,