# Accounting and decision making techniques

__Executive summary__

In today's modern business world a company must have a strong financial backup so as to survive? Investment appraisal is a method by way of which a company can decide whether to invest or not in a project so as to grow. Through this assignment certain key concepts of investment appraisal and how to calculate these with the help of an example. This project also shows how and why a company can decide between multiple projects shown in the assignment. Reasons as to why NPV method is regarded as a superior method over IRR are as mentioned in the assignment.

This assignment is a compilation of various books from different authors, education journals as well as certain information pages over the internet.

#### Investment Appraisal

Investment appraisal is a method by way of which a company can confirm whether an investment plan is worthwhile to invest in or not. Investment plan could be the procurement of a new computer in a small firm, a new piece of machinery in a manufacturing firm, an entire new factory, etc; so basically in means to invest the funds of the business in a manner whereby the firm's reputation would stand stronger. Both public and private sector industries need to invest their funds so as to move forward with the time and prosper in a wholesome way.

#### (Bized, 2007)

- Payback Period
- Accounting Rate of Return (ARR)
- Internal Rate of Return (IRR)
- Profitability Index
- Net Present Value (discounted cash flow)

#### Investment appraisal is very important to any business for the following reasons (Bized, 2007):

- For yielding future income streams
- Increasing efficiency and productivity of the overall business
- It analysis the income streams against the cost of investment to the organization
- Useful to the management in making short term and long term decisions based on the previous investments and the amount of cash inflows

Payback = year of breakeven + amount required in a year to break even /amount acquired in the year

Therefore,

Payback of Project "A"

- = 3+ ({110000-90000}/50000)
= 3+ (20000/50000)
= 3.4 years
= 3 years and 3 months.

And;

Payback of Project "B"

- 2+ ({110000-80000}/40000)
- 2+ (30000/40000)
- 2.75 years
- 2 years and 9 months.

Project "B" has a payback period of 2 years and 9 months and so if AP Ltd. imposes a maximum payback period of 3 years then project "B" should be accepted.

- Criticisms of the payback period (Blackstaff, 1998):
- Can give an very unsophisticated view of the entire situation
- Doesn't take into account the fact that future returns may turn out to be less valuable
- Ignores qualitative aspects of the decision making
- Focuses just on the payback period and therefore doesn't look at how much cash is generated after payback is reached
- Doesn't look at the profitability of project and compare the return to the initial investment
- Takes no account of what is happening with interest rates

__Calculation of NPV__

The discount rate is 12%. Since the return on investment is constant throughout the entire tenure, the total of the discount rate can be calculated and simply multiplied by the return on investment to calculate the Net Present Value. So, the total of the discount rate is 3.605 {addition of all the discount rates}.

Therefore, Present value = total of discount rate values * annual rate of return

So,

Present value = 3.605*40000

Present value = 144200

Less: initial investment = 110000

Net Present Value = 34200

The Net Present Value of Project "A" and Project "B" is to be accepted by the organization because the present value is greater than the initial investment which the firm has incurred and so the firm would not be in any type of loss but would be profitable for the business. Had the Net Present Value in any of the two projects be less than zero then that project would not have been accepted because the initial investment would not be recovered in such a case.

__Logic of the NPV approach__

The NPV approach is based on the 'time value of money' concept. That means that it is better to have $90 today than to have $100 say five years from now. If you have it now, you could invest it, and you would have more than the original $100 five years from now. From the reverse direction, the $100 to be received five years from now has less present value than $90 to be received today. This might seem very basic but in actuality the NPV approach also considers the risk factor and so if the investment is not got much risk then the investor might prefer to get more at a later stage. According to the discount rate the investor must take his decision as to if he can get a better rate of return from his investment from other sources or not. This decision has to be made very carefully by the investor as once an investment is blocked in for a particular number of years the investor would not get the same rate or return if he would want to exit and reinvest his money in any other source and so would not seem to be profitable (Mott, 2005).

Therefore, the main logic behind the NPV approach to investments is the decision of whether the money in hand is more valuable today or at a discounted rate at a later year.

__Effects on NPV__

__When cost of capital increases:__

The cost of capital also referred to as opportunity cost is the rate of the investment made by the company had it invested. The Present Value would fall when the cost of capital is increased. Basically, the NPV is the excess of the present value over the initial investment and so when the initial investment increases the difference between the cost of capital and the present value is narrowed down so as to decrease the Net Present Value.

**When cost of capital decreases:**

The Present Value would increase when the cost of capital is decreased. Basically, the NPV is the excess of the present value over the initial investment and so when the initial investment decreases the difference between the cost of capital and the present value is broadened down so as to increase the Net Present Value.

#### Internal Rate of Return(IRR)

Total present value when the discount rate is 23% is 112120 and so the NPV = 112120-110000. Therefore the NPV @ 20% = 2120.

Similarly the total Present value when the discount rate is 24% is 109760 and so the NPV = 109760-110000. Therefore the NPV @ 24% = -240

Therefore,

IRR = Positive discounted rate + (NPV at positive discounted rate calculated / {NPV at positive discounted rate calculated - NPV at negative discounted rate calculated} * difference in discounted rate

__Effects on the IRR when cost of capital changes__

One of the two discounted cash flow (DCF) methods (the other being net present value) used in relative appraisal of investment proposals where the flow of income varies over time. IRR is the average annual return earned through the life of an investment and is calculated in various ways. It can give incorrect or misleading answers, especially where two mutually-exclusive projects are to be appraised (Mott, 2005).

The IRR is highly dependent on the NPV which is derived from the cost of capital and so when the cost of capital changes the NPV would get affected resulting in a subsequent change in the IRR as well. When the cost of capital is increased it results in an increase in the NPV; the IRR is a point between two NPV's where the NPV comes closest to zero and so the IRR would increase with a given change in the projects cost of capital. Similarly, when the cost of capital would decrease the projects IRR would also result in a subsequent decrease.

__NPV method is regarded as a superior method to IRR?__

Bothinternal rate of return (IRR) andnet present value (NPV) measurementsto appraise projects often result in the same findings. However, in a number of projects using IRR is not as successful as using NPV to discount cash flows.

Although using a single discount rate simplifies matters, there are a number of circumstances that cause problems for the IRR. If an analyst has to evaluate two projects, both of which share the same discount rate, cash flows and risk; IRR will probably work.

Anothertype of project for which an IRR calculation is unproductive is a project with a combination of manypositive and negative cash flows.

Two solutions are there for every IRR that make the equation equal to zero, so there are many rates of return for the project that producemany IRRs. The advantage of using the NPV method here is that NPV can handle multiple discount rates without any issues (www.investopedia.com).

Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known or cannot be applied to a specific projectfor whatever reason, the IRR is of limited value. In such cases NPV method is superior.

__References__

- Accounting for non accountants ; 6th edition ; Graham Mott ; 2005
- Bized ; Business Education journal ; 2007
- Finance for I.T. decision makers ; M.Blackstaff ; 1998
- http://bized.co.uk ; assessed on 24/11/2009
- http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp ; assessed on 24/11/2009
- http://www.bcs.org//upload/pdf/profissuessamplechapter.pdf ; assessed on 25/11/2009