Capital investment Appraisal

Capital investment Appraisal

Introduction

When a business spends money on new non-current assets it is known as Capital Investment or Capital Expenditure. A business can spend money for maintenance, profitability, expansion or indirect purposes. One stage in the capital investment is the appraisal or evaluation of that capital investment. This appraisal has the following features.

* Assessment of the level of expected returns earned for the level of expenditure made.

* Estimates of future costs and benefits over the project's life.

There are two main types of investment appraisal techniques. Simple technique which do not take the time value of money into account and the other are DCF techniques which take the time value of money into account like NPV, IRR etc. Later technique is better than former technique because they take the time value of money into account and evaluate the projects in today's figures.

Assumptions:

I have taken the following assumptions while evaluating both proposals.

There is no inflation.
There are no tax implications.
Fixed cost arises as a direct consequence of both proposals and hence is a relevant cost.
Discount rate of 15% is assumed.
Actual demand of products is same as forecasted.
All cash flows occur at the start or end of a year.
Initial investments occur at T0.
Other cash flows start one year after that (T1).

Discounted Payback Period

Discounted payback period is the time a project will take to pay back the money spent on it, taking the time value of money into account. According to this evaluation method, only those projects are selected which pay back within the specified time period. If there is more than one project then that project is selected whose payback period is fastest. This method ignores the returns after the initial investment has been recovered. The discounted payback period of Proposal 1 is 3 years and 10 months however that for the proposal 2 is 2 years and 10 months. On the basis of these results the proposals 2 is more preferable than the proposal 1 subject to the acceptance criteria of the company.

· Advantages

1. It is simple.

2. It is useful in certain situations like rapidly changing technology and for improving the investment conditions.

3. It favors quick returns.

4. It helps to improve the growth of the company.

5. It helps in maximizing the liquidity.

6. It uses the cash flows, not accounting profit.

* Disadvantages

It ignores the returns after the payback period.
It ignores the timings of the cash flows.
It is subjective.
It ignores project profitability.

NPV

NPV and IRR both take the time value of money into account. NPV is based on the cash flows instead of the accounting profits and takes the whole life of the project into account which is its killer advantages. NPV of the both proposals are positive which means that both proposals are acceptable. However proposal 2 has greater NPV than the proposal 1 and hence proposal1 can be given preference over proposal 2.

* Advantages

1. It considers the time value of money.

2. It is an absolute measure of return. The NPV of an investment represents the actual surplus raised by the project. This allows a business to plan more effectively.

3. It is based on cash flows not on accounting profits. The subjectivity of profits makes them less reliable than cash flows and therefore less appropriate for decision making. Neither ARR nor payback is an absolute measure.

4. It considers the whole life of the project.

5. It should lead to the maximization of shareholder wealth.

* Disadvantages

1. It is difficult to explain the managers. To understand the meaning of the NPV calculated requires an understanding of discounting. This method is not as intuitive as techniques such as payback.

2. It requires the knowledge of the cost of capital. It involves gathering data and making a number of calculations based on the data and some estimates. The process may be deemed too protracted for the appraisal to be carried out.

3. It is relatively complex. For the reasons explained above, NPV may be rejected in favor of simpler techniques.

IRR

The IRR is another project appraisal method using DCF techniques. The IRR represents the discount rate at which the NPV of an investment is zero. As such it represents a breakeven cost of capital. The project is acceptable if its IRR is greater than the cost of Capital. The IRR of the proposal 1 is 15.8% however for the proposal 2, the IRR is 25.6%. Surprisingly again both projects are acceptable under IRR criteria. However again since the IRR of the project 2 is greater than the project 1, so project 2 is preferable than project 1.

* Advantages

1. It considers the time value of money. The current value earned from an investment appraisal is therefore more accurately measured.

2. IRR is a percentage and therefore easily understood. Although managers may not completely understand the detail of the IRR.

3. It uses cash flows instead of accounting profits.

4. It considers the whole life of project rather than ignoring later flows.

* Disadvantages

1. It is not a measure of absolute profitability.

2. Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet program.

3. It is fairly complicated to calculate.

4. Non-conventional cash flows may give rise to multiple IRRs which mean the interpolation method can't be used.

ARR

According to ARR which is also known as ROCE (Return on Capital Employed), those projects are selected whose expected ARR is greater than the target or hurdle rate (as decided by the management). ARR is not a DCF technique and hence ignores the time value of money. ARR is based on the accounting profits rather than cash flows. The decision rule is that if the expected ARR for the investment is greater than the target or hurdle rate then the project should be accepted. ARR of the project 1 is 21.5% however the project 2 has an ARR of 38%. Therefore the project 2 is acceptable and project 1 should be rejected because its ARR is less than the company's desired rate that is 30%.

· Advantages

1. It is simple - being based on widely-reported measures of return (profits) and asset (balance sheet values), it is easily understood and easily calculated.

2. It links with other accounting measures.

· Disadvantages

1. It does not consider the life of the project.

2. It does not take into account the life of the project.

3. It does not take into account the timing of cash flows.

4. It may ignore the working capital requirements.

5. It does not measure the absolute gain.

6. There is no definitive investment signal. The decision to invest or not remains subjective in view of the lack of an objectively set target ROCE.

Non-Financial Implications

Following non-financial implications should be taken into account in addition to the above results before making any decisions.

Expertise of the management for introduction of new product JJ.
The durability of the product JJ.
Ability of the product JJ to attract new potential customers.
Alignment of the both projects with the interest of shareholders.
Effect of taking either project on the image of BRAND.
Development cycle time of the new product JJ.

Conclusion

I will base my conclusion by first of all giving preference to the results of NPV, then IRR, then discounted payback period and at last to the results of ARR. The reason is that NPV takes the whole life of the project into account and is based on cash flows however the ARR is based on the accounting profits and non-cash flow items like depreciation. From the results of NPV and IRR, it is clear that both projects can be accepted but project 2 should be given preference. Discounted payback period also shows that the payback period of project 2 is shorter than the project 1 and hence project 2 should be accepted. At last the ARR shows that project 1 should be rejected and project 2 should be accepted because the ARR of project 1 is less than the target return on capital employed.

So, finally we can conclude that project 2 is more preferable then project 1 and should be taken.

Discounted Payback Period

Proposal 1

Year

Demand

Sales Revenue

(£)

Variable Operating Cost

(£)

Fixed Operating cost (£)

Net Cash Flows

(£)

0

0

1

60,000

1200000 (w1)

480000 (w2)

170000 (w3)

550000

2

70,000

1400000

560000

170000

670000

3

120,000

2400000

960000

170000

1270000

4

45,000

900000

360000

170000

370000

Workings

W1.

60000 units * £20/unit = £ 120000.

W2.

60000 units * £8/unit = £ 480000.

W3.

Fixed operating cost is assumed to be incurred as a direct consequence of the Proposal 1 and remains fixed no matter what is the demand.

Year

Cash Flows

(£)

Discount Rate (15%)

(£)

Discounted Cash flows

(£)

Cumulative Cash Flows

(£)

0

-2000000

1

-2000000

-2000000

1

550000

0.87

478500

-1521500

2

670000

0.756

506520

-1014980

3

1270000

0.658

835660

-179320

4

370000

0.572

211640

32320

Discounted Payback period = 3 years + 10 months {(179320/211640)*12 months}

Proposal 2

Year

Demand

Sales Revenue

(£)

Variable Operating Cost

(£)

Fixed Operating cost (£)

Net Cash Flows

(£)

0

0

1

70,000

1400000 (w1)

560000 (w2)

170000 (w3)

670000

2

106,000

2120000

848000

170000

1102000

3

102,000

2040000

816000

170000

1054000

4

72,000

1440000

576000

170000

694000

Workings

W1.

70000 units * £20/unit = £ 1400000.

W2.

70000 units * £8/unit = £ 560000.

W3.

Fixed operating cost is assumed to be incurred as a direct consequence of the Proposal 1 and remains fixed no matter what is the demand.

Year

Cash Flows

(£)

Discount Rate (15%)

(£)

Discounted Cash flows

(£)

Cumulative Cash Flows

(£)

0

-2000000

1

-2000000

-2000000

1

670000

0.87

582900

-1417100

2

1102000

0.756

833112

-583988

3

1054000

0.658

693532

109544

4

694000

0.572

396968

506512

Discounted Payback period = 2 years + 10 months {(583988/693532)*12 months}

Net present value and internal rate of return

Proposal 1

Year

0

1

2

3

4

Net Cash Flows

-2000000

550000

670000

1270000

370000

Discount factors (15%)

1

0.87

0.756

0.658

0.572

Discounted Cash flows

-2,000,000

478,500

506,520

835,660

211,640

NPV

32,320

Discount Factors (20%)

1

0.833

0.694

0.579

0.482

Discounted Cash fows

-2000000

458150

464980

735330

178340

NPV

-163200

The project is acceptable at the discount rate of 15% because the NPV is positive. Hence, the project should be accepted.

IRR

IRR \approx \!\, LR + [NPV LR / {NPV LR - NPV HR}] * [HR - LR]

IRR \approx \!\, 15 % + [32320 / {32320 + 163200}] * [20 % - 15 %]

IRR \approx \!\, 15.8 %

Proposal 2

Year

0

1

2

3

4

Net Cash Flows

-2000000

670000

1102000

1054000

694000

Discount factors (15%)

1

0.87

0.756

0.658

0.572

Discounted Cash flows

-2,000,000

582900

833112

693532

396968

NPV

506512

Discount Factors (20%)

1

0.833

0.694

0.579

0.482

Discounted Cash flows

-2000000

558110

764788

610266

334508

NPV

267672

The project is acceptable at the discount rate of 15% because the NPV is positive. Hence, the project should be accepted.

IRR

IRR \approx \!\, LR + [NPV LR / {NPV LR - NPV HR}] * [HR - LR]

IRR \approx \!\, 15 % + [506512 / {506512 - 267672}] * [20 % - 15 %]

IRR \approx \!\, 25.6 %

Return on Capital Employed (ARR)

Proposal 1

Initial Investment = £2000000.

Scrap Value = £0

Average investment = (£2000000 + £0)/2 = £1000000.

Annual Depreciation = £2000000/4 = £500000.

Total cash inflow for 4 years = £2860000. (From above)

Average cash inflow = £2860000/4 = £715000.

Average profit for 4 years = £715000 - £500000 = £215000.

ARR = (£215000/£1000000) * 100 = 21.5%.

Proposal 2

Initial Investment = £2000000.

Scrap Value = £0

Average investment = (£2000000 + £0)/2 = £1000000.

Annual Depreciation = £2000000/4 = £500000.

Total cash inflow for 4 years = £3520000. (From above)

Average cash inflow = £3520000/4 = £880000.

Average profit for 4 years = £880000 - £500000 = £380000.

ARR = (£380000/£1000000) * 100 = 38%.

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