Accounting and decision making

You are required to provide an evaluation of two proposed projects, both with five year expected lives and identical initial outlays of 110,000. Both projects involve additions to AP Ltd.'s highly successful product range and as a result, the cost of capital on both projects has been set at 12%. The expected cash flows from each project are shown below.

In evaluating the projects please respond to the following questions:

  1. Why is the investment appraisal process so important?
  2. 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?
  3. What are the criticisms of the payback period?
  4. Determine the NPV for each of these projects? Should they be accepted - explain why?
  5. Describe the logic behind the NPV approach.
  6. What would happen to the NPV if:
    1. The cost of capital increased?
    2. The cost of capital decreased?
  7. Determine the IRR for each project. Should they be accepted?
  8. How does a change in the cost of capital affect the project's IRR?
  9. Why is the NPV method often regarded to be superior to the IRR method?
  1. Why is the investment appraisal process so important?
  2. Ans. Finance is the life blood of business. Business needs finance from its cradle to grave, so it is very important that where are you going to do investment, that decision will be good for the business or not and for that investment appraisal is very necessary. Investment appraisal refers to an evaluation of attractiveness of investment proposal, using methods such as average rate of return (ARR), Internal rate of return (IRR), net present value (NPV) payback period. Investment appraisal is an integral part of capital budgeting and is applicable to areas even where the returns may not be easily quantifiable.

  3. 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?
  4. Ans. : Pay Back Period of Project A and project B (AP ltd.)

    EVALUATION:

    The payback period of project A is 3 years and 5 month which is more than mentioned pay back period which is 3 years. So it is advisable to not to select project A.

    The payback period of project B is 2 years 9 month which is less than decided payback period, so it is advisable to select the project B.

    In illustration, consider again the two projects, project A and project B in the example above. Since project B has shorter payback period than project A. It shows that project B is more desirable than project A. Project B cover money earlier than project A, that is why project B should be accepted. Because money received now is important than money receive in future.

  5. What are the criticisms of the payback period?
  6. Ans. The payback method is not a true measure of the profitability of an investment. Rather, it is simply tells the manager how many years will require to cover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.

    There are also another two major problems with the payback periods rule. First, it does not take into take into account the time value of money. Second. It ignores what happens after the pay back. Because of these two filings, the payback rule sometimes accepted projects that should be rejected that should be accepted.

  7. Determine the NPV for each of these projects? Should they be accepted - explain why?
  8. Ans. NPV FOR PROJECT A AND PROJECT B:

    EVALUATION:

    If net present value of any project is positive then it is advisable to select that project and if net present value of the project is negative then it is advisable not to select that project.

    In above example, net present value of project A and project B is 31.74 and 34.2 respectively, which is positive. So both project should be accepted. But if we compare both project then project B is most advisable than project A, because the net present value of project B is higher than project B.

  9. Describe the logic behind the NPV approach.
  10. Ans. The Net Present Value(NPV) is the first discounted cash flow(DCF) technique covered here. It relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment. Opportunity cost is the calculation of what is sacrificed or foregone as a result of particular decision. It is also referred as the real cost of taking some action. We can look concept of present value as being the cash equivalent now of a sum receivable at a later date. So how does the opportunity cost affect revenues that we can expect to receive later. As we see before money received now is more important than money received in future. well, imagine could do now with the cash sums it must wait some time to receive. The effect of net present value describe as follow.

    • NPV method indicates the projects that maximizes the NPV of future cash flows. So it is more complicated to understand by the financial managers.
    • Any project with a positive NPV increases the wealth of the firm as chief goal is to make the most of the wealth of the ordinary shareholders and selection of projects on an NPV basis is steady with this intention
    • Time value of the money is taken into account and as a result the opportunity cost
    • nothing like the payback method, it takes into account measures right through the lifetime of the project
    • advanced to the internal rate of return (IRR) approach because it does not bear the problem of multiple rates of return due to irregularities in the sample of cash flows
    • enhanced than the accounting rate of return method because it focuses on the cash flow rather than profits and avoids the irony of returns. So it may be difficult to predict the future gains and losses
  11. What would happen to the NPV if:
    1. The cost of capital increased?
    2. The cost of capital decreased?

    Ans.

    • If the cost of capital increased:
    • There is inverse relationship SSbetween NPV and cost of capital. If cost of capital increased then NPV decreased. If cost of capital increases it reduces the net income and hence reduces the present value of future cash flow for any company with high cost of capital.

    • If the cost of capital decreased:
    • There is inverse relationship between NPV and cost of capital. If cost of capital decreased then NPV increased. If cost of capital decreases, it reduces the net income and hence increase the present value of future cash flow for any company with low cost of capital.

  12. Determine the IRR for each project. Should they be accepted?
  13. Ans. Calculation of IRR of project A and project B

    Conclusion:

  14. How does a change in the cost of capital affect the project's IRR?
  15. Ans. The following are the effects on IRR when COC changes:

    • IRR does not specify the size of the investment, thus the risk involved in the investment can be added to the cost of capital
    • IRR is an intent financial indicator, which does not consider biased non-financial factors
    • It assumes that incomes throughout the period of the investment are reinvested at the same rate of return
    • In case when there are jointly exclusive investment options, the IRR can give incompatible signals when compared with NPV, as it is a superior measure.
    • For a project having unequal cash flows there is more than one IRR for that project
    • IRR is a calculation based on cash-flow whereas ARR or ROI are calculations based on profits of cost of capital
    • Another downside of IRR is that it cannot be calculated using a simple calculator and present value tables.
  16. Why is the NPV method often regarded to be superior to the IRR method?
  17. Ans. Both IRR and NPV make use of the similar procedure of discounted cash flow analysis. Whereas the financial conclusion of a project is represented as a economic return using NPV, under the IRR method it can be represented as a percentage rate of return.

    Another drawback to IRR is that it has to use a scientific calculator or a computer spreadsheet programmer with the capacity to run number of operations in order to determine the internal rate of return

    The IRR rule is to allow the investment project if the IRR is greater than the suitable cost of capital. In most easy situations, IRR and NPV will appear at the same conclusion regarding acceptance of a project. However, there are a number of limitations to the IRR approach when compared to NPV in making capital budgeting recommendations.

    IRR can twist the selection of projects in favor of small, high percentage return projects away from large cash return, but lower percentage return projects. In short, IRR takes no description of the size of the project under study. However, given that managers and analysts have ample of other data that indicates the size of the project, this limitation is not too serious.

    In some equally exclusive situations, NPV and IRR methods can give up incompatible recommendations. These will occur either because of the difference in amount of the projects or because of a difference in the timing of the cash flows.

    IRR does not recognizes the time value of money as precisely as the NPV method. It is one of the key features of NPV that makes it the recommended measure by the managers.

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