Decision making techniques make or break

Why is the investment appraisal process so important?

As the word investment appraisal suggests it about how the investment can be multiplied. Talking about why it is important, as every business needs to take a risk irrespective of size when it plans to start a new project so to determine if the decision about to be taken will yield returns or not can be found out by this investment appraisal. For every businessman or company knowing this process is very important as there are different methods under investment appraisal which can be used for different companies. Investment appraisal is very important because this also helps the company to be guaranteed of profits or if not at least the rate of returns. As everyone businessman says greater the greater the profit but this method tells is the risk worth the investment, which can be very useful for the investors as this method not only take the basic factors into account but also the external factors like time value of money, through this we can also compare two or more projects and come to a conclusion as to which project is more suited for the company and the investors.

The methods under investment appraisal are:

  • Payback period
  • Accounting rate of returns
  • Net present value
  • Internal rate of returns
  • Profitability index
  • Cash flows

Ref: www.bized.co.uk

calculation of payback period for project 'A'

Initial investment for project 'A' is 110000

(ANS): As for the AP Ltd deadline of 3years it would be advisable for the company to go ahead with the project 'B' as the investment will be returned in 2years 4months as compared to project 'A' where it takes 3years 4months.

what are the criticisms of payback period?

As for every method there are advantages and criticisms and when it come to the case of payback period also it's the same. Many of the theorists and other businessman believe that this payback will be help full for a project which is short term, because this methods Is accurate when the returns are expected within a couple of years after starting the project, but there is also a drawback for this it can only tell us in how many years the investment can be recovered but not the returns after the payback period which makes it more difficult. Other than not considering the cash flows after the payback period, it does not take time value of money which means the value of money of today and a year later is not considered..

If you have two different project with the with the same payback, using this method it not possible to choose which project to go for as it cannot differentiate the projects with same payback. Even though this period take the risk of timing of cash flows but then it ignores the variability of those cash flows which is another criticism of this method. Payback period has got so much criticism is because it does not consider the moneys worth in the future, which is very essential for a business to plan according to the future.

calculation of net present value for project 'A'

Yes both the projects can be accepted as they yield profits in the future with this initial investment of 110,000 and a discount rate of 12%.

The reason these projects can be accepted is that they both yield profit for the organization even after the initial investment is recovered and also paying the share holders their assured dividend. So by accepting these two projects not only will the investment be recovered and share holders be paid, the company also will be left with profits which the company can use for improvement or for investing in other project.

what is the logic behind NPV approach?

When ever a method is found for calculating any business related reason there is a logic behind it, and even for NPV it is the same. NPV is basically used to know the value of money of today and its value a year later or even later. Unlike payback period which does not take time value of money into consideration, NPV does. NPV also helps in differentiating between projects to find out which project is best suited for the company. Through this method we can also find out if the budget allotted by the company for the project can be invested in that project or can be invested in any other source so that the returns are much higher and better. NPV method will also take into consideration all the factors like interest which will eventually turn out to be as dividends and so when the initial investment is taken off from the total present value the exact profits are know.

What would happen to the NPV if:
  1. The cost of capital increased?
  2. The cost of capital decreased?

Net present value is vast subject so it has the ability to calculate any amount and determine which project is best suited. So to know what happens if the capital is increased, the amount of present value is reduced as the interest rates are high.

And when it comes to what happens if the cost of capital is reduced, it's the vice-versa of the above when the cost of capital is reduced, the interest rate is also reduced and the firm will eventually end up having more net present value than when the cost of capital is increased.

It may not be right always as there may be situations where you need more capital to implement that project but to convince banks and the investors, you need to agree to pay them more interest so that you can start the project and end up in good profits, and when you prefer to start a project which does not involve much risk and the cost of capital is less you have more investors and can pay less interest.

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

Project 'B' should be accepted as it gives 24.14% rate of returns which is better when compared to project 'A' return of 21.04%. Project 'B' should be accepted when calculating in IRR method as the rate of returns is more.

How does a change in the cost of capital affect the project's IRR?

Cost of capital does affect the IRR to find out if the project can be accepted or rejected. If the cost of capital is more than the projects IRR which means the company will not get any returns from the project it has to be rejected and if the cost of capital is less than the projects IRR in which case the company will be left out with profits and getting more returns, then at that rate the project can be accepted. For (e.g.) for one project the cost of capital is 15% and the IRR is 20% it can be accepted as the cost of capital less than the IRR and if the cost of capital is 22% and still the IRR is only 20% the project can not be accepted. So the change in the cost of capital does affect the projects IRR.

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

In capital budgeting there are various approaches to approve a project.

But the best among those are the NPV and the IRR.

According to many analysts NPV has always been regarded to be superior to IRR. The main drawback for IRR being it uses single discount rate to evaluate every investment. Another drawback of IRR is that it can not be calculated if the discount rates are not given as IRR is calculated to find if the interest rate is more than the desired rate then the project can be accepted else reject the project, in the case of NPV if it is above zero then the project can straight away be rejected so this way I\NPV is superior to IRR.NPV is very accurate as it can calculate multiple discount factors without any problem.

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