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MBA1-C OCTOBER 2009

STRATEGIC FINANCIAL MANAGEMENT

INVESTMENT APPRAISAL

ASSIGNMENT DEADLINE:
17 DECEMBER 2009
Submitted to:
DR.GERALD POLLIO/S A PALAN

STUDENT NAME: MUHAMMAD SHARJEEL-


0096KRKR0609
FIRMEX Corporation (PLC)

Year Project A ($) Project B ($)


0 (200) (150)
1 200 50
2 800 100
3 (800) 150

• Importance of Capital Investment Appraisal:

Capital Investment Appraisal is of fundamental importance because:

1. Large Amount of Company Resources: Involvement of large amount of


company resources and efforts which will necessitate careful evaluation to be
undertaken before a decision is reached.

2. Maximization of Shareholder wealth: Investment decision is linked with


strategic and tactical business decisions and therefore need to achieve desired
long-term objectives. The most usual objective being the maximization of
shareholder wealth.

3. Difficult to Reserve: It can be very expensive and perplex to reserve an


investment decision so caution need to be exercised in reaching the initial
investment decision.

4. High Risk Involvement: Projected future benefits and costs are hard to
forecast. As a result, the risk and uncertainty of undertaking medium to long-
term investment can be high.

• Evaluation of Project by using Net Present Value Method (NPV)

NPV is one of the most common universal methods being used by managers to
select the best alternative options. Net present value (NPV) can be defined as the
difference between the present value of investment and the present value of benefits
in the future, which are discounted at the cost of capital.
Net Present Value of Project A & Project B for FIRMEX

Project A

Year Cash flow(£000) Discount Factor PV


@10%
1 200 0.9090 181.8
2 800 0.8264 661.12
3 (800) 0.7513 (601.04)
Present Value 241.88
Less: Initial (200.00)
investment 41.88
NPV@10%

Project B

Year Cash Flow(£000) Discount factor PV


@10%

1 50 0.9090 45.45
2 100 0.8264 82.64
3 150 0.7513 112.69
Present Value 240.78
Less: Initial (150.00)
investment 90.78
NPV@10%

• Calculation of Profitability Index for Project A & Project B

Profitability index is the ratio of the present value of project benefits to the present
value of initial cost. Profitability sometimes called the benefit-cost ratio.

A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value
lower than 1.0 would indicate that the project's PV is less than the initial investment.
As values on the profitability index increase, so does the financial attractiveness of the
proposed project.
Profitability Index = PV of future cash flows
Initial Investment

Project
A 241.88 = 1.2094
200

Project
B 90.78 = 1.6052
240.78

As far as profitability index of Project A and Project B are concern, both profitability
index are more than 1. However, Profitability Index of Project B is more than Project
A.

• Calculation of internal rate of return method for both projects (IRR)

Internal Rate of Return (IRR) or DCF is also used widely by different organizations to
evaluate different projects. This method is defined as the discount rate at which the
present value of the cash flows generated by the project is equal to the present value
of the capital invested, so that the net present value of the project is zero. (Weetman
P, 2006). Formula to calculate the IRR is as following:

IRR = R+ + N+ x (R- - R+)


(N+ - N-)

IRR: Internal Rate of Return


R+: discount rate which gives a positive NPV
R-: discount rate which gives a negative NPV
N+: positive NPV at the discount rate R+
N-: negative NPV at the discount rate R-

o Calculation for IRR of Project A:

Assuming the internal rate of return is 0 per cent, NPV for project A will be:

Year Expected Discounted Cash Flows


Cash Flows ($) at 0% required rate of return ($)
0 (200)
1 200 200 x 1 = 200
2 800 800 x 1 = 800
3 (800) (800) x 1 = (800)
Present Value 200
Less: Initial Investment (200)
NPV 0

 When IRR is 0%, NPV will be zero, i.e. IRR<cost of capital investment

Let again assume the internal rate of return is 100 per cent, NPV for project A will be:

Year Expected Discounted Cash Flows


Cash Flows ($) at 100% required rate of return ($)
0 (200)
1 200 200 x 0.5 = 100
2 800 800 x 0.25 = 200
3 (800) (800) x 0.125 = (100)
Present Value 200
Less: Initial Investment (200)
NPV 0

 When IRR is 100% , NPV will be zero, i.e. IRR<cost of investment


In Project A, due to irregular cash flow in mutually exclusive project, IRR will always
give wrong information. That is why, we have to rely on NPV only.

o Calculation for IRR of Project B:

Assuming the required rate of return is 20 per cent, NPV for project B will be:

Year Expected Discounted Cash Flows


Cash Flows ($) at 20% required rate of return ($)
0 (150)
1 50 50 x 0.833 = 41.65
2 100 100 x 0.694 = 69.4
3 150 150 x 0.579 = 86.85
Present Value 197.9
Less: Initial Investment (150)
NPV 47.9

Let again assume the internal rate of return is 40 per cent, NPV for project B will be:

Year Expected Discounted Cash Flows


Cash Flows ($) at 40% required rate of return ($)
0 (150)
1 50 50 x 0.714 = 35.7
2 100 100 x 0.510 = 51.0
3 150 150 x 0.364 = 54.6
Present Value 141.3
Less: Initial Investment (150)
NPV (8.7)

Now from IRR Formula:

 IRR = 20% + 47.9 x (40% - 20%)


(47.9 – 8.7)
 IRR = 20.24%
 IRR > Cost of investment
• Superiority of NPV over IRR:

The NPV method is new concept as compare to traditional methods i.e. Payback
and Accounting Rate of Return (ARR).NPV method discounts the future cash
flows linked with the investment project using the cost of capital as the
appropriate discount rate. If NPV of required project is positive then we should
accept the project and if it is negative then we should not accept the project.
However if NPV of any project is zero then we can accept or reject the project it
depends on management decision. Normally, to be competitive in market,
managers like to accept the project if NPV is zero.
Advantages of NPV are:
• Time Value of Money: It takes account of time of value of money, by
discounting the cash flows arising in the future

• Cash Flows: takes account of all relevant cash flows

• Indicates Clear Decision: provides a clear decision rule concerning


acceptance/rejection of a project

• Primary Objective: It is consistent with the aim of maximizing shareholder


wealth, which is assumed to be the primary objective of any business.

As far as Internal Rate of Return is concerned, it is based on the principles of


discounting cash flows and will normally give the same accept/reject decisions and
will rank investment projects in the same way as the NPV method.
Contrary, it has difficulty in handling unconventional cash flows and does not address
the issue of wealth maximization. It may give conflicting recommendations to
NPV.IRR cannot consider changes in interest rates over the life of a project. It
assumes that funds are reinvested at a rate equivalent to the IRR itself, which can be
produce unrealistically high.
Due to above reasons we can conclude that NPV is superior to IRR.

• Conclusion:

After analyzing data available to assess Project A and Project B, Project B seems
much more beneficial to accept. The NPV, Profitability Index and IRR are much
higher than Project A. So Project B should be accepted.

• References:

1. Dyson,J.R 2004, Accounting For Non-Accounting Students, 6th edition


2. Weetman, P, 2006, Management Accounting, Essex, Prentice Hall
3. Lumby, S & Jones, C, 2003, Corporate Finance Theory and Practice,
London, Thomson
4. Aidan Berry and Robin Jarvis Accounting in a Business Context, 3rd
Edition, Zrinski dd., Croatia

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