investment - appraisal(1)

Investment appraisal is also known as capital budgeting, a process designed to evaluate the future profitability and cost effectiveness in the private or public companies (Olawale et al., 2010) It aims to find the most profitable investment by using investment appraisal techniques, such as net present value, internal rate of return, average rate of return or payback period. The importance of Investment Appraisal is to evaluate whether capital should be spent on a particular project now by the company would produce future benefits or not. The decisions made during capital budgeting process are essential to the future growth and productivity of the firm. The main purpose of the essay is to evaluate the project for Gamma plc by using four main techniques, after estimating cash flows from Gamma Plc project, four major investment appraisal methods are available to address the question of whether or not the project should be accepted or rejected by Gamma Plc. In the end, recommendations would be made to help Gamma plc decide whether or not accept the project as well as by using risk analysis.

Net Present Value

A project is considered as financially viable if project produces positive NPV. Thus, the project can cover the cost of capital and still create a surplus or profit. NPV= -300000 + (-145000)/ (1.15) + 180000/ (1.15)+ 215000/ (1.15)+370000/ (1.15)

= -300000+(-145000)X0.870+180000X0.756+215000X 0.572 = 63040

This figure shows the project carry 15% cost of capital and still leaves a surplus of benefits to cover costs, which is approximately ￡63040. According to NPV rule, Gamma Plc should accept project as a result of positive NPV achieved by this project.

NPV uses discounted cash flows at the cost of capital and deduct initial outlay. NPV is a superior method that used to determine whether the company should accept or

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reject the project. Firstly, NPV considers the time value of money invested in a business and compare today's investment capital with future cash flows (Pike, 1996). Also, the use of cash flows instead of accounting profit is another major advantage of NPV, thus timing and amount of project cash flow has always been considered by NPV. Additionally, NPV focus on all relevant cash flows over the whole life of investment. NPV can also adapt non-conventional cash flow; hence it always provides the correct selection advice. Generally speaking, as the most logical technique to investment appraisal, NPV is also flexible and understandable to accounting users. Unlike other techniques, NPV can deal with complexity. NPV considers the whole economic life of project rather than just number of years. However, the disadvantages of Net Present Value still need to be aware. Gardiner & Stewart (2000) argue that NPV will guide company to accept all independent projects with positive NPV. Another drawback of NPV is it is not easy for company to find cost of capital. Also, NPV does not focus on the project's size.

Internal rate of return (IRR)

IRR is one of the useful Investment appraisal methods which evaluate the attractiveness of future investment by using discounted cash flows. For example, if IRR is bigger than cost of capital of project, the project will be considered to be economically desirable. IRR method is the rate of return when the present value of investment cash inflows equal to the present value of the money outflows (Olawale et al, 2010) When r = 21%,

NPV = -300000 + (-145000)/ (1.21) + 180000/(1.21)+ 215000/(1.21)+370000/(1.21) =-2922

IRR = 15%+63040/ (63040+2922) X6% = 15%+5.73% = 20.73%

IRR of this project is 20.73%, which is greater than cost of capital (15%). Following

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IRR rule, the project should be accepted by Gamma plc.

Collier & Gregory (1995) suggest that IRR takes into account time value of money, which make the whole project more reliable. Compared with NPV, IRR evaluates the value of investment by using a single discount rate. IRR is playing a communication role in communicating the value of investment to its users, more important, it is understandable to people who is not familiar with capital budgeting. In addition, IRR uses cash flows rather than accounting profit, which makes the concept easy and gets rid of complexities which involves in determining the earnings. IRR considers all cash flow is equally important as it calculates rate of return when the present value of investment money inflow equates the present value of money outflow. IRR is a good method which would select suitable project that create maximum wealth to shareholders. Same as NPV, there is no need to work out cost of capital. In other words, IRR can be used to evaluate the future benefit of project without calculating cost of capital.

The limitations of IRR should be addressed on the process of making investment decisions. A number of possible IRR can be created because of unconventional cash flows. Unlike NPV, the decision rule of IRR does not always rank projects. However, it is essential to find out which project produces a positive return and which project gives the greatest positive return. Sometime, using IRR technique might lead to some wrong decision taken by the company when the project has non-conventional cash flows. Not taking account into changes in the discount rate is another drawback of IRR. When IRR is used for mutual exclusive projects, IRR does not consider risks.

The payback period

As Arnold (2002) suggest, Payback period should be defined as the number of years for company to use payback its investment's capital, usually shows in years. When business decides to invest between two or more competing projects, it usually

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accept the project with the shortest payback. Payback is regarded as a \method\it indicates the number of years for the projects to pay back its cost of capital. The payback period is the number of years until the investment in a project is covered (Drury, 2008).

Payback period for Gamma plc can be calculated as follows:

PP= 3+ (300000-250000)/370000= 3.135 Years

Apparently that the total of discounted cash flows does not recover from its cost of capital after Year 3.135, so the payback period is 3.135 years. According to the question, expected payback period is 3 years, based on Payback period rule, Gamma Plc should not take this project as its payback period is more than its target period. Simplicity is the major advantage of Payback period as it is easy to apply to select correct project. The use of cash flow instead of earning is another advantage of PP. PP clearly shows the project carries less risk. Shorter payback period is a sign of increased liquidity and speed of growth. However, ignoring the time value of money is major drawback of Payback period. PP does not consider the investment as a whole. It seems Payback period is too subjective, in other words, PP is lack of objectivity. PP neglects the life expectancy of a project (Pratt & Grabowski, 2008).

Accounting rate of return (ARR)

The accounting rate of return can be calculated by using the project’s average profit divide its average investment (Drury & Tayles, 1997). In Gamma Plc,

Average profit= (-190000+135000+170000+205000)/4 = 80,000 Average investment= (30000+120000)/2= 210,000

ARR= Average Profit / Average Investment = 80,000/210000= 38.09%

Accounting rate of return (ARR) uses historical costs to evaluate the project. Unlike

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Payback period, ARR is expressed as a percentage rate of return, so it is comparable with company's other ARR. And it is easy for company to apply this method. ARR is a useful tool which can be used to rank the investments in mutually exclusive projects.

Nevertheless, ARR evaluate the investment based on accounting data, such as average profit, rather than cash flows. Timing is neglected as ARR uses average profits. Also, it does not take account into time value of money. ARR is a financial measurement, which does not determine investment signal and size of initial investment. Finally, it is difficult to state the profit (Drury, 2008).

Importance of Cost of capital

Calculating cost of capital is an important part in the evaluation and investment decision making processes. Cost of capital is essential to estimating of present value. In the market, better-informed cost of capital would affect billions of dollars business's financial decision. In Gamma Plc, cost of capital is 15%, which can help to calculate NPV, IRR by using 15% as discount rates (Pratt & Grabowski, 2008)

Risk analysis

When business makes investment decisions, company might face certain risks on the process of meeting investment goals due to project uncertainty.

Inflation has an impact on capital investment decision. For instance, reducing the real value of future cash flow or increasing the uncertainty can affect investment decisions. Inflation will be defined as the fall in the real value of money over time, usually shows as an annual percentage (Savvides, 1994). Hence, take an example, goods cost ￡100 today, if an inflation rate is 8%, goods will cost ￡108 in one year's time. After two years, it will cost ￡116.64. Inflation would result in reducing the value of company's money. There is risk company might lose buying power because of

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inflation risk.

Taxation can adversely affect the calculation of NPV. In a project, the value of cash flows must be reduced because of the amount of taxation payable on the cash flows. Thus, impact of taxation would affect investment decisions (Savvides, 1994).

Various discount rate of return can also increase the risks to the project. Changes in discount rate would produce unstable NPV, this leads to a riskier project. In order to achieve a greater return for accepting a higher risk, company would accept higher discount rate and riskier project.

Recommendation

In Gamma Plc, The project produces a positive NPV, which is ￡63040. According to NPV decision rule, therefore, the project would create shareholder wealth. Based on this figure, it suggests that the project should be accepted by Gamma plc because NPV is a superior method, which always gives the correct selection advice for the company. At the meantime, IRR and ARR methods also suggest Gamma Plc should accept the project as it would bring future benefits to the company and enhance shareholders wealth. Overall, it is suggested that Gamma Plc should accept this project by applying NPV, IRR, ARR methods, which address the question of Gamma Plc should accept the project as the project would become economically desirable. .

Conclusion

Effective evaluation on capital budgeting is essential to business success. More accurate and reliable capital budgeting would help company to make best investment decisions, thus more value will be added to the firm. Investment appraisal process would enhance profitability and remain competitive advantage of the firm. Four major investment appraisal methods can be applied to evaluate the attractiveness of project,

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namely NPV, IRR, Payback period and ARR. However, in respite of advantages of these investment appraisal techniques, weaknesses in the application of investment appraisal methods need to be stated in order to make best decisions. Based on calculations, it is suggested that Gamma plc should accept the project due to positive NPV produced by this project as well as other satisfactory results of IRR and ARR. NPV is a superior method as it always gives best selection advice. To meet investment goals, certain risks should be analyzed by the company on the investment decision making process, such as inflation risk, taxation and various discount rate of return. The use of risk analysis in investment appraisal can support investment decisions.

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References:

Arnold, G. (2002), Corporate Financial Management, 2nd edn. Prentice Hall.

Collier, P. & Gregory, A. (1995), \study analysis of the UK hotels sector\Management Accounting Research, Vol 6, pp33- 57

Devereux, M. & Schiantarelli, F. (1990) Investment, Financial Factors and cash flow: Evidence from UK panel data. University of Chicago Press

Drury, C. (2008), Management and Cost Accounting, 7th edn, Pat Bond

Drury, C. & Tayles, M. (1997), \investment appraisal techniques\Management Decision. Vol 2. Pp86-93.

Gardiner, P. D. & Stewart, K. (2000), \quality: the role of NPV in project control, success and failure.\International Journal of Project Management, Vol 18, pp251- 256

Olawale, F.& Olumuyiwa, O. & George, H (2010) \of investment appraisal techniques on the profitability of small manufacturing firms in the Nelson Mandela Bay Metropolitan Area\African Journal of Business Management, Vol 4, pp1274 -1280

Pike, R. (1996), “A longitudinal survey on capital budgeting practices”, Journal of BusinessFinance and Accounting, Vol. 23, pp 70-93.

Pogue, M. (2004), Investment appraisal: A new approach. Managerial Auditing Journal, vol 19, No. 4, pp565-570

Pratt, S. P. & Grabowski, R.J. (2008), Cost of Capital, John Wiley & Sons Inc. Hoboken: New Jersey.

Savvide, S.C. (1994), Risk Analysis in Investment Appraisal. Investment Appraisal and Management. Vol 9, No. 1. Pp3-18

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