Question

Critically examine how you might undertake a detailed financial appraisal of a number of different potential investments in a company, to identify which option should be pursued. You are required to include within your answer the key data inputs that will be necessary to ensure an accurate financial appraisal is undertaken. (700 words)

Don´t put images -it should be in word

Answer 1

Managers must make careful choices about when and where to invest capital to ensure that it is used wisely to create value for the firm. The process of making these decisions is called capital budgeting. This is a very powerful financial tool with which the investment in a capital asset, a new project, a new company, or even the acquisition of a company, can be analyzed and the basis (or cost justification) for the investment defined and illustrated to relevant stakeholders. Capital budgeting allows the comparison of the cost / investment in a project versus the cash flows generated by the same venture. If the value of the future cash flows exceeds the cost/investment, then there is potential for value creation and the project should be investigated further with an eye toward extracting this value.

Financial appraisal involves usage of following methods/ techniques based on different situations. The appraisal techniques have been notified as under:

1. Net present value NPV: It is the most common method of investment appraisal. Net present value is the sum of discounted future cash inflow & outflow related to the project. Generally, the weighted average cost of capital (WACC) is the discounting factor for future cash-flows in net present value method.

In essence, this method sums up the discounted net cash flows from the investment by the minimum required rate of return & deducts initial investment to give the ‘net present value’. The company should accept the project if the NPV is positive.

Example: ABC Inc. is starting the project at cost of $ 100,000. The project will generate cash-flow of $ 40,000 , $ 50,000 & $ 50,000 in year 1, year 2 & year 3 respectively. Company’s WACC is 10%. Find out NPV.

Formula of NPV = [ $40,000/( 1+0.1)1] + [ $ 50,000 / (1+0.1)2 ] +[ $ 50,000/ (1+0.1)3 ] – 100,000

Net present value = $ 36,363.63 + $ 41,322.31 +$ 37,565.74 – $ 100,000

= $ 115,251.68 – $ 100,000

The net present value of the project is $ 15,251.68.

Here, the net present value of the project is positive & therefore the project should be accepted

2. Internal rate of return / IRR:

An internal rate of return is the discounting rate, which brings discounted future cash flow at par with the initial investment. In other words, it is the discounting rate at which the company will neither make loss nor make a profit. It is obtained by trial & error method. We can also state that IRR is the rate at which the NPV of the project will be zero. i.e. Present value of cash inflow – Present value of cash outflow = zero

Let us use example from NPV to compute the IRR.

Example: ABC Inc. is starting the project at cost of $ 100,000. The project will generate cash-flow of $ 40,000 , $ 50,000 & $ 50,000 in year 1, year 2 & year 3 respectively. Compute IRR of theproject.

CFo = -100,00

CF1 = +40,000

CF2 = +50,000

CF3 = +50,000

Using Financial calculator, input the above and compute IRR = 18.14%

3.Payback period PB - One of the simplest investment appraisal techniques is the payback period. Payback technique states how long does it take for the project to generate sufficient cash-flow to cover the initial cost of the project. The advantage of payback is, it is very easy to calculate & understand. Even people not from finance background can easily understand it. But the disadvantage is that it ignores the time value of money & anything that happens after a payback point

Example: XYZ Inc. is considering buying a machine costing $100,000. There are two options Machine A and Machine B. Machine A will generate revenue of $ 50,000, $ 50,000 & $ 20,000 in year 1, year 2 & year 3 respectively. Machine B will generate revenue of $ 30,000, $ 40,000 & $ 60,000 in year 1, year 2 & year 3 respectively.

Payback period is 2 years & 2.5 years for machine A & machine B respectively. According to the payback period method, machine A will be given preference.

4. Discounted Payback Period Method: This method is the same as the payback period method. The only difference is, in discounting payback method is that payback period is calculated on the basis of discounted future cash-flows while in payback method it is calculated on the basis of future cash-flows.

4. Sensitivity analysis: While a positive NPV on a base case projection is an indication that the project is worth further consideration, it should not be the sole basis for proceeding with an investment. Recall that all of the values in the analysis are based on projections, a process that itself is a complicated art. Therefore if a positive NPV is returned, don’t pop open champagne just yet; instead, start stress testing your work. Various “what if” analyses should be run.

5. Scenario Analysis: Before taking up any investment opportunity, one must always analyse its feasibility in different business scenarios. In the world of finance, we have by default three kinds of scenarios namely - Base case, best case, worst case. We have to assume the numbers for each case depending on the business conditions prevailing in the business. We compute NPV, IRR and other techniques and evaluate all options in order to decide whether to take up or abandon the project.

6. Profitability index: It defines how much you will earn per dollar of investment. The present value of an anticipated future cash flow divided by initial outflow gives the profitability index (PI) of the project. It is also one of the easy investment appraisal technique.

Example: The present value of anticipated future cash flow is $ 120,000 & Initial outflow is $ 100,000.Find PI.

Profitability index = 1.2. i.e. $ 120,000 / $ 100,000.

For each invested dollar is generating revenue of 1.2 dollars. If the profitability index is more than 1, the project should be accepted & if it is less than 1 it should be rejected.If we reduce complication, it is nothing but a different presentation of NPV.

7.Accounting rate of return: It is an accounting technique to measure profit expected from an investment. It expresses the net accounting profit arising from the investment as a percentage of that capital investment. It is also known as return on investment or return on capital

Example: XYZ Inc. is looking to invest in some machinery to replace its current malfunctioning one. The new machine, which costs $ 420,000, would increase annual revenue by $ 200,000 and annual expense by $ 50,000. The machine is estimated to have a useful life of 12 years.

• Depreciation expense per year = $ 420,000/ 12 = $ 35,000
• Increase in average annual profit = $ 200,000 – ( $ 50,000 + $ 35,000) = $ 115,000
• Initial investment = $ 420,000
• ARR = ( $ 115,000 / $ 420,000 ) * 100 = 27.38%

ARR=(Average annual profit after tax / Initial investment) X 100