investment-appraisal(1)

1Investmentappraisalisalsoknownascapitalbudgeting,aprocessdesignedtoevaluatethefutureprofitabilityandcosteffectivenessintheprivateorpubliccompanies(Olawaleetal.,2010)Itaimstofindthemostprofitableinvestmentbyusinginvestmentappraisaltechniques,suchasnetpresentvalue,internalrateofreturn,averagerateofreturnorpaybackperiod.TheimportanceofInvestmentAppraisalistoevaluatewhethercapitalshouldbespentonaparticularprojectnowbythecompanywouldproducefuturebenefitsornot.Thedecisionsmadeduringcapitalbudgetingprocessareessentialtothefuturegrowthandproductivityofthefirm.ThemainpurposeoftheessayistoevaluatetheprojectforGammaplcbyusingfourmaintechniques,afterestimatingcashflowsfromGammaPlcproject,fourmajorinvestmentappraisalmethodsareavailabletoaddressthequestionofwhetherornottheprojectshouldbeacceptedorrejectedbyGammaPlc.Intheend,recommendationswouldbemadetohelpGammaplcdecidewhetherornotaccepttheprojectaswellasbyusingriskanalysis.NetPresentValueAprojectisconsideredasfinanciallyviableifprojectproducespositiveNPV.Thus,theprojectcancoverthecostofcapitalandstillcreateasurplusorprofit.NPV=-300000+(-145000)/(1.15)+180000/(1.15)2+215000/(1.15)3+370000/(1.15)4=-300000+(-145000)X0.870+180000X0.756+215000X0.572=63040Thisfigureshowstheprojectcarry15%costofcapitalandstillleavesasurplusofbenefitstocovercosts,whichisapproximately£63040.AccordingtoNPVrule,GammaPlcshouldacceptprojectasaresultofpositiveNPVachievedbythisproject.NPVusesdiscountedcashflowsatthecostofcapitalanddeductinitialoutlay.NPVisasuperiormethodthatusedtodeterminewhetherthecompanyshouldacceptor2rejecttheproject.Firstly,NPVconsidersthetimevalueofmoneyinvestedinabusinessandcomparetoday'sinvestmentcapitalwithfuturecashflows(Pike,1996).Also,theuseofcashflowsinsteadofaccountingprofitisanothermajoradvantageofNPV,thustimingandamountofprojectcashflowhasalwaysbeenconsideredbyNPV.Additionally,NPVfocusonallrelevantcashflowsoverthewholelifeofinvestment.NPVcanalsoadaptnon-conventionalcashflow;henceitalwaysprovidesthecorrectselectionadvice.Generallyspeaking,asthemostlogicaltechniquetoinvestmentappraisal,NPVisalsoflexibleandunderstandabletoaccountingusers.Unlikeothertechniques,NPVcandealwithcomplexity.NPVconsidersthewholeeconomiclifeofprojectratherthanjustnumberofyears.However,thedisadvantagesofNetPresentValuestillneedtobeaware.Gardiner&Stewart(2000)arguethatNPVwillguidecompanytoacceptallindependentprojectswithpositiveNPV.AnotherdrawbackofNPVisitisnoteasyforcompanytofindcostofcapital.Also,NPVdoesnotfocusontheproject'ssize.Internalrateofreturn(IRR)IRRisoneoftheusefulInvestmentappraisalmethodswhichevaluatetheattractivenessoffutureinvestmentbyusingdiscountedcashflows.Forexample,ifIRRisbiggerthancostofcapitalofproject,theprojectwillbeconsideredtobeeconomicallydesirable.IRRmethodistherateofreturnwhenthepresentvalueofinvestmentcashinflowsequaltothepresentvalueofthemoneyoutflows(Olawaleetal,2010)Whenr=21%,NPV=-300000+(-145000)/(1.21)+180000/(1.21)2+215000/(1.21)3+370000/(1.21)4=-2922IRR=15%+63040/(63040+2922)X6%=15%+5.73%=20.73%IRRofthisprojectis20.73%,whichisgreaterthancostofcapital(15%).Following3IRRrule,theprojectshouldbeacceptedbyGammaplc.Collier&Gregory(1995)suggestthatIRRtakesintoaccounttimevalueofmoney,whichmakethewholeprojectmorereliable.ComparedwithNPV,IRRevaluatesthevalueofinvestmentbyusingasinglediscountrate.IRRisplayingacommunicationroleincommunicatingthevalueofinvestmenttoitsusers,moreimportant,itisunderstandabletopeoplewhoisnotfamiliarwithcapitalbudgeting.Inaddition,IRRusescashflowsratherthanaccountingprofit,whichmakestheconcepteasyandgetsridofcomplexitieswhichinvolvesindeterminingtheearnings.IRRconsidersallcashflowisequallyimportantasitcalculatesrateofreturnwhenthepresentvalueofinvestmentmoneyinflowequatesthepresentvalueofmoneyoutflow.IRRisagoodmethodwhichwouldselectsuitableprojectthatcreatemaximumwealthtoshareholders.SameasNPV,thereisnoneedtoworkoutcostofcapital.Inotherwords,IRRcanbeusedtoevaluatethefuturebenefitofprojectwithoutcalculatingcostofcapital.ThelimitationsofIRRshouldbeaddressedontheprocessofmakinginvestmentdecisions.AnumberofpossibleIRRcanbecreatedbecauseofunconventionalcashflows.UnlikeNPV,thedecisionruleofIRRdoesnotalwaysrankprojects.However,itisessentialtofindoutwhichprojectproducesapositivereturnandwhichprojectgivesthegreatestpositivereturn.Sometime,usingIRRtechniquemightleadtosomewrongdecisiontakenbythecompanywhentheprojecthasnon-conventionalcashflows.NottakingaccountintochangesinthediscountrateisanotherdrawbackofIRR.WhenIRRisusedformutualexclusiveprojects,IRRdoesnotconsiderrisks.ThepaybackperiodAsArnold(2002)suggest,Paybackperiodshouldbedefinedasthenumberofyearsforcompanytousepaybackitsinvestment'scapital,usuallyshowsinyears.Whenbusinessdecidestoinvestbetweentwoormorecompetingprojects,itusually4accepttheprojectwiththeshortestpayback.Paybackisregardedasafirstscreeningmethod,itindicatesthenumberofyearsfortheprojectstopaybackitscostofcapital.Thepaybackperiodisthenumberofyearsuntiltheinvestmentinaprojectiscovered(Drury,2008).PaybackperiodforGammaplccanbecalculatedasfol