INTRODUCTION:Archer’s Organic Foods plc - Investment appraisals of two farms
1 I. Introduction
Archer’s Organic Foods plc is a producer and distributor of organic foods. The company is looking to expand the business by acquiring a farm in the North of England. This report analyses the financial viability of two farms by using a number of investment appraisal methods. The two farms differ in their initial investments, sales and costs. The freehold of option 1 farm will be acquired at the beginning of the project. The farm in option 2 will be taken on a 10-year lease with deposit and annual rent payments. The report makes a recommendation on the final selection of a farm by evaluating the results, strengths and weaknesses of four investment appraisal methods.
The four investment appraisal methods used in this report are the Accounting Rate of Return (ARR), payback period, Net Present Value (NPV) and Internal Rate of Return (IRR). The results of the four investment appraisal methods may not be similar because of differences in their approaches and calculations. Hence, it is beneficial to use more than one investment appraisal method and understand the benefits and limitations of each method before making a final decision.
2 II. Investment appraisal methods
The four investment appraisal methods can be classified into two main categories. The ARR and payback period are non-discounting methods whereas the NPV and IRR are discounting methods. The ARR method measures the accounting profit rate by dividing the average income by the average investment (Hansen and Mowen, 2007, p. 568). The method is simple to use but has major limitations. It ignores the time value of money which is a major drawback in case of projects with long lives. Also, a benchmark rate is required for comparison.
The payback period calculates the time required to recover initial investment from the operating cash flows of a project (Brigham and Houston, 2007, p. 373). Shorter payback period projects are preferred as they generate cash equal to initial investment in a shorter duration and this can be viewed as a proxy of risk.
However, the payback period method ignores the time value of money (Kinney & Raiborn, 2011, p. 655). It also ignores the cash flows after the payback period which could result in a selection of a project that adds less value.
The NPV method calculates the net value of a project by discounting the cash flows at a rate which reflects the risks of those cash flows. The discounting of the future cash flows is a major advantage of the NPV method over the non-discounting methods. This is very important for valuing the two alternatives as cash flows are spread over 10 years.
The drawback of the NPV method is that it assumes constant gearing to maintain same cost of capital. This rarely happens as cash inflows over the period change the gearing. A company will have to issue debt regularly to maintain same gearing (Delaney, 2008, p. 37). This is difficult to do due to administrative issues and costs. It is also not easy to calculate cost of capital that is used for discounting cash flows (Howe, 1992, p. 34). Finally, the NPV method is not useful on its own when a company faces capital rationing. The profitability index may have to be used along with the NPV to evaluate investments in a capital rationing scenario.
IRR method also discounts the future cash flows and gives the cost of capital at which the NPV would be zero. This gives an idea about the margin of safety that is available in terms of possible decline in the rate of return before it equals cost of capital. The limitation of the IRR method is that it can give two IRRs for same set of cash flows if the pattern of cash inflows and outflows reverses more than once during the life of a project (Brigham and Daves, 2009, p. 421). It also assumes that cash inflows during the life of a project will be reinvested at the IRR which may not be true as...