Capital Investment Decisions: the Case of Diamond Plc

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  • Topic: Net present value, Internal rate of return, Rate of return
  • Pages : 14 (3272 words )
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  • Published : April 15, 2010
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Capital Investment Decisions: The case of Diamond PLC

CONTENT PAGE
PAGES
1.1 - Introduction...................................................................................................4

1.2 - Literature review............................................................................................4-6

2.1 - Advantages and disadvantages of Net Present Value....................................6-7

2.2 - Advantages and disadvantages of Internal Rate of Return............................7-8

2.3 - General formulas............................................................................................9-14

3.1 - Critical Analysis.............................................................................................15-17

4.1 - Conclusion......................................................................................................17-18

References...............................................................................................................19-20

1.1 - Introduction
This assignment is based on Capital investment decisions: the case of Diamond Chemicals plc. A critical analysis of this case study will examine the characteristics and concerns in the case study. This research will discuss the use of Discounted Cash Flow (DCF) techniques known as Net Present Value (NPV) and Internal Rate of Return (IRR), which are the two most popular and important techniques in investment decisions. Although these two techniques are closely-related, they have fundamental differences between each other. “The IRR is the discount rate that makes the present value of a future stream of cash flows equal to the initial investment(s).”Arnold 2008. Whereas, NPV is the “difference between a project’s value and its cost” Breadley, Myers and Allen, 2006.

1.2 - Literature Review
Three research articles will be reviewed focusing on the performances of NPV and IRR relating to real cases in investment evaluation.

“Do managers of South African manufacturing firms make optimal capital investment decisions?” - E.Gilbert, 2003. The purpose of the study was to investigate capital budgeting behaviour of firms in South Africa. It reveals that majority of manufacturing firms use only the NPV technique when evaluating their capital investment projects, and of the DCF techniques used, the NPV technique is used more often than the IRR. Research shows that manufacturing firms adjust the discount rate used in their NPV calculations to incorporate the project specific risk; according to the results of this research, majority of firms do this. It considers that the majority of firms use only the NPV technique when evaluating their capital investment projects (i.e. no other techniques are used at all). However, on average, the IRR technique is used more often than NPV (48% versus 47%). Nevertheless, in summary, the study suggests that manufacturing firms in South Africa deviate from the behaviour prescribed by corporate finance theory because they do not use NPV in isolation with projects specific risk adjusted discount rates when evaluating capital investment projects.

The next article titled “Capital budgeting practices in the US. Forest product industry: A reappraisal” - L.S. Hogaboam and S.R. Shook, 2004. This study observed the capital investment practices of publicly owned forest product firms in the U.S. in 2001by replicating research reported by Cubbage and Redmond in 1985. In this research Baile et al (1979) conducted a survey and case study of capital budgeting in the forest products industry and found that most forest products companies had formal budgeting systems, but these companies lacked post audit procedures, did not account for risk and utilized primitive risk adjustment methods. The researchers correlated the use of NPV and IRR to the size of the firm, finding that firms that had smaller gross sales revenue primarily used payback period for their projects. Nine firms ranked NPV either...
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