Penta ltd (Investment appraisal)

Introduction

What is investment appraisal? It is the activity responsible for carrying out a cost benefit analysis to justify capital expenditure for a new investment. Capital investment decisions are those decisions that make current outlays in return for a stream of benefits in future years.

. The characteristic of many investments is risk and uncertainty. many organisations prefer to avoid high risk investments but may consider these investments if they believe they will receive a greater return for the increased risk ; but firms can only guess the future revenue and costs of an investment as they are so many different that make the outcome of a investment uncertain for example the economic environment. Techniques have been developed that try and asses the feasibility of projects and rank investment alternatives as seen below in this case study.

1. An evaluation of the investment opportunities separately

Option one should be undertaken since it has a positive net present value hence maximises shareholders objective of wealth maximisation. Option two should be rejected because it has a negative net present values i.e. the cash out flows are greater than the cash inflows. In the above evaluation the uncertainty that exists is the determination of future expected cash inflows. In the calculation of increases in sales consideration has been made to cater for the increase in negative net present value i.e the cash outflow are greater than the cash inflows. In the above evaluation the uncertainty that exist is the determination of the future expected cash inflows. In the calculation of increase in sales consideration has been made to cater for the increase in inflation of 2%.therefore where cost will, increase with 50% adjustments are taken at 52% to get the nominal rise in costs.

The WACC has been used to discount the cash flows i.e. 8.6-0.04=8056%.

For option 1 debt constitute 50% i.e. 0.5*8=4million

The interest expense will thus be 0.08*4=0.32.this increase the interest to 0.8 million

1. Discussion of the methods

Net present value (NPV) this is the present value of an investment's future net cash flows minus the initial investment. A positive NPV means the investment should be made (unless an even better investment exists), and if negative this means that the amount by which an investment does not match an equal risk investment in financial securities. (Drury 2005)

Net present value method has been used in the evaluation of the investment decision. In this method the future expected cash flows has been discounted at the cost of capital to determine the net present value of the amounts.

In this method the project with a positive net present value should be undertaken since maximises the shareholders wealth. The advantage of this method is that it considers the time value of money; it gives the criteria of ranking projects.

The method has the disadvantage that it estimates the future expected cash flows i.e. it’s uncertain to estimate the future cash inflow. Again the method of net present value discounts the future cash inflows at one rate yet the cost of capital varies from amongst the various sources.

Other methods of evaluating investment decisions are:

Payback period

This is an investment decision where the duration of time taken to recoup the initial capital outlay considered i.e. the cost of investment. The shorter the payback period is the better the investment decision. The advantage of the method is that it prefers projects with higher cash inflows at the beginning of the project, ventures this improve the liquidity of the firm. The investment decision has the draw back that it doesn’t consider the time value of money, it fails to take into account all cash inflows and it also assumes that cash inflows are evenly generated throughout the year. Again the method is not consistent with type shareholders...

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