A Breakdown of Investment Appraisal Methods, Associated Questions and Answeress

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LONDON SCHOOL OF COMMERCE.|
ASSIGNMENT ON ACCOUNTING AND DECISION MAKING TECHNIQUES|
|
QUINCY|
4/20/2011|

(A) Why is investment appraisal process so important?
Answer
Capital investment involves the commitment of large amounts of company resources, which will necessitate careful evaluation to be undertaken before a decision is reached. The investment appraisal process helps managers make the right investment decisions as regards what projects to invest in to maximize shareholders wealth in the long and short run. Seeing how difficult and extremely expensive it would be to reverse an investment decision, the investment appraisal process equips one with strategic and tactical skill-set to exercise care in making informed initial investment decisions. Also, as projected future benefits and cost are difficult to predict the risk and uncertainty of taking a medium to long-term investment can be high. The knowledge of Capital investment process can help non-accountants better interpret information and constructively question recommendations received from their accounts so as to make the appropriate investment decision as opposed to just doing what they are told by the accountant.

(B) Calculate the payback period for project A.

Payback period is defined as the amount of time it takes for a project to pay for itself or the length of time it take to recover the cost of an investment.

PROJECT A
Initial Investment: The amount of money a business invests in a capital investment project. It can be sourced from various means such as banks or shareholders funds. It is given as ₤115,000

NO OF YEARS(YR)| NET CASH FLOW (NCF)| CUMMULATIVE NET CASH FLOW(CNCF)| 1| 38,000| 38,000|
2| 42,000| 80,000|
3| 48,000| 128,000|
4| 50,000| 178,000|
5| 70,000| 248,000|

Payback period = 2 + 115,000 − 80,000
48,000
= 2 + 35,000
48,000
= 2years + 0.7291 × 12 months of a year.
= 2 years 8.7 month = 2years and 8 months

PROJECT B
Payback period for project B has a constant net cash flow (NCF) referred to as, Annuity. Taking the annuity factor into consideration payback period (B.P.B) is calculated as

P.B.P = Initial investment = 115,000
Net cash flow 43,000

= 2.6744 = 2 years and 7 months

DECISION
If the company were to choose between investing in one of the projects A and B, the company should choose the project with the shortest payback period which is project B.

However, if the company has retained earnings to invest in more than one project at a time the can invest in both projects A and B.

(C) What are the problems of payback period?

Payback period is the amount of time it takes to breakeven on an initial investment. The returns from a project or investment in a given is usually measured in net cash flow terms. Net cash flow is the difference between cash received and cash paid over a defined period of time. It is associated with the following problems.

Payback period measures the rate at which the original investment is recovered in net cash flow terms. This implies that non-cash flow items are not taken into account such as depreciation, losses and Profit from sales of fixed assets.

Payback period has difficulty in estimating the amount and timing of instalments due to be paid on the original investment.

Payback period has difficulty in determining an appropriate rate of interest as it is an estimated time frame for a project to recover the initial investment. Also net cash flows received after payback period is ignored.

(D) Determine the NPV for each of these projects?
PROJECT A

INITIAL INVESTMENT = £115,000.
YEARS(YR)| NET CASH FLOWS(NCF)£| DISCOUNTING FACTOR (DF)11.5%| NET PRESENT VALUE (NPV)£| YR1| 38,000| 0.897| 34086|
YR2|...
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