lONDON SCHOOL OF COMMERCE
ACCOUNTING AND DECISION MAKING TECHNIQUES
You are required to provide an evaluation of two proposed projects, both with five year expected lives and identical initial outlays of £110,000. Both projects involve additions to AP Ltd.’s highly successful product range and as a result, the cost of capital on both projects has been set at 12%. The expected cash flows from each project are shown below.
In evaluating the projects please respond to the following questions:
(A) Why is the investment appraisal process so important?
(B) What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback period which of these projects should be accepted?
(C) What are the criticisms of the payback period?
(D) Determine the NPV for each of these projects? Should they be accepted – explain why?
(E) Describe the logic behind the NPV approach.
(F) What would happen to the NPV if:
(1) The cost of capital increased?
(2) The cost of capital decreased?
(G) Determine the IRR for each project. Should they be accepted?
(H) How does a change in the cost of capital affect the project’s IRR?
(I) Why is the NPV method often regarded to be superior to the IRR method?
Why is the investment appraisal process so important?
Finance is the life blood of business. Business needs finance from its cradle to grave, so it is very important that where are you going to do investment, that decision will be good for the business or not and for that purpose investment appraisal is very necessary. Investment appraisal refers to an evaluation of attractiveness of investment proposal, using methods such as average rate of return (ARR), Internal rate of return (IRR), net present value (NPV) payback period. Investment appraisal is an integral part of capital budgeting and is applicable to areas even where the returns may not be easily quantifiable. Each and every firm requires to evaluate many projects in terms of inputs and outputs. There is no single way of assessing and comparing the different proposals. Following factors must be taken into consideration while selecting a project: * The extent to which the proposals are consistent with the company’s long-term plans. * The risk attached to the project.
* The availability of the necessary resources even if the money is available. This process of assessment of the proposed projects and to select the best out of them is called Investment Appraisal. [B]
What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback period which of these projects should be accepted? Ans. : Pay Back Period of Project A and project B (AP ltd.) * Pay back period of project A in (£’000)
* Initial outlay
Pay back period
If 50 Month 12 20 × 12 / 50 = 4.80 monthThen 20
Pay back period = 3 years and 5 months.
* Pay back period of project B in (£’000)
* Initial out lay
* Annual inflow
Pay Back period
= Investment Required / Net annual cash inflow
=2 years and 9 months
The payback period of project A is 3 years and 5 month which is more than mentioned pay back period which is 3 years. So it is advisable to not to select project A. The payback period of project B is 2 years 9 month which is less than decided payback period, so it is advisable to select the project B. In illustration, consider again the two projects, project A and...
References: * FUNDAMENTALS OF FINANCE MANAGEMENT BY JAMES C. VAN HORNE AND M. WACHOWICZ, JR. (13TH EDITION)
* FINANCE AND ACCOUNTING FOR NON-FINANCIAL MANAGERS BY WILLIAM G. DROMS, 2003 (pg.187)
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