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Investment Appraisal should add value to the business entity, do you agree?

Answer: Successful companies are always looking at various ways in which they can change and develop. The top management will be faced with a number of different proposals, ranging from the development of a new product to establishing a companys presence in another part of the world. Investment appraisal is the evaluation of the attractiveness of an investment proposal using method such as, Average Rate of Return (ARR), Internal Rate of Return (IRR), Net Present Value (NPV), or Payback period. Investment appraisal is an integral part of capital budgeting, it is applicable to areas where the returns may not be easily quantifiable such as personnel, marketing and training. Capital budgeting is the plan for raising large and long term sum for investment in plant and machinery, over a period greater than the period considered under an operating budget. Techniques such as IRR, NPV, are employed in creating capital budget. With the above explained, Investment appraisal should add value to the business entity because it will clearly explain how visible and viable a business is at the initial start up of the business and during the running of the business because it gives a clearer picture of what should be expected in the running of the business. B. What is the payback period of each project? If AP ltd imposes a 3yr maximum payback period, which of these project should be accepted Answer: Payback of project A will be: Year 1 2 3 4 5 i) ii) using: Payback = Initial Investment/ Annual NCF Therefore; 125,000/43 Payback = 2.9years (A) NCF 000 22 31 43 52 71 Cumulative NCF 000 22 53 96 148 219

Payback = 3 + 29/52 = 3.55years (approx. 3.6years) To calculate for project B Since the cash flow for project B is the same; thus we calculate the payback

Project B should be considered because it is less than the 3years estimated payback period. C. What are the criticisms of payback period? The criticisms of payback period are; i. It ignores the time value of money ii. It ignores any benefit that occurs after the payback period: the payback does not recognise any profit that the business make after the initial capital has been recovered. iii. It does not measure the profitability of an investment: what the payback is concerned about is when to recover the initial investment and not how profitable the business will be

D. Determine the Net Present Value (NPV) for each of the project. Should they be accepted? Explain why. Answer: Determining the NPV at 12% Project A (A) NCF Discount Present 000 Factor Value 1 22 0.8928 19.64 2 31 0.7971 24.71 3 43 0.7117 30.60 4 52 0.6355 33.04 5 71 0.5674 40.28 Total PV = 148.27 Less Initial Investment - 125 23.27 Therefore, the NPV for project A is 23.27 Discount Present Factor Value 1 0.8928 38.39 2 0.7971 34.27 3 0.7117 30.60 4 0.6355 27.32 5 0.5674 24.39 Total PV = 154.97 Less Initial Investment -125 29.97 Therefore, the NPV for project B is 29.97 Should they be accepted? Yes they should be accepted Yr Project B (B) NCF 000 43 43 43 43 43 Yr

They should be accepted because the rule of Net Present Value states that an investment should be accepted if its NPV is greater than zero (0) and rejected if otherwise. The two projects are greater than zero (0) therefore, they should be accepted. According to the theory of NPV, participating in a positive NPV will increase the firm or shareholders wealth. E. What is the logic behind the NPV?

The logic behind the NPV approach is that it is better to have a sum of money now than in the future because the money you have now could be properly invested and get more return. A dollar today is worth more than a dollar in the future. The idea of NPV is to take future cash flows received or paid and convert them into todays value using the rate of return that you should earn on your investment. The NPV allows you to value a companys asset at their correct current value, usually at the end of the year when the accounts are prepared. The calculation of NPV takes into account the asset original cost, less all accumulated depreciation allowed against that asset in previous tax computation. F. What happens to the NPV if; i. The cost of capital increased ii. The cost of capital decreased i. If the cost of capital increases, the Net Present Value will decrease because in calculating for the NPV, it is the cumulative of the present value less the cost of capital that gives the NPV. So therefore, as the cost of capital increases, the NPV decreases. The implication is that, if the NPV decreases, it gives a negative value, therefore decreasing the companys value which will in turn reduce the shareholders wealth. If the cost of capital decreases, the NPV will increase because in calculating for NPV, it is also the cumulative of the present value less the cost of capital. So therefore, as the cost of capital decreases, the NPV increases. The implication is that, if NPV increase, it gives a positive value therefore increasing the companys value and increasing the share holders wealth. Determine the IRR for each project. Should they be accepted? Project A using 22% Yr 1 2 3 4 5 NCF 000 22 31 43 52 71 DF (22%) 0.8196 0.6718 0.5507 0.4513 0.3699 PV 000 18.031 20.825 23.680 23.467 26.262



Project A using 17% DF PV (17%) 000 0.8547 18.803 0.7305 22.645 0.6243 26.844 0.5336 27.747 0.4561 32.383 Total PV=128.42 Less Initial Inv. =125.00 NPV @ 17% 3.42 Project B using 17% and 22% respectively Yr NCF 000 1 22 2 31 3 43 4 52 5 71

Total PV=112.27 Less Initial Inv=125.00 NPV @ 22% -12.73

NCF DF PV 000 17% 000 5 43 3.199 137.57 Less Initial Inv=125.00 NPV at 17% for project B 12.57 Using 22% as the cost of capital Yr 5 NCF 000 43 DF 22% 2.864 PV 000 123.15


Less Initial Inv=125.00 -1.85 IRR for project A IRR= NPV @ 17%= 3.422 NPV @ 22%= -12.735 17% + 3.422 x 22%-17% 3.422 + 12.735 17% + 3.422 x 5% 16.157 17% + 1.05% =18.05% IRR for project B NPV @ 17%= 12.565 NPV @ 22%= -1.676 17% + 12.565 x 22% - 17% 12.565 + 1.676 17% + 12.565 x 5% 14.241 17% + 4.41% = 21.41% Should they be accepted? Yes. Both projects should be accepted because in the internal rate of return decision making, in situation where the IRR is more than the cost of capital, we accept such and where the IRR is less than the cost of capital, we reject. In the above project (A and B), the IRR is greater than the cost of capital, therefore making the projects more viable, in this case, they should be accepted.


How does a change in the cost of capital affect the projects IRR?

The change in the cost of capital does not majorly affect the IRR. What the change in the cost of capital does is that, it affect in the decision being made on an investment. An increase in the cost of capital does not change the IRR, it only leads to fewer investment decisions being acceptable when using the IRR as a way of assessing the investment decision. I. Comparing the effectiveness of the Net Present Value with the Internal rate of Return, the NPV compares the value of money today to the value of that same value in the future, after adjusting for inflation and taking returns into account. The NPV is expressed in monetary units while the IRR is the true interest yield expected from an investment expressed in percentage. There are some instances where the NPV will be most preferable to the IRR; the NPV will be preferred to the IRR when it uses one single discount rate to evaluate the investment. Although, there are some cases where the IRR could also be employed, such situation is when the IRR also uses a single discount rate. An example is when an analyst is evaluating for two project, both of which has a common discount rate, equal risk, time period and a predictable cash flow, the IRR could be used. In situation where IRR will not be effective is when the project has the mixture of multiple positive and negative cash flow, in this case, the NPV value will be used because the NPV can handle multiple discount rate. Also, there may be a problem in computing for the IRR if the discount rate of a project is not known. The discount rate must be known to be able to calculate for the IRR. For the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. In this kind of situation, the NPV could be employed.