Capital Investment Appraisal: Methods And Techniques

Prepare a report to the Directors of AYR Co. which includes the following.

1. A calculation of the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period for projects Aspire and Wolf. Detailed calculations should be included as an appendix to the report. All cash flows should be rounded to the nearest $. 30%

2. Analysis and evaluation of the investment project options as follows:

i. A recommendation regarding which project (if any) to undertake;
ii. Justifications for your recommendation including an evaluation of the investment appraisal techniques used in task 1 above.
iii. A summary of other factors that should be considered and information that may be needed prior to making a final decision. 30%

3. A discussion of the two sources of finance being considered by the board of AYR Co. Your report should include:

i. A description of Equity and Debt.
ii. An explanation of the costs of each source of finance.
iii. An analysis of the effect the selection of the source of finance may have on AYR Co.’s weighted average cost of capital.
iv. An assessment of the impact of the selection of finance on current and potential shareholders and lenders.

The capital investment appraisal is a segment of the planning which assist in evaluating the long terms investments or the short term investment. There are various methods to calculate the viability of the investments and such techniques are namely IRR, Net present Value, and Profitability index. The current report will be restricted to these three methods an these techniques are used to determine the future prospects that will be beneficial after the implementation. In order to increase the market share the AYR Co shall focus on the ability of the projects to generate enough cash flows (Caselli and Negri, 2018).

As mentioned in the report the three methods of the appraisal and capital investments include the net present value, the IRR and the payback period. The first two methods also consider the concept of the time value of money (Burns and Walker, 2015).

Net Present value: it is the calculative description of the difference between the inflows and the outflows of the cash. The net present value is calculated at the discounted rate. The decision on the basis of the net present value can be considered on the basis of the high or low present value. The higher the net present value, the desirability of the project increases accordingly (Rad, Jamili, Tavakkoli-Moghaddam and Paknahad, 2016).

Formula:

NPV = Cashflow  -  Initial Investment

(1+i)^t

Internal rate of return: IRR is the discounting rate that brings the NPV value equivalent to zero. The decision on the basis of the IRR can be taken if the cost of capital is lower than the IRR, otherwise the project is rejected (Gallo, 2016).

Formula:

IRR(Sum of cash flows including initial investment)

Payback period: The payback period can be referred to as the period in which the cost of investment can be recovered. The investment proposals that have the shorter payback period shall be selected (Abor, 2017).

Payback Period = A +	B
	C

Variable A:  is the last period with a negative cumulative cash flow;
Variable B:  is the absolute value of cumulative cash flow at the end of the period A
Variable C:  is the total cash flow during the period after A

To analyze the discounted cash flows, NPV stands out as one of the common techniques used for measuring the projects. In this way the future uncertainty of the cash flows is compensated. This techniques allows the good comparison between the cash flows, hence the net present value is a good factor to analyze the present position of the investment proposals. For two investment proposals the project with higher NPV shall be selected. For the purpose of calculation the discounted rate of 10% is used to discount all the net cash flows to their present value. The same can be observed with the help of the table (Leyman and Vanhoucke, 2016).

Project Aspire
Calculation of Net present Value	Years	Cash flows	Discounting Factor @ 10%	NPV
	0	-2250000	1.00	-2250000
	1	623000	0.91	566930
	2	665328	0.83	552222
	3	664403	0.75	498302
	4	699570	0.68	475708
	5	1113063	0.62	690099
	6	-193599	0.56	-108415
Net Present Value				424846

Net Present Value

Project Wolf
Calculation of Net present Value	Years	Cash flows	Discounting Factor @ 10%	NPV
	0	-2250000	1.00	-2250000
	1	847600	0.91	771316
	2	678350	0.83	563031
	3	678384	0.75	508788
	4	678273	0.68	461226
	5	678019	0.62	420372
	6	-169518	0.56	-94930
Net Present Value				379801

From the above analysis it can be found out that the net present value of the Project Aspire is better than the net present value of the Project Wolf. But this single factor lone cannot help in deciding whether the project shall be accepted or rejected or not. The other factors must also be considered to determine which proposal shall be included.

The internal rate of return is the accounting rate which is basically achieved when the project is at breakeven. The investors invest in the project on the basis of the internal rate of return because this rate reflects what amount in return the investor is going to get. The decision to choose the investment is based upon IRR greater the cost of capital. The higher the IRR the more attractive the project is.  In order to calculate the IRR the following method can be used to present the IRR (Bornholt, 2017).

Calculation of IRR	Cash flows (Aspire)	Cash flows (Wolf)
	-2250000	-2250000
	623000	847600
	665328	678350
	664403	678384
	699570	678273
	1113063	678019
	-193599	-169518
IRR	16.8%	17.0%

The payback period of the company is the most simplest and the easiest tool to work upon which does not entertain the concept of the time value of money. The majority of the investors use the concept of the IRR to evaluate the decision, whether to accept the proposal or reject the proposal. IRR is commonly used to determine the attractiveness of the project especially if company is looking for the proposals which have fast turnaround times (Mukherjee, Al Rahahle and Lane, 2016).

Calculation of Payback Period	Cash flows Aspire	Cumulative Cash flows	Cash flows Wolf	Cumulative Cash flows
	-2250000	-2250000	-2250000	-2250000
	623000	-1627000	847600	-1402400
	665328	-961673	678350	-724050
	664403	-297270	678384	-45666
	699570	402301	678273	632607
	1113063	1515364	678019	1310626
	-193599	1321766	-169518	1141107
		3.42		3.07

From the above analysis it can be figured out that the payback period after calculating the cumulative cash flows of the project Aspire and project Wolf is 3.42 years and 3.07 years respectively. The Wolf project has more capacity than the Aspire project. This certainly doesn’t mean that the Aspire project is bad and shall not be selected the Aspire project though is going to recover the cost a little later yet it can be chosen on the basis of the net present value and internal rate of return if combined in taking the overall decision (Robinson and Burnett, 2016). 

In this section the interpretations and the recommendations are clarified to the directors of the AYR co. on which proposal shall be selected.

Summary of findings
Project	NPV	IRR	Payback Period
Project Aspire	$424,845	17%	3.42 Years
Project Wolf	$379,801	17%	3.07 Years

From the overall analysis the Project Aspire is considered as the most viable option in contrast to the project Wolf because of the following reasons which have been outlined below. The selection depends upon the basis of the Net present value, IRR and the payback period (Nazir and Javaid, 2018).  

Internal Rate of Return

Net Present value: The project Aspire has the highest Net present value as compared to the Project Wolf this is because the project Aspire is utilizing the fewer costs than the project Wolf. Amongst any two projects the one with the higher NPV is selected and therefore the Project Aspire is selected. The project Aspire will add more benefits however the decision alone cannot be taken (Fracassi, 2016).

IRR: Internal rate of return is the rate at which the project shall be accepted or rejected when the cost of capital is less than the rate of return. Since the IRR is almost same and therefore the decision remains indifferent between two persons. But when compared along with the Net Present Value the project Aspire is the right choice for the company and hence it can generate greater cash flows than the project Wolf. On the contrary the Project Wolf can also be considered just on the basis of the IRR and this can also add more value to the AYR Co. hence, overall conclusion will fall in favor of the Project Aspire only (Ehrhardt and Brigham, 2016).

Payback Period: Lastly in terms of the payback period the Project Wolf is ahead of Project Aspire as the number of days the investment can recover the cost of investment in 3.07 years whereas in case of the Aspire project the payback period is 3.42 years. Under this situation the project Wolf is recommended to the AYR Co. as it will recover the cost of investment in the faster manner. The project Wolf might be a fruitful one but the Project Aspire is the most desirable choice in terms of the overall selection of the proposal (Pham and Alenikov, 2018).

The strategy plays an important factor determining the selection of the proposal and the acceptance. This usually occurs when the product breaks the sales of another product. If such case arises for the Project Aspire it is recommended to the directors of the company to entertain the Wolf project more as it appeal to the different categories and while the Aspire project is used to fulfill the expectations of the existing customers. In such a case the desirability of the project will increase and will be favorable for the company. Such strategies will define the right choice that fits the resources of the company.

Personnel also play a vital role in selection of the proposal and the situations differ accordingly. In case of the AYR Co. has experts and the skilled people or they have the capacity to enjoy the wider options in the market. The non-financial factors shall also be considered (Harris, 2018).

Payback Period

The culture and system of the company can interfere the performance of the company in many ways. This may also leads to the either the enhancement in the performance or the declining in the performance of the company. If undertaking the Aspire project by the company can lead to the interference of the culture and the values possessed by the companies on the basis of say the method of the communication than the company can make the changes accordingly and decide. It is the duty of the management to take all the possible alternatives before making any capital investment decision. Therefore it is advised to the management of the AYR Co that it shall analyze the effects of the investment proposal before spending the funds.

The economic and the political factors are also critical from the point of view of the management. The interest rates and the taxes can affect the performance the company that may also give rise to inflation (Michiels and Molly, 2017).

The ethical practices and the environmental concerns are the major reasons that are to be analyzed because it can possibly effect the financial option the company is going to adopt. This suggests that the management shall supervise the changes happening in the external as well as the internal environment (Frank and Shen, 2016).

In this particular phase of the report the methods of the financing are being discussed by the AYR Co. The methods are classified into the Equity financing and debt financing. Under the equity financing the new shares are issued to the general public whereas in debt financing the money is borrowed from the third party (Chod, 2017).

Intended financing sources for AYR Co.
Capital employed	$million	% per source
Equity holder funds	20	52.63
Long term debt	18	47.37
Total	38	100

Equity financing is considered as the basic method of raising the capital of the company by selling of the shares. Under this process both the shares are involved that is the common shared and preferred shares as well as share warrants. Therefore is the AYR Co. choses this option then the company can sell the unsold shares if there are any to the shareholders. Also one fact shall be considered by the AYR Co. that if the company agreed on selling shares to the investors ot means that the company is also selling the ownership to the investors and in return the investors will demand for a smooth return against the investment made in the company. Therefore before entering into the Equity financing option the company must rethink the idea as investors are not only going to share the profits but they have the right in deciding how the business shall run on work upon. So, the entire process depends upon the choice of option and its consequences after implementation (Graham, Harvey and Puri, 2015).

Analysis of Investment Proposals

The other option that is available for the AYR Co.is the debt financing where the company can borrow money from the third party which may include banks, financial institutions or other lenders. This process may also involve the company to use the bonds notes and the other agreements with the lenders. Here the company needs to pay a fixed income in the form of the interest cost from whom the money is borrowed (Foley and Manova, 2015).

On the basis of the analysis it is recommended that the company shall sell their shares rather than paying the fixed income in the form of the interest cost which will only increase the liabilities on account of the AYR Co. and this can also lead to the increase in the financial leverage (Serfling, 2016).

The equity financing is more expensive and complex than the debt financing which gives the benefit of the deduction of the interest payments as tax deduction (Öztekin, 2015).

In equity financing the cost of the equity is also associated with the higher risk. The investors on one hand expect a smooth return from the company’s side whereas the management on the other hand expects the investors to invest high amount of funds in the company. So this is the two way concept. For instance if the company is bankrupt the investors had to lose all the money. Also this situation can  create loss for the company as well when the money is borrowed from the debt lenders as if the company goes bankrupt the first hand will be of the debt holders. Further if analyzed only a fixed income needs to be paid by the company for which the tax advantage is also available hence the company shall opt for the debt financing rather than the equity financing (Drover, et al 2017).

AYR Co. shall in detail decide the procedure of how well the company can finance the money with the available options after taking into consideration the past as well as the current performance of the company. However, whatever choice the company makes it has a direct effect on the weighted average cost of capital of the company.

The scenario will be such that if the company wants to choose the equity financing the company may face an increase in the cost of the capital due to increase in share whereas of the debt financing is the option of the company there may be a reduction in the cost of capital due to the increased size of the cheapest source. Not only this, AYR Co. shall also analyze the rate of interest that will directly affect the annual cash flows generated (Klasa, Ortiz-Molina, Serfling and Srinivasan, 2018).

Summary of Findings

There are two major sources of financing, namely the debt and the equity. In general these two options affect the ownership and the profitability of the business which in fact affects the shareholders and the investors of the company as well. In case if the equity financing the shareholders which have the shares at present are diluted if they haven’t purchased any new shares, whereas in case of the debt financing the liability increase on part of the management as the fixed amount is kept aside in case of the interest income to be paid to the debenture holders. Though the process may not have the direct impact on the shareholders yet it touches the overall concept of the liability (Miller and Skinner, 2015).

Conclusion

From the overall analysis the investment proposal that shall be selected is the Aspire one in contrast to the Wolf project. The following reasons were mentioned above and discussed in detail however the Aspire showcased its best ability to fit within the requirements of the AYR Co. The project has the real ability to pay back the proposal within the time period given. Furthermore the internal rate of return is also more than the cost of capital as the Aspire has the ability to generate the enough cash flows than the Wolf. Though the choice recommended to the company is Aspire yet it is sensitive to certain number of factors such as culture, strategy, environmental concerns and ethical concerns associated with it. Therefore on the final level the AYR Co. shall choose the Aspire. The sources of the finances are also analyzed that affect the cash flows such as the expected return, risks in the market and the ownership. The debt financing is advised over the equity as the debt is the more cost effective option rather than the equity.

References 

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