Capital Budgeting: Investment Appraisals Of Payback Period, Accounting Rate Of Return, Internal Rate Of Return, And Essay. (70 Characters)

Dsicuss about the Investment Analysis and Portfolio Management.

The main objective of the report is to focus on the aspect of capital budgeting and discuss various investment appraisals like payback period, accounting rate of return, internal rate of return and net present value. The report will further compare among net present value and payback period to measure financial viability of project. The report will take into consideration 2 given projects that is G120 and Z125. Finally the report will consider another project that is new build engine plant to analyse whether it will have impact on the investment decision of G120 and Z125 (Temper and Martinez-Alier 2013).

Capital budgeting is the step by step procedure used by the business for determining the acceptability of investment project. Generally the main objective of the business is to earn profit. The process of capital budgeting is the measurable way for the business to determine long term financial and economic profitability of investment project (Burns and Walker 2015).

• The process of capital budgeting helps in determining long term financial and economic profitability of investment project
• It helps in estimating future cash flows that is creation of business value over the period of time (Grob 2013).
• Though the capital budgeting process the company is able to take decision regarding whether the project is acceptable or shall be rejected.

• Decisions regarding capital budgeting are generally of long-term nature that is not certain. Even if the management takes complete care it is not possible to take 100% certain and correct decisions. Therefore, the analysts must be analytical while taking decisions.
• The finance manager may face issues regarding measurement of benefits and costs of the project with quantitative terms. For instance, the projection of costs and benefits may change after new product launch of the company (Rossi 2014).

Payback period determines the time length required for recovering the project’s initial cash outflow. It is the method used for calculating the time in which the cost incurred for the investment is earned back through successive cash inflows. The formula used for computing the project’s payback period when the cash flows are even is = initial investment / cash inflow per period. On the other hand, if the cash flows are uneven the payback period = A + B/C, where, A = last period with the negative cumulative cash flow, B = absolute value of the cumulative cash flow at the end of A and C = Entire cash flow during period A. Generally, the project is accepted if the payback period is lower than the target for payback period (Militaru 2016).

Various advantages of payback period are as follows –

• It is quite simple and easy to calculate the payback period
• For the entities those are facing issues regarding liquidity can rank their projects as per the payback time of return
• Payback period can be used as a measure for measuring the inherent risk of a project. As the projects with longer payback period are considered as uncertain, it provides the indication regarding the certainty of project cash flows (Gorshkov et al. 2014).

From the given situation of projects G120 and Z125 it can be observed that payback period for project G120 is 2 years 10 months whereas the payback period for project Z125 is 3 years 8 months. Therefore, if only the payback period is considered G120 shall be chosen as it has lower payback period.

Accounting rate of return is used under capital budgeting method for estimating whether to accept the project or reject it. It is computed through dividing the annual average accounting profit by initial investment. ARR enables the companies to analyse the profitability and basic viability of the project based on the projected revenue reduced by initial investment (Damodaran 2016). This method can be used for quick computation of any project’s viability specifically if the project is compared with any other project. However, the major disadvantage of using ARR is that it does not consider taxation, accrued interest, cash flows, inflation which in turn makes ARR poor method while planning for long-term project (Borodin and Chentsov 2016).

Accounting Rate of Return

  Various advantages of ARR are as follows –

• ARR recognizes the net earnings concept that is the earning after depreciation and tax. This concept plays important role for the appraisal of investment proposal.
• It is quite simple and easy to calculate the accounting rate of return
• It helps in comparing the new project with the project that reduces costs and any other competitive project (Thamhain 2014)
• Only the ARR approach takes into consideration accounting concept of the profit to calculate the return rate. Further, the accounting profit can readily be computed from accounting records.
• This method can be used for measuring the company’s current performance.
• This method can also be used for satisfying the investors and owners interest as they are more interested in return on their investment (DeFusco et al. 2015).

From the given situation of projects G120 and Z125 it can be observed that the accounting rate of return for project G120 is 18.0% whereas the accounting rate of return for project Z125 is 14.7%. Therefore, if only the accounting rate of return is considered G120 shall be chosen as it has higher accounting rate of return as compared to Z125.

NPV is present value of cash flows at required return rate for the project under consideration as compared to its initial investment. Analysis of NPV is an intrinsic valuation form and it is extensively used for accounting and finance to determine the business value, capital project, investment security, cost reduction projects, new ventures and any other approach that involves cash flow. NPV is used to determine the worth of investment or cash flow (Gallo 2014). It is considered as an all encompassing measurement as it considers all the accounting metrics like expenses, revenues, associated capital costs with investments and free cash flows. Positive NPV indicates that the estimated earning that will be generated by the project will exceed the amount of initial investment and associated costs. Normally, the investment with positive NPV is considered as profitable and acceptable. On the contrary, the investment with negative NPV is not considered for taking up (Pasqual, Padilla and Jadotte 2013).

Various advantages of NPV are as follows –

• It takes into consideration the time value of the money
• While calculating NPV both before cash flow as well as after cash flows over the useful life of the project are taken into consideration.
• NPV assists in maximising the value of the firm
• Risk and profitability of the treated with high priority.
• NPV method can be used for direct measurement of dollar contribution to stakeholders (Žižlavský 2014).

From the given situation of projects G120 and Z 125 it can be observed that both the project has positive NPV. The NPV for project G120 is £ 284,864 whereas the NPV for project Z125 is £ 420,194. Therefore, if only the NPV is considered as selection criteria for the projects Z125 shall be chosen as it has higher net present value as compared to G120.

IRR metric is used under capital budgeting for estimating the profitability for the potential investment. IRR is the discount rate that makes NPV of entire cash flows of the specific project equal to ‘0’. Calculation of IRR is based on the same formula used by NPV. Generally, the project with higher IRR is preferred over the project with lower IRR. As IRR is uniform for different types of investments it can be used for ranking various projects on relative basis. If the IRR of the project is more than its capital cost, the project is considered as acceptable as it will generate profit from the project (Harrison and Lock 2017). While planning the project, generally the company sets up required rate of return (RRR) for determining the project’s acceptability. Therefore, the IRR of project that exceeds the RRR will be acceptable. However, the IRR can further be compared with the prevailing return rate under the securities market. Therefore, if the analyst finds that the IRR of the project is more than the returns that can be gained from the financial market the project is considered as acceptable (Guerard Jr 2013).

Net Present Value

• Most attractive factor regarding IRR is that it is simple and easy to calculate and interpret the IRR. Further, it is easy for the managers to visualize the acceptability of the project when they have to choose any mutually exclusive projects.
• Another important factor of IRR is that it takes into consideration the time value of money factor while analysing the project. This fact is widely lacked in other methods like accounting rate of return.

From the given situation of projects G120 and Z125 it can be observed that both the projects IRR is greater than the cost of capital that is 15%. The internal rate of return for project G120 is 25% whereas the internal rate of return for project Z125 is 20%. Therefore, if only the internal rate of return is considered G120 shall be chosen as it has higher internal rate of return as compared to Z125.

Payback period is the simplest technique to use for analysing the alternative investment projects. With the payback method the investor can be informed the time when the amount of his initial investment will be recovered. Payback period term is referred to the time required by the capital project for recovering initial invested amount and associated cost of the project. Core idea for the payback period is to assess the risk associated with the project (Lane and Rosewall 2015). Longer the time taken by the project to recover the initial investment higher is the risk associated with the project. On the contrary, if the payback period is lower the project is considered as less risky. Further, payback period can be used for analysing the liquidity risk. If the company is facing short term liquidity issues project with shorter payback period can solve the issue as the cash that will be received from the project can be used to enhance the short term asset position. Therefore, the risk averse investor will prefer the project with lower payback period.

While evaluating any particular project the managements shall takes into consideration that the project shall maximize the shareholders wealth through higher NPV. For maximizing the shareholder’s wealth, time value of money, magnitude of the cash flow and risk associated with the cash flows shall be considered. Cash flows derived from the project are discounted at the rate of capital cost to bring those at present value. Rate of the discount at which the cash flows are discounted is minimum return rate required for compensating shareholders (San Ong and Thum 2013). From the perspective of the company discount rate shall be equal to the capital cost while from the investor’s perspective the rate of discount is required rate of the return from the project. If the main objective of the company is to maximize the shareholder’s wealth project with highest NPV shall be chosen. NPV is the method that is used to measure the project’s contribution towards shareholders value. Therefore, when the company prefers to maximize the wealth of the shareholders over other factors they must chose the project with higher NPV.

Internal Rate of Return

Whether the company will chose the project with lower payback period or with higher NPV it depends on their personal preference. If the company is facing liquidity risk or for any other reasons it requires cash within shorter span of time it will prefer the project with lower payback period. On the other hand, if the company’s main objective is to maximize the wealth of the shareholders it will prefer the project that will give higher NPV as compared to the project with lower NPV.  Therefore, the project selection is ultimately depends on the individual preference and insight.

Many companies use IRR for measuring the success of project. However, various technical issues as well as general issues are there with computing IRR in excel that shall be taken care of. These issues are as follows –

• Multiple return rates – If the cash flow is positive IRR will have more than one result and only the 1^st one will be displayed by excel. In the same way every time there is changes in the cash flows from negative to positive an additional solution for the IRR is generated and again excel will display only the 1^st one that it finds. Further, if the excel is required to go through more than 20 iteration for finding out IRR, it will display #NUM! Error. General rule where the patterns of cash flows are changed more than once the user will find more than one IRR. Therefore, these numbers are not accurate completely. This takes place owing to mathematical error of complex formula. In such cases, NPV is better choice as compared to IRR (Gotze, Northcott and Schuster 2016).
• Multiple rate of discount – even if cash flow does not change in middle of project computation of IRR will still be difficult for computing and implementing. Therefore, for using the IRR the user have 2 choices – (i) IRR and discount rate shall be calculated in each year and make the decisions accordingly, or (ii) weighted average IRR can be computed and used for making the decisions (Frank and Keith 2016).

As per the general rule when the cost of capital is equal to the IRR, the net present value of the project is zero. In such situation shareholders will receive their required value however no growth will be there for the company. With increase in NPV the IRR of the project also increases. As it can be seen from the given details that the NPV of project G120 is £ 284,864 and for project Z125 it is £ 420,194 (Noreen, Brewer and Garrison 2014). Therefore, both the project is showing positive NPV that is more than zero. It is possible only when the IRR of the project is more than the cost of capital. Therefore, even if the calculation of IRR is quite difficult, looking into the positive NPV of both the projects the finance director was confident that IRR for both the projects will be more than 15% that is the cost of capital.

From the given details it can be identified that for project Z125 the amount of initial investment was £ 32,32,000 and the resultant net present value of the project was £ 420,194. Therefore, the earnings from the project exceed the initial investment by £ 420,194. Further, the initial investment of the project will be recovered in 3 years 8 months period. 

From the given details it can be identified that for project Z120 the amount of initial investment was £ 11,12,000 and the resultant net present value of the project was £ 284,864. Therefore, the earnings from the project exceed the initial investment by £ 284,864. Further, the initial investment of the project will be recovered in 2 years 10 months period.

Comparison of Investment Appraisals

From the given details it can be identified that for new engine build plant the amount of initial investment will be £ 20,80,000 and the resultant net present value of the project will be £ 140,800. Therefore, the earnings from the project exceed the initial investment by £ 140,800.

Considering the above details regarding project G120, Z125 and new build plant it can be stated that if the management is to choose any one project among G120 and Z125 along with purchasing of new build plant they shall consider various factors like amount of initial investment, net present value of the project, internal rate of return and payback period. If the new build plant is taken up along with G120 requirement for initial investment will be (£ 11,12,000 + £ 20,80,000) = £ 31,92,000. Net present value will be (£ 284,864 + £ 140,800) = £ 425,664. On the other hand, if the new build plant is taken up along with G120 requirement for initial investment will be (£ 32,32,000 + £ 20,80,000) = £ 53,12,000. Net present value will be (£ 420,194 + £ 140,800) = £ 560,994. Therefore, for receiving additional net present value amounting to (£ 560,994 - £ 425,664) = £ 135,330 requirement of additional investment will be (£ 53,12,000 - £ 31,92,000) = £ 21,20,000. In other words, for 32% increase in NPV initial investment will be increased by 66%. Hence, it will be beneficial for the company to invest in the new build plant along with G120 machine. Therefore, if the management has to select only one machine among G120 and Z125 along with new engine build plant they must select G120 as it will increase their profitability as compared to initial investment amount.

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