The importance of investment appraisal

The importance of coronation appraisalInvestment appraisal helps the investors or the financial institutes to identify the attractiveness of any investment funds proposal among different available methods, for instance IRR (Internal aim of Return), NPV ( meshing move over abide by), payback hitch etc. Investment Appraisal is a fundamental body of great Budgeting which is also applicable in the aras where the rejoin may non be quantifiable. Investment Appraisal is historic as because it shows the investors to calculate the out get along of the investment. Further more, with the help of Investment Appraisal the investors so-and-so easily identify the trump or most profitable option among the available alternatives. (Investment Appraisal, n.d.).(b) What is the payback period of from each one confound? If AP Ltd imposes a 3 year maximum payback period which of these regurgitates should be veritable?The payback period is the sequence frame required to recover the investe d step. In the shell of the cash combines with an annuity (same amount in each year), then payback period can be easily calculated by dividing the cost by the annual cash come down. Otherwise we subtract the cash flows from the cost until the remainder is zero. For any sort of investment firms prefer short payback period as the investment can be used someplace else. Gener tout ensembley, firms maintain some maximum allowable payback period against which all investments be compared. It is a touristy method as is quick and easy to calculate and importantly it gives a circular of the liquidity of the project. (Timothy R. Mayes, n.d.)Payback occlusive for range A stratum money FlowCumulative immediate payment Flow1383824280348128450178570248The payback period for Project A= 2+ (115000-80000)/48000= 2+ 0.73= 2.73 yearsPayback Period for Project BAs this is a constant stream of cash flow, the payback period for Project B= 115000/43000= 2.67 yearsBoth the projects can be accepte d, If AP Ltd imposes a 3 year maximum payback. scarcely between these two projects, B will be preferred over A.(c) What are the problems of the payback period?Though the payback method provides real usefulness by providing information on how long pecuniary resource will be engaged in the project it suffers from two primary problemsPayback Period does not consider the time nurture of money In this count, Cash Flows are simply added without discounting. This violates the most canonic principle of financial analysis which stipulates that cash flows occurring at different points can be considered only by and by suitable compounding/ discounting. (V S RAMA RAO, 2008)This measure does not consider a projects profitability. It is just a measure of a projects crown recovery.Though it measures a projects liquidity, it does not indicate the liquidity position of the firm as a whole. (V S RAMA RAO, 2008)The payback period method leads to ignore projects generating substantial cash infl ows in later years. (Sarma, Deepak, nd)(d) Determine the NPV for each of these projects? Should they be accepted explain why?Project AYearCash Flow force out FactorNet Present apprise1380000.89686098734080.722420000.80435962933783.103480000.72139877134627.144500000.64699441332349.725700000.58026404840618.48 measure175459.16So, Profit = Total Inflow- Initial Investment= 175,459.16-115,000.00= 60459.17As the NPV of Project A seems a profitable one (Projects NPV is bigger than the Initial Investment) it can be accepted.Project BYearCash FlowDiscount FactorNet Present Value1430000.89686098738565.022430000.80435962934587.463430000.72139877131020.144430000.64699441327820.755430000.58026404824951.35Total156944.74So, Profit = Total Inflow- Initial Investment= 156944.74- 115000= 41944.74As the NPV of Project B seems a profitable one (Projects NPV is bigger than the Initial Investment), it can be accepted.(e) Describe the logic behind the NPV approach.The cyberspace give in honor (NPV) i s the difference between the stick in value of the cash flows (the benefit) and the cost of the investment (IO)In other words, this is the projected increase in wealth that the shareholders will receive out of any accepted project. All projects with NPV greater than or impact to zero should be accepted. A project with positive Net Present Value means the IRR is greater than the Weighted Average Cost of Capital (WACC).NPV, Net Present Value, allows you to value a companys assets at their correct current value when the accounts are prepared. The calculation of NPV takes into account the assets master cost, less all accumulated depreciation allowed against that asset in previous tax computations.The NPV method is ground on a logical approach. An NPV of zero signifies that the projects cash flows are exactly sufficient to repay the invested uppercase and to provide the required rate of return on that crown. If NPV 0, then the project is generating a larger amount of cash that req uired to service debt and to allow a return to shareholders. So if the firm takes on projects that pee positive net present values (NPV) then the wealth of shareholders will increase, enticing them to increase their investment in the firm.The NPV method of capital budgeting dictates that all independent projects that have positive NPV should accepted. The rationale that is behind that command arises from the idea that all such projects add wealth, and that should be the overall goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher NPV).Net present value is defined as a way to improve the effectiveness of project evaluations through the use of discounted cash flow techniques. To find the present value of a project, you must first find the present value of each cash flow discounted at the cost of capital. Then, sum the discounte d cash flows. If the NPV is positive, accept the project. If NPV is negative, reject the project. It is important to remember that if two projects are mutually exclusive, the project that has the higher NPV should be selected.Net present value is defined as a way to improve the effectiveness of project evaluations through the use of discounted cash flow techniques. To find the present value of a project, you must first find the present value of each cash flow discounted at the cost of capital. Then, sum the discounted cash flows. If the NPV is positive, accept the project. If NPV is negative, reject the project. It is important to remember that if two projects are mutually exclusive, the project that has the higher NPV should be selected(f) Discuss the relationship between NPV and cost of capital.NPV has a plow impact on the capital budgeting decision. These two factors are directly inter-related.NPV NPV = 0 implies IRR = Cost of Capital Provides the minimum return. Probably rejec t from the cash flow perspective. Others factors could be important.NPV 0 implies IRR Cost of Capital Screen in for further analysis. Other investments may provide better returns and capital should be rationed, i.e., go to the most profitable projects. Others factors could be important.(g) Calculate the IRR for each project. Should they be accepted?IRR of Project ANPV at 25%YearCash FlowDiscount FactorNPV1380.830.42420.6426.883480.51224.5764500.409620.485700.3276822.9376Total125.2736Initial Investment115.0000Net Present Value at 25%10.2736NPV at 30%YearCash FlowDiscount FactorNPV1380.76923076929.230772420.59171597624.852073480.45516613621.847974500.35012779717.506395700.26932907418.85304Total112.2902Initial Investment115Net Present Value at 30%-2.70976So, IRR For Project A = 25%+ 10.2736/(10.2736+2.7097) x (30%-25%)=25%+3.95%=28.95%As the IRR of Project A is a positive one, it can be accepted, considering the remaining factors constant.IRR of Project BNet Present Value at 25%YearC ashFlowDiscount FactorNPV1430.834.42430.6427.523430.51222.0164430.409617.61285430.3276814.09024Total115.639Initial Investment115Net Present Value at 25%0.63904YearCashFlowDiscount FactorNPV1430.76923076933.076922430.59171597625.443793430.45516613619.572144430.35012779715.05555430.26932907411.58115Total104.7295Initial Investment115Net Present Value at 30%-10.2705So, IRR For Project A = 25%+ 6390/(6390+102705) x (30%-25%)= 25% +0.29%=25.29%As the IRR of Project B is a positive one, it can be accepted, considering the remaining factors constant.(h) How does a change in the cost of capital affect the projects IRR?The inner rate of return (IRR) is considered as the discount rate that nullify the present value of a particular projects projected cash inflows to the present value of the projects cost (interest rate) or equivalently, the IRR is the rate that forces the NPV to equal zeroThediscount rate often used in capitalbudgetingthat makes the net present value of all cash flows from a pa rticular projectequal to zero. Generally speaking, the higher a projects internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several(prenominal) prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.The logic behind the IRR method isThe IRR on a project is its measured rate of return. If the internal rate of return exceeds the cost of the funds used to finance the project, a superfluous will remain after paying for the capital, and this surplus will accrue to the firms stockholdersTherefore, taking on a project whos IRR exceeds its cost of capital increases shareholders wealth. On the other hand, if the IRR is less than the cost of capital, then taking on the project will impose a cost on current stockholders. It is this breakeven characteristic that makes the IRR useful in evalua ting capital projects.(i) Discuss why the NPV method is often regarded to be superior to the IRR method?The IRR is defined as the discount rate that equates the present values of a projects expected cash inflows to the present value of the projects be (Page 351). Additionally, when dealing with independent projects, the NPV and IRR methods will always yield the same accept/reject result. However, in the case of mutually exclusive projects, NPV and IRR can give conflicting results. One shortcoming of the internal rate of return is that it assumes that cash flows received are reinvested at the projects internal rate of return, which is not usually trueA conflict exists if the cost of capital is less than the crossover rate. Two basic conditions can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR(1) when project size (or scale) differences exist, meaning that the cost of one project is largest than that of the other, or(2) when quantify differences exist , meaning that the timing of cash flows from the two projects differs such that most of the cash flows from one project come in the early years while most of the cash flows from the other project come in the later years (Page 355)The value of early cash flows depends on the return we can earn on those cash flows, that is the rate at which we can reinvest them. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR (Page 355). Because of the above criteria The NPV method is considered as more reliable method than IRR. The best assumption is that the projects cash flows can be reinvested at the cost of capital (Page 355).The IRR is a popular technique primarily because it is a percentage which is easily compared to the WACC. However, it suffers from a couple of flawsThe calculation of the IRR implicitly assumes that the cash flows are reinvested at the IRR. This may not always be realistic.Percentages can be misleading (would you rather earn 100% on a $100 investment, or 10% on a $10,000 investment?)Using both measures gives better results than using either completely. IRR is also useful alone in virtually all time-value-of-money problems.