Executive Summary
Companies as they grow will face a situation whether to invest in a project or not. In case that the company has chosen a project, the problem will be the method of financing whether to use equity or to use debt.
Concerning the investment appraisal, in this paper, we will discuss investment decision-making process for Trugrit Ltd. We will take into account four methods of investment appraisals. In general there are two types of investment appraisals: traditional and DCF method. Traditional method composes of payback period and average rate of return (ARR) while DCF method composes of net present value (NPV) and internal rate of return (IRR).
According to above appraisals and background information that the company only can choose one project out of four, we suggest that the director should select Project B for the company’s investment target. The reason is due to the project B has the best and most attractive financial information.
The main consideration of selecting project B as the chosen project for the Trugrit Ltd is its net present value (NPV), internal rate of return (IRR). The reason is that the two methods are discounted cash flow (DCF) method that takes into account the time value of money factor.
Understanding Appropriate Recommendation of Investment Appraisal
It has become a common circumstance within growing economy to witness that many companies start their expansion plans in terms of coverage and the number of products/services in order to obtain more revenues and thus profit.
Deciding which plans the companies should conduct is not an easy task since there should be a thorough appraisal so that the company takes appropriate decision and prevents further investment downfall.
Concerning the investment appraisal, in this paper, we will discuss investment decision-making process for Trugrit Ltd. We will take into account four methods of investment appraisals. They are payback period, average rate of return (ARR), net present value (NPV), and internal rate of return (IRR).
In general, the four methods can be divided into two general groups: conventional and discounted cash flow (DCF) methods. The conventional method composes of payback period and average rate of return (ARR) while discounted cash flow (DCF) method composes of net present value (NPV), internal rate of return, and profitability index (PI).
The two methods have both advantages and disadvantages. For example, the conventional method is the fastest way for assessing the capital investment but unfortunately it does not consider the time value of money. While in the discounted cash flow method, although it takes more time than the conventional method for evaluating the capital investment, the inclusion of considering the time value of money makes this method is the most appropriate and acceptable. The reason is money has the time value so we should consider it in our evaluation of capital investment.
Time value of money is basically the concept explaining that, for example, a dollar we receive today is worth more than a dollar we will receive at some point in the future (“Time Value”). The reason is that today’s one dollar can be invested to earn interest within a specific period of time. In addition, inflation exists that will reduce the value of money. Therefore, concept of time value of money involves the relationship between amount of money, a certain period of time, and a certain rate of compound interest.
Concerning the situation, below we provide the four types of investment evaluation in much detail including the formula on how to conduct the calculation.
Payback Period
Payback period is one of the conventional methods that we still witness some companies using it since this method is the simplest one that anyone with enough computing skills can calculate it.
Corporate Finance Live defines payback period as the illustration of the number of time that it takes for a capital budgeting project to recover its initial cost or investment (Mathis 2000). In other words, the payback period tells investors how long it will take to earn back the money they spend on a project (Mathis 2000).
If we assume that the cash inflows occur regularly over the course of the year, we can compute the payback period using the following equation (Mathis 2000):
When choosing project based on payback period method, investors simply choose projects with shorter payback periods since shorter payback period means the projects are more liquid and less risky than ones that give longer paybacks (Mathis 2000).
However, the method also posses some drawbacks since it disregards any benefits that occur after the payback period since the concern of payback period method is to look for any projects that have shorter return in term of the number of year.
In this manner, a project that provides returns $1 million after a six-year payback period is ranked lower than a project that returns zero after a five-year payback and $100,000 return in the sixth year. Most importantly, another drawback that payback period method attains is that it lack of time value of money consideration.
Average Rate of Return (ARR)
The second method of conventional method is the average rate of return (ARR), which explains the profits arising from a project as a percentage of the initial capital cost (“Investment Appraisal” 2005).
The main advantage of ARR method is exactly similar to Payback method that is the simplicity that makes the method is familiar to most project managers since it is relatively easy to understand and is easy to calculate (“Investment Appraisal” 2005).
However, the method has several demerits since it is considered not practical in today’s business environment that demands careful and comprehensive investment analysis. Firstly, the ARR does not take account of the project duration or the timing of cash flows over the course of the project. Secondly, the concept of profit can be very subjective, varying with specific accounting practice and the capitalization of project costs, rendering to different results from business to business. Thirdly, there is no exact signal provided by the ARR in order to help managers decide whether or not to invest (“Investment Appraisal” 2005).
We could calculate the average rate of return (ARR) by using following equation, (“Investment Appraisal” 2005):
ARR = x 100%
Where:
X = average annual revenue within the depreciation period
Y = initial investment during the period
Net Present Value (NPV)
The first method of DCSF is net present value (NPV). This is a useful method since it considers the difference in the value of future cash flows and the cost of raising the capital required for the investment. Projects associated with positive NPVs represent net savings for the organization. Projects associated with an NPV of zero will recuperate only the cost of the capital required to make the investment. Projects associated with negative NPVs represent a financial loss for the organization (Gannon).
We could calculate the net present value (NPV) by using following equation, where CFIn is net cash flow at the nth year after buying the machine, r is discount rate, n is total year of depreciation, and I0 is total investment (Gannon).
NPV = CFI 1 + CFI 2 + . . .+ CFI 3 – I0
(1 + r) 1 (1 + r) 2 (1 + r) n
The decision in evaluating a project by using Net Present Value (NPV) is done by choosing a project with a positive NPV. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted and when comes into situations where several projects all give positive NPV, investors should select the largest one (Gannon).
Internal Rate of Return (IRR)
The second method in DCF is internal rate of return (IRR). This method simply calculates the discount rate at which the Net Present Value (NPV) of a project equals zero (Mathis).
In this method, investors make evaluation based on the value of IRR in which all independent projects with an IRR greater than the cost of capital should be accepted. The highest IRR is preferable for inventors when dealing with many projects as long as the IRR is greater than the cost of capital (Mathis).
Selecting The Right Projects for Trugrit Ltd
In this section, we will provide analysis for Trugrit Ltd concerning which project the company should choose. According to data, currently, Trugrit Ltd has no system of investment appraisal and has asked a management consultant for guidance.
Payback Period
In order to calculate the payback period, we can use the following formula
PBP (Project A) = 1 year and 6 months
PBP (Project B) = 2 years
PBP (Project C) = 3 years
PBP (Project D) = 2 years and 6 months
Based on the theory of payback period as described above, the most attractive project is one having the shortest payback period. It means that project that has shorter payback period ranks higher than one with longer payback period.
Therefore, in terms of Payback period, Trugrit should invest in Project A since it has the shortest payback period, about 1 year and 6 months. By comparing the four projects, it is obvious that in terms of payback period (PBP), the most attractive project is Project A since it provides Trugrit with the shortest time to recover its invested capital.
Average Rate of Return
We could calculate the average rate of return (ARR) by using following equation, where X is the average of annual revenue within the depreciation period, and Y is the initial investment during the period.
ARR = x 100%
By using the above formula, we can obtain the ARR for each investment as following:
- ARR (A) = 100,000 x 100% = 30% 300,000
- ARR (B) = 120,000 x 100% = 40% 300,000
- ARR (C) = 150,000 x 100% = 50% 300,000
- ARR (C) = 60,000 x 100% = 20 300,000
According to theory of ARR, a company should select a project that has the highest profits arising from a project as a percentage of the initial capital cost. Under such circumstances, in terms of ARR, Trugrit Ltd should select project C since it has the highest ARR about 50%.
Net Present Value (NPV)
We could calculate the net present value (NPV) by using following equation, where CFIn is net cash flow at the nth year after buying the machine, r is discount rate, n is total year of depreciation, and I0 is total investment.
NPV = CFI 1 + CFI 2 + . . .+ CFI 3 – I0
(1 + r)1 (1 + r)2 (1 + r)n
By using the above formula, we can obtain the NPV for ach investment as following:
- NPV (A) = 190,000
- NPV (B) = 270,000
- NPV (C) = 240,000
- NPV (D) = (10,000)
According to theory of NPV, when investors face many projects, they should choose the project that has the highest NPV. Therefore, in the case of Trugrit where there are three of four projects having positive NPVs, the company should select the project B since it has the highest NPV that means the company will have the highest net savings from the project.
Internal Rate of Return (IRR)
By using following equation and a trial and error process to obtain the value of IRR, we have IRR for each investment as following:
- NPV (A) = 0 when IRR = 17%
- NPV (B) = 0 when IRR = 23%
- NPV (C) = 0 when IRR = 21%
- NPV (D) = 0 when IRR = 11%
Similarly, when investors face several projects to choose from, they should choose project with the highest IRR. Therefore, in the case of Trugrit, the most attractive project is project B since it provides the company with the greatest IRR value.
According to above appraisals and background information that the company only can choose one project out of four, we suggest that the director should select Project B for the company’s investment target. The reason is due to the project B has the best and most attractive financial information.
The main consideration of selecting project B as the chosen project for the Trugrit Ltd is its net present value (NPV), internal rate of return (IRR). The reason is that the two methods are discounted cash flow (DCF) method that takes into account the time value of money factor.
Conclusion
Selecting the right projects from a pool of proposals demands careful analysis so that the company does not make a blunder. In this paper, we have shown that there are in general two types of investment appraisals: traditional and DCF methods.
Since DCF method provides reasonable and appropriate method for todays’ investment appraisal, therefore, we prefer to IRR and NPV as methods to assess which project a company should select and invest in.
The two methods also become the chosen methods to assess the feasibility of project that Trugrit wants to invest in. The result is that Trugrit should invest in Project B since the project is the best in terms of IRR and NPV among the four available projects.
In today’s business practices, investors or managements often face dilemma. At one occasion, they need to develop their business in order to sustain growth but in the other hand they have limited budget to invest. Under such circumstances, a company should consider loan option or use their own money reserves.
Using debt as the chosen financing method becomes common in business nowadays. This is because the profit generated from sales cannot be used for financing future business like buying new machines since a great portion of the profit is used for daily operational expenses.
In case that the companies have a pile of money, it is acceptable that they do not need to worry about raising funds from outside sources, thus keeping the companies with no debt. But if the situation is vice versa, the companies can borrow money from outside sources but there is a limit to the amount of money a firm can borrow. In short, debt is limited.
According to the case, we find that Trigrit intends to use 12% debenture to fund the chosen project. By meaning, debentures are long term debt that commonly used by large companies to obtain funds to finance their projects.
According to Ross, Thompson, Christensen, Westerfield, and Jordan (2001), long term financing provides capital deficit businesses funds for the period over 1 year. There are some benefits for using long term financing over short term since long term financing has a lower monthly payment (“Benefits”).
The basic sources of long term financing are debt, equity, and derivatives. Meanwhile, types of Long term debt products include debentures, secured and unsecured notes, mortgages, convertible notes, preference shares and many others.
Specifically, a debenture is a long-term debt commonly used by governments and large enterprise to fund their projects. The characteristic of debenture is similar to a bond but the debenture’ securitization conditions are different since a debenture is unsecured because it has no liens or pledges on specific assets.
In addition to debenture, there are several types of long term debt for organization to choose from as following:
- Mortgages from Commercial Banks
- Loans from Financial Institutions
- Private Notes and Bonds
- Industrial Development Bonds
- Publicly Issued Notes and Bonds
In this manner, there should be tools that could integrate ritual processes in capital budgeting, which includes the phases of identification, development, screening and authorization. However, at the same time, the method also pays attention to particular organizational aspects of the process such as current market situation and what action needs to handle it.
In conclusion, while there is obvious that there is gap between theory and practice of capital budgeting or in other words the gap between ritual and reality in capital budgeting, still we found that companies rely on the DCF method for evaluating projects. This is due to the method provide rational and scientific data for appropriate decision making. However, to prevent data collection process from leading to bias decision, the companies should employ scenario planning as suggested by Beck.
Works Cited
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