Calculation Of Payback Period, Accounting Rate Of Return And Net Present Value

(The details calculations are shown in the excel file)

The net present value of any project is the difference among the present value of cash inflows and present value of cash outflows. The NPV is utilized in the capital budgeting to analyze the profitability of any projected investment or the project. It is also used to take the decisions regarding whether any asset shall be purchased or not (Baum and Crosby 2014). When the discounted cash inflow is more than the cash outflow, the NPV is positive. It is recommended that if any asset has positive NPV, the asset can be considered for purchase. In the given circumstance, the net present value of the cash inflow with the 7% cost of capital is £ 57,402,764.10 and the initial cash outlay is £40,000,000 for the purchase of the machine. As the investment is giving the positive NPV amounting to £17,402,764.10, it is recommended to purchase the machine.

The major techniques that are used for investment are –

• Accounting rate of return
• Discounted cash flow
• Payback period
• Sensitivity analysis and investment risk.

• Enable to take quick decisions as the information are available with better availability
• Greater production quality and flexibility (Upton et al. 2015).
• Improves the image of the company, job satisfaction, better staff morale that leads to greater productivity
• Faster pace for the time-to-market that leads to gain bigger share of the market
• The investment appraisal techniques are simple and easy to use
• Easy to understand and takes into account the time value of the money

• Under the payback period method all the  cash flows of the project are not taken into consideration and biases are there towards the short-term investment with the shorter PBP that ignores the cash timing (Eliasson and Börjesson 2014)
• With regard to the profitability index it ignores the scale or size of the project
• With regard to discounted payback period cash flows that fall beyond the payback period are not taken into consideration. Further, no objective criteria are specified for making any decision.
• With regard to the internal rate of return, the problems arise with regard to non-conventional flow of cash, timing of the cash and size of the project (Willcocks 2013).
• With regard to the average accounting rate of return, the AARR is just a ratio and it ignores the market value or the time value of money and are focussed only on the historical figure.

• Bank borrowing – loan is the form of finance taken from the bank in terms of payment of interest that is paid on with the instalment. The main advantage of bank loan is the repayment can be made in instalment rather than paying the full amount at a time. However, the main limitation of bank loan is the approval of the loan is depended on the credit score of the company (Almarri and Blackwell 2014)
• Debentures – the finance can be raised through issuance of debentures and it is a form of loan only. The main advantage of raising finance through debentures is that the finance can be obtained immediately and can be redeemed after specified period. However, the limitation is that at the time of repayment the borrower will have to repay it along with the specified rate of interest.
• Factoring debts – under factoring the debts of the company can be sold to factor or the special factoring team to sell their debts and get immediate recovery in exchange of some immediate payment to the factor (Gotze, Northcott and Schuster 2016). The main advantage of this is that the organization does not have to worry about the collection of debts and the debt amounts are realized immediately. However, the limitation is that the factor charges commission for his service and sometimes the charges are quite high.

Reference

Almarri, K. and Blackwell, P., 2014. Improving risk sharing and investment appraisal for PPP procurement success in large green projects. Procedia-Social and Behavioral Sciences, 119, pp.847-856.

Baum, A.E. and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.

Eliasson, J. and Börjesson, M., 2014. On timetable assumptions in railway investment appraisal. Transport Policy, 36, pp.118-126.

Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. SPRINGER-VERLAG BERLIN AN.

Upton, J., Murphy, M., De Boer, I.J.M., Koerkamp, P.G., Berentsen, P.B.M. and Shalloo, L., 2015. Investment appraisal of technology innovations on dairy farm electricity consumption. Journal of dairy science, 98(2), pp.898-909.

Willcocks, L., 2013. Information management: the evaluation of information systems investments. Springer.