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).
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 –
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).
Various advantages of ARR are as follows –
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 –
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).
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.
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 –
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.
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.
Reference
Borodin, A.I. and Chentsov, A.S., 2016. Model of the design and investment analysis on the basis of qualitative characteristics. Bulletin of the Udmurt university. Economy series and right, 26(4), pp.11-19.
Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.
Chandra, P., 2017. Investment analysis and portfolio management. McGraw-Hill Education.
Damodaran, A., 2016. Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons.
DeFusco, R.A., McLeavey, D.W., Pinto, J.E., Anson, M.J. and Runkle, D.E., 2015. Quantitative investment analysis. John Wiley & Sons.
Frank, K.R. and Keith, C.B., 2016. Investment analysis and portfolio management.
Gallo, A., 2014. A refresher on net present value. Harvard Business Review, 19.
Gorshkov, A.S., Rymkevich, P.P., Nemova, D.V. and Vatin, N.I., 2014. Method of calculating the payback period of investment for renovation of building facades. Stroitel’stvo Unikal’nyh Zdanij i Sooruzenij, (2), p.82.
Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. SPRINGER-VERLAG BERLIN AN.
Grob, H.L., 2013. Capital budgeting with financial plans: an introduction. Springer-Verlag.
Guerard Jr, J.B., 2013. Introduction to financial forecasting in investment analysis. Springer Science & Business Media.
Harrison, F. and Lock, D., 2017. Advanced project management: a structured approach. Routledge.
Lane, K. and Rosewall, T., 2015. Firms’ investment decisions and interest rates. Reserve Bank of Australia Bulletin. June quarter, pp.1-7.
Militaru, I., 2016. A USEFUL TOOL FOR BOLSTERING INVESTMENT DECISIONS-MODIFIED IRR (MIRR). Romanian Economic and Business Review, 11(4), p.33.
Noreen, E.W., Brewer, P.C. and Garrison, R.H., 2014. Managerial accounting for managers. New York: McGraw-Hill/Irwin.
Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value. International Journal of Production Economics, 142(1), pp.205-210.
Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice. International Journal of managerial and financial accounting, 6(4), pp.341-356.
San Ong, T. and Thum, C.H., 2013. Net present value and payback period for building integrated photovoltaic projects in Malaysia. International Journal of Academic Research in Business and Social Sciences, 3(2), p.153.
Temper, L. and Martinez-Alier, J., 2013. The god of the mountain and Godavarman: Net Present Value, indigenous territorial rights and sacredness in a bauxite mining conflict in India. Ecological Economics, 96, pp.79-87.
Thamhain, H.J., 2014. Evaluating And Selecting Technology?Based Projects. Mechanical Engineers’ Handbook, pp.1-12.
Žižlavský, O., 2014. Net present value approach: method for economic assessment of innovation projects. Procedia-Social and Behavioral Sciences, 156, pp.506-512.
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order formOnce we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignmentAs soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download