Investment appraisal is a process which is used by business for assessing the attractiveness of investments or projects by using financing and capital budgeting techniques (Harris, Hoang and Ngan 2017). It is very important as it helps in doing the fundamental analysis of the company by identifying long-term trends. Cost of capital denotes the return that is to be achieved by the company for justifying the cost of the capital project. The cost of capital includes the cost of equity as well as debt. The cost of capital is used in investment appraisal techniques for making the correct decision regarding investment in projects and also for analysing whether the project maximises the wealth of the shareholders or not. Analysis of risk is very important as it helps in analysing and assessing factors that create an effect on the success of the project. Analysis of risk helps in mitigating the risk and also helps in taking decisions whether to proceed with the project or not. Hence, the main aim of this project is to analyse the profitability of the project (Elmassri, Harris and Carter 2016).
Cost of capital is considered to be an important factor for company. Cost of capital has been ascertained by considering the cost of equity capital, preference share capital, and debt capital (Frank and Shen 2016). By using the capital asset pricing model cost of equity has been ascertained and it has been calculated by considering the market value of equity and existing shares with the share price. Based on the calculation cost of equity is 16.8%. The cost of preference shares has been calculated by considering the dividend paid and the price of preference shares of the company. Based on the calculation market value of preference shares is 1 million and the cost of preference share capital is 10%. YTM of bond is the redeemable debt which is based on the concept of bond pricing that indicates that when the price of the bond is more than the par value of bond then YTM of bond is less as compared to the coupon rate of the bond. Based on the calculation redeemable debt is 6.08%. The market value of a non-redeemable bond is calculated by considering issued bonds and the price of each bond and market value of a non-redeemable bond is 2 million. Based on the calculation non-redeemable debt is 6.60%. Therefore, in the calculation of the cost of capital, it has been assumed that the risk of the project is the same as the risk of the company (Johnstone 2016). Based on the calculation cost of capital is 14.13%.
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Details |
Details |
0 |
1 |
2 |
3 |
4 |
|
A |
Initial investment |
8000000 |
||||
|
B |
Working capital |
1500000 |
||||
|
C=a+b |
Total initial investment |
-9500000 |
||||
|
D |
Sales |
6090000 |
9750000 |
12109500 |
7716600 |
|
|
E |
Less: variable cost |
1890000 |
2925000 |
3510000 |
2160000 |
|
|
F=d-e |
Contribution |
4200000 |
6825000 |
8599500 |
5556600 |
|
|
Less: expenses |
||||||
|
G |
Fixed cost |
100000 |
100000 |
100000 |
100000 |
|
|
H |
Professional fees |
50000 |
||||
|
I |
Marketing fees |
60000 |
60600 |
61206 |
61818 |
|
|
J |
Depreciation |
1875000 |
1875000 |
1875000 |
1875000 |
|
|
K=g+h+i+j |
Total expense |
2085000 |
2035600 |
2036206 |
2036818 |
|
|
L=f-k |
Net profit before tax |
2115000 |
4789400 |
6563294 |
3519782 |
|
|
M |
Tax |
423000 |
957880 |
1312659 |
||
|
N=l-m |
Profit after tax |
-9500000 |
2115000 |
4366400 |
5605414 |
2207123 |
|
O |
Add: depreciation |
1875000 |
1875000 |
1875000 |
1875000 |
|
|
P |
Add: scrap value |
400000 |
||||
|
Q |
Add: working capital |
1500000 |
||||
|
R=n+o+p+q |
-9500000 |
3990000 |
6241400 |
7480414 |
5982123 |
|
|
Df @13.98% |
1.000 |
0.877 |
0.770 |
0.675 |
0.592 |
|
|
Present value |
-9500000 |
3500614 |
4804240 |
5051725 |
3544384 |
|
|
Npv |
7400963 |
|||||
|
Irr |
45% |
|||||
|
Cumulative cash flows |
-9500000 |
-5510000 |
731400 |
8211814 |
14193937.1 |
|
|
Payback period |
1.88 |
YEARS |
||||
|
Return on capital employed |
||||||
|
A |
Average annual net income |
3573484 |
||||
|
C |
Average investment |
5750000 |
||||
|
(A-b)/c |
Return on capital employed |
62% |
Net present value method: Companies use this method in investment planning as well as in capital budgeting for ascertaining the profitability of the projected investment. NPV method in project management is used for ascertaining whether the project is worth undertaking or not. In other words, NPV is the difference between the value of cash today and the value of cash in the future. When the NPV of the project is positive then it denotes that the project will be profitable in the future and it will result in financial profit whereas when it is negative then the project will result in net losses and it will not be accepted (Marchioni and Magni 2018). This method is used for making investing as well as operating decisions. There are some advantages and some disadvantages of using a net present value method.
Pros of net present value: While calculating NPV, the life of the project, after cash flow, and before cash flow all are taken into consideration. The time value of money is given much importance and along with that much priority is also given to profitability as well as the risk of the project. This method is also used for maximizing the value of the firm (Magni and Marchioni 2020).
Cons of net present value: When mutually exclusive projects are not equal and the life of projects are unequal then during that time this method does not give accurate decisions. It is very complex to use and calculation of the discount rate is also very difficult.
According to the calculation, the net present value of the project is $7400963. This means that in the future project will generate earnings. Therefore, it is recommended to accept the project as it will be profitable in the future.
Payback period method: Companies use this method for ascertaining investment opportunities. This method helps in determining the time period in which initial investment will be recovered. This method is related to the break-even point of investment. In other words, it is the amount of time needed for an investor to recover the initial cost of the project. It is the quickest and easiest way for assessing investment opportunity and risk (Lane and Rosewall 2015). It is generally expressed in terms of years. When the payback period is shorter then, it is considered as an attractive investment as it means that less time will be taken to reach break-even. The payback period is calculated by the dividend initial cash outlay of the project with the amount of net cash inflow generated by the project each year. There are some advantages and some disadvantages of using a payback period.
Pros of payback period: It acts as a simple risk analysis and it is easy to understand. A quick view of how quickly the initial investment will be recovered is easily ascertained. This method helps in easily analysing two competing projects (Gorshkov, Murgul and Oliynyk 2016).
Cons of payback period: Calculation is done very quickly and easily which makes it overly simplistic. It does not depict the specific profitability as it only shows the length of time taken for return on investment which creates a problem in choosing between two projects. The time value of money is not taken into account as it assumes that money will be worth more today than the same amount in the future because of depreciation.
According to the calculation, the payback period of the project is 1.88years. This means that the initial cash outlay will be recovered within this span of time. Therefore, it is recommended to accept the project as it will be profitable in the future.
Internal rate of return: This method is used for evaluating projects or investments and for estimating the break-even discount rate of projects which denotes projects potential for profitability. When the IRR of the project is positive it means that the project will earn a return and it will add value to the organisation whereas when it is negative it indicates more complicated cash flow which in turn makes this metric less useful (de Souza Rangel, de Souza Santos and Savoia 2016). It is also termed as the discounted cash flow rate of return. While analysing investment it is very common to use IRR in conjunction with NPV. IRR is used by businesses for analysing whether an investment or project will yield benefits in excess of costs or not. Calculation of IRR depends on the same formula as NPV. There are some advantages and some disadvantages of using an internal rate of return method.
Pros of internal rate of return: In the evaluation of the project time value of money is considered and it is interpreted very easily. It does not depend on the hurdle rate which mitigates the risk of doing wrong determination of hurdle rate ((Hazen and Magni 2021).
Cons of internal rate of return: In this method, actual dollar value of benefits that is economies of scale is ignored. Assumption of investment rate is done impractically and contingent projects and different terms of projects are ignored.
According to the calculation, the internal rate of return of the project is 45%. This means that the project will earn a return and it will add value to the organization. Therefore, it is recommended to accept the project as it will be profitable in the future.
Return on capital employed: This method is used for ascertaining the profitability of long-term investment over a period of time. Companies use this method for assessing capital budgeting decisions and investment opportunities. This method enables investors to take decisions on the viability and profitability of capital projects that should be undertaken (Majchrzak and Nadolna 2019). It also helps investors in analysing the risk involved in investment and take decisions whether the investment will yield sufficient earnings to meet the level of risk. There are some advantages and some disadvantages of using the return on capital employed method.
Pros of return on capital employed: This method is very simple and profit is used for ascertaining investment to know the return quickly. It helps in measuring the current performance of the company and it shows the profitability of the investment. Various projects that are of competitive nature are compared easily. For appraising investment decisions this method is used frequently by small-time investors.
Cons of return on capital employed: Cash flows and taxes are not considered as it only takes into account the accounting profit. When a project is made at a different time then this method is not used. The time factor and external factors are ignored and it also does not provide accurate results when different projects are compared (Shrotriya 2019). This method is not suited for long-term projects.
According to the calculation, the return on capital of the project is 62%. This means that the project will earn a return and it will add value to the organization. Therefore, it is recommended to accept the project as it is an attractive investment.
The company should finance the project internally by retaining a part of the profit to pay its shareholders. 0.12 per share of dividend is paid by the company and outstanding shares of the company is 20 million which results in 2.4million of dividend cost. Based on information initial investment is 8 million and if the earnings of the company are retained then it will result in investment reduction which in turn will increase the NPV of the project and will reduce the cost of capital that will arise from borrowing externally.
The company has to consider the nonfinancial costs when determining to undertake a project. The cost can be in the form of the environmental cost, social cost, and ethical cost (Greenberg and Hershfield 2019). The company needs to understand if the project initiation would cause any environmental damage and if so, how can the damage be reduced. In a similar manner, the company should consider the social cost and see if the project does not lead to a loss of livelihood for the local population. The company should also be considerate about the ethical product being made and has no moral or other obligations on society (Almansour, Almansour and Almansour 2019).
Exchange rate risk creates an impact on the feasibility as well as viability of the project as the revenue will be generated by the project in dollar value as well as Euro value. This is due to the reason that goods will be exported by the company to US and the amount will be received in dollar value which will create an impact on the company’s net cash flow of the project as exchange rate impact will be formed in the dollar received. For reducing the risk, the company needs to hedge volatility in the exchange rate and this can be done by using money market hedge, and options contracts. The risk can also be mitigated by following the principles of ERM or by employing other techniques of hedging (Park, Kazaz and Webster 2017). In a money market hedge, the exchange rate can be synthesized by the company by borrowing the amount of dollar receivable and converting it to the spot rate of today to euro. Therefore, the own exchange rate can be created when the value of receivables will be received by the company and it can also be invested. In option contracts, based on the movement of exchange rate the company can buy the option contracts (Królikowska, Sierpi?ska-Sawicz and Królikowski 2019). A company can buy a call option when it is expected that the exchange rate will rise and when the exchange rate is more than the strike price then the option is exercised and it can be sold at the strike price exchange. The option contract will lapse if the strike price is not breached and during that time the exchange rates are lower.
Conclusion
Based on the above discussion it can be concluded that the NPV of the project is positive, the payback period is shorter, IRR is more than the cost of capital and ROCE is also higher so the project should be accepted as it will be profitable in the future. It can also be concluded that sources of finance are used for financing the project and it creates an impact on the valuation of the project. The conclusion can also be made that risk hedging techniques are used by companies for hedging foreign exchange risk. Therefore, on the basis of the discussion, the investment opportunity is considered to be favourable based on the results of the investment appraisal. It can also be concluded that the project is creating long-term value for the shareholders. Based on the above discussion it is recommended to the finance manager undertake the risk analysis as the investment is exposed to risk on the basis of fluctuation in foreign currency and non-financial factors. Hence, the conclusion can be made that the main objective of this project is to maximize the shareholder’s wealth and it is recommended to the finance manager evaluate the feasibility of investment from both financial and non-financial viewpoints.
Reference
Almansour, B., Almansour, Y. and Almansour, A., 2019. Small and medium size enterprise: Access the financial and non-financial factors. Management Science Letters, 9(5), pp.687-694.
de Souza Rangel, A., de Souza Santos, J.C. and Savoia, J.R.F., 2016. Modified profitability index and internal rate of return. Journal of International Business and Economics, 4(2), pp.13-18.
Elmassri, M.M., Harris, E.P. and Carter, D.B., 2016. Accounting for strategic investment decision-making under extreme uncertainty. The British Accounting Review, 48(2), pp.151-168.
Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.
Gorshkov, A., Murgul, V. and Oliynyk, O., 2016. Forecasted payback period in the case of energy-efficient activities. In MATEC Web of Conferences (Vol. 53, p. 01045). EDP Sciences.
Greenberg, A.E. and Hershfield, H.E., 2019. Financial decision making. Consumer Psychology Review, 2(1), pp.17-29.
Harris, E., Hoang, T. and Ngan, G., 2017. Accounting for capital investment appraisal. The Routledge companion to accounting information systems.
Hazen, G. and Magni, C.A., 2021. Average internal rate of return for risky projects. The Engineering Economist, 66(2), pp.90-120.
Johnstone, D., 2016. The effect of information on uncertainty and the cost of capital. Contemporary Accounting Research, 33(2), pp.752-774.
Królikowska, E., Sierpi?ska-Sawicz, A. and Królikowski, M., 2019. Volatility in the Raw Materials Market and Risk Mitigation Methods. In?ynieria Mineralna, 21.
Lane, K. and Rosewall, T., 2015. Firms’ investment decisions and interest rates. RBA Bulletin, pp.1-7.
Magni, C.A. and Marchioni, A., 2020. Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach. International Journal of Production Economics, 229, p.107769.
Majchrzak, I. and Nadolna, B., 2019. Capital budgeting as a management accounting instrument used for planning project activities. Folia Pomeranae Universitatis Technologiae Stetinensis. Oeconomica, 94.
Marchioni, A. and Magni, C.A., 2018. Investment decisions and sensitivity analysis: NPV-consistency of rates of return. European Journal of Operational Research, 268(1), pp.361-372.
Park, J.H., Kazaz, B. and Webster, S., 2017. Risk mitigation of production hedging. Production and Operations Management, 26(7), pp.1299-1314.
Shrotriya, V., 2019. Analysis of Return on Total Assets (ROTA) and Return on Capital Employed (ROCE) of IFFCO Limited.
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