Investment Appraisal Financial Strategy: Techniques And Evaluation

Business Report

Discuss about the Investment Appraisal Financial Strategy.

The current report aims to evaluate the feasibility of the proposed investment in the context of Motorway Troll Limited. Therefore, the various techniques of investment appraisal have been used to determine the viability of the proposed project. These techniques include “net present value (NPV)”, “payback period (PBP)”, “internal rate of return (IRR)” and “accounting rate of return (ARR)”. In addition, the sensitivity of the project has been evaluation with a rise or fall of 10% in the expected demand. Finally, the report sheds light on evaluating the key benefits and drawbacks of the techniques related to investment appraisal.

To,

The Board of Directors,

Motorway Troll Limited

Date: 17/2/2017

Subject: Feasibility of the proposed investment

The cost of capital and relevant cash flows for the project has been computed based on the provided data (Refer to Appendix, Tables 1, 2 and 3). The corporate tax rate has been assumed as 30% for Motorway Troll Limited. It has been found that the cost of capital for the proposed investment has been obtained as 13%. This has been derived from multiplying the cost of equity and cost of debt with equal weights based on the gearing ratio. As commented by Baum and Crosby (2014), cost of capital is the rate of return, which could be made by investing the same amount into other project with equal risk. In order to arrive at the relevant cash flows, the initial cash flows have been derived by multiplying the estimated number of journeys per year with a price of £10 per journey. After arriving at the initial cash flows, the bid price for operating the toll road has been subtracted from the same each year to arrive at the relevant cash flows (Burns and Walker 2015).

Years	Cash Inflows	Fixed Cost	Tax Rate @30%	Net Cash Inflows	Cumulative Cash Flows
0	-£          1,100,000	£                       –	£                       –	-£          1,100,000	-£                   1,100,000
1	£          1,500,000	£          1,200,000	£               90,000	£             210,000	-£                      890,000
2	£          1,850,000	£          1,200,000	£             195,000	£             455,000	-£                      435,000
3	£          3,500,000	£          1,200,000	£             690,000	£          1,610,000	£                   1,175,000
Payback Period	2.27 years
ARR	69%

Table 4: Payback period and accounting rate of return for proposed investment

(Source: As created by author)

The above table clearly indicates that the payback period for the proposed investment has been obtained as 2.27 years and the accounting rate of return is 69%. In the words of Coleman et al. (2013), the payback period refers to the time length needed to recover the investment cost. Hence, it is a significant determinant for Motorway Troll Limited in deciding whether to progress ahead with the project. The lower the payback period, the greater is the ability of the organisation to recover the amount of investment within shorter timeframe.

Relevant cash flows and cost of capital for investment appraisal in the context of Motorway Troll Limited

According to the case study, it has been observed that the organisation has hurdle payback period of two years with average return on investment of 25%. In this case, the payback period has been slightly higher; however, the value of ARR is significantly higher in contrast to the business expectations. In addition, if the payback period is less than the economic life of the project, it is profitable for an organisation to undertake (Daunfeldt and Hartwig 2014). Thus, from these two techniques of investment appraisal it is feasible for Motorway Troll Limited to undertake the project.

Years	Cash Inflows	Fixed Cost	Tax Rate @30%	Net Cash Inflows	Cumulative Cash Flows
0	-£          1,100,000	£                       –	£                       –	-£          1,100,000	-£                   1,100,000
1	£          1,500,000	£          1,200,000	£               90,000	£             210,000	-£                      890,000
2	£          1,850,000	£          1,200,000	£             195,000	£             455,000	-£                      435,000
3	£          3,500,000	£          1,200,000	£             690,000	£          1,610,000	£                   1,175,000
Net Present Value	£                                                                                                                                                621,716.99
IRR	33%

Table 5: Net present value and internal rate of return for proposed investment

(Source: As created by author)

According to the above table, it has been found that the NPV and IRR of the proposed investment have been obtained as £621,716.99 and 33% respectively. The NPV method denotes the amount of profit that could be realised from a specific investment by considering the cost of capital (Dyson and Berry 2014). The IRR method, on the other hand, depicts the amount of return, which could be expected after the project completion. If the value of IRR is higher than the cost of capital, it denotes the feasibility of the project (Eliasson and Börjesson 2014). In this case, the NPV realised is positive and the IRR value is greater compared to the cost of capital. Therefore, it is viable for Motorway Troll Limited to undertake the project. 

Increase of 10% in expected demand or number of journeys:

Years	1	2	3
Number of Journeys	150,000	185,000	350,000
Increase in journeys	165,000	203,500	385,000
Price per journey	£                  10	£                  10	£                     10
Cash Inflows	£      1,650,000	£      2,035,000	£         3,850,000

Table 6: Initial cash inflows from 10% increase in number of journeys

(Source: As created by author)

Years	Cash Inflows	Fixed Cost	Tax Rate @30%	Net Cash Inflows	Cumulative Cash Flows
0	-£     1,100,000	£                   –	£                      –	-£         1,100,000	-£                    1,100,000
1	£      1,650,000	£      1,200,000	£            135,000	£            315,000	-£                       785,000
2	£      2,035,000	£      1,200,000	£            250,500	£            584,500	-£                       200,500
3	£      3,850,000	£      1,200,000	£            795,000	£         1,855,000	£                    1,654,500
Net Present Value	£                                                                                                                                       997,917.59
Payback Period	2.34
IRR	45%
ARR	83%

Table 7: NPV, IRR, ARR and PBP for the proposed investment with 10% increase in number of journeys

(Source: As created by author)

Based on the above tables, it has been found that NPV of the project is highly positive, while IRR and ARR are higher than cost of capital and average investment return respectively. The payback period is above the expected hurdle payback period of the organisation, which is 2.34 years and the return on investment is 83%, which is much higher than the expected return of 25%. Hence, it is feasible for Motorway Troll Limited to continue with the project under this scenario.

Decrease of 10% in expected demand or number of journeys:

Years	1	2	3
Number of Journeys	150,000	185,000	350,000
Decrease in number of journeys	135,000	166,500	315,000
Price per journey	£                         10	£                  10	£                      10
Cash Inflows	£             1,350,000	£      1,665,000	£          3,150,000

Table 8: Initial cash inflows from 10% decrease in number of journeys

(Source: As created by author)

Years	Cash Inflows	Fixed Cost	Tax Rate @30%	Net Cash Inflows	Cumulative Cash Flows
0	-£            1,100,000	£                   –	£                      –	-£         1,100,000	-£                   1,100,000
1	£             1,350,000	£      1,200,000	£              45,000	£             105,000	-£                      995,000
2	£             1,665,000	£      1,200,000	£            139,500	£             325,500	-£                      669,500
3	£             3,150,000	£      1,200,000	£            585,000	£          1,365,000	£                       695,500
Net Present Value	£                                                                                                                                                   245,516
Payback Period	2.49
IRR	20%
ARR	54%

Payback period (PBP) and accounting rate of return (ARR) for proposed investment

Table 9: NPV, IRR, ARR and PBP for the proposed investment with 10% decrease in number of journeys

(Source: As created by author)

According to the above table, it has been found that it has been found that the value of NPV is positive along with desired IRR and ARR values. The payback period of the project is, however, higher than the expected payback. However, since the payback period is less than the economic project life, Motorway Troll Limited could accept the project.

Advantages of NPV:

• It provides significant stress on the time value of money (Enever, Isaac and Daley 2014).
• In order to compute NPV, both before and after tax cash flows over the entire project life have been taken into account.
• With the help of this method, the gain amount could be realised by deducting the initial investment, which helps in increasing the value of the firm (Götze, Northcott and Schuster 2015).

Disadvantages of NPV:

• This method fails to provide right decisions, in case, there is difference associated with the amount of mutually exclusive projects (Mackie, Worsley and Eliasson 2014).
• Under this method, the effective rate of discount could not be computed.

Advantages of ARR:

• Since ARR is dependent on accounting information, there is no need for special reports to ascertain ARR.
• Since this method is developed on accounting profit, it helps in gauging the profitability of investment (Götze, Northcott and Schuster 2015).

Disadvantages of ARR:

• This method fails to take into account the time value of money.
• ARR does not consider the project terminal value and cash flows from investment (Venables, Laird and Overman 2014).

Advantages of PBP:

• This method places greater concentration on liquidity to make decisions regarding investment alternatives.
• This method deals with risk and thus, projects with shorter PBP are less risky compared to those of longer PBP.

Disadvantages of PBP:

• Like the ARR method, time value of money is not considered
• Due to its greater emphasis on liquidity, it ignores the profitability of a project (Žižlavský 2014).

Conclusion:

From the above discussion, it has been found that the proposed investment would help in increasing the profitability of Motorway Troll Limited; however, the payback period obtained under the normal scenario is below the expectations. Thus, two different scenarios with an increase of 10% and decrease of 10% have been considered. It has been found that increase in expected demand of 10% would help in matching all the expectations of the organisation in the long-run with maximum returns on investment.

References:

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

Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.

Coleman, C., Crosby, N., McAllister, P. and Wyatt, P., 2013. Development appraisal in practice: some evidence from the planning system. Journal of Property Research, 30(2), pp.144-165.

Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.

Dyson, R.G. and Berry, R.H., 2014. Capital investment appraisal. Developments in Operational Research: Frontiers of Operational Research and Applied Systems Analysis, p.59.

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

Enever, N., Isaac, D. and Daley, M., 2014. The valuation of property investments. Taylor & Francis.

Götze, U., Northcott, D. and Schuster, P., 2015. Methods and Models for Appraising Investment Projects Under Uncertainty. In Investment Appraisal (pp. 247-298). Springer Berlin Heidelberg.

Götze, U., Northcott, D. and Schuster, P., 2015. Selected Further Applications of Investment Appraisal Methods. In Investment Appraisal (pp. 105-159). Springer Berlin Heidelberg.

Mackie, P., Worsley, T. and Eliasson, J., 2014. Transport appraisal revisited. Research in Transportation Economics, 47, pp.3-18.

Venables, A., Laird, J.J. and Overman, H.G., 2014. Transport investment and economic performance: Implications for project appraisal.

Žižlavský, O., 2014. Net present value approach: method for economic assessment of innovation projects. Procedia-Social and Behavioral Sciences, 156, pp.506-512.