Capital Budgeting Analysis of AP Plc - Case Study Example

Capital Budgeting Analysis The board of directors of AP plc is currently in deliberation on which of five proposed projects to pursue. The company may invest up to £300,000 on any one or a combination of five proposals, details of which are presented in Table 1. Table 1: Proposals, their initial investments, and expected benefitss Proposal Initial Investment (£) Expected net cash inflow or cost savings in the next five years (£) 1 100,000 Nil in the first two years, 73,000 in the final three 2 180,000 66,000 over five years 3 200,000 145,000 in the first two years, none thereafter 4 40,000 16,000 over five years 5 70,000 70,000 over five years Based on incremental analysis, cost savings realized as a result of a business decision is treated as incremental income (Weygandt, Kimmel & Kieso, 2010:299). Therefore for Proposals 2, 4 and 5, the cost savings that benefit the company are treated as cash inflows. The company has set 10% as the minimum expected return, but beyond that they require a method of determining which proposals to approve within the constraints of the available fund. 1. Calculation of payback period, NPV and IRR for each proposal 1.1 Payback Period Method The payback period is the number of years needed to recover the initial investment (Groppelli & Nikbakht, 2006:157; Needles, Powers & Crosson, 2008:1259). This method involves a straightforward calculation that does not take into account the time value of money or the cost of capital. Cash benefits are merely added up until the initial investment is recovered. For the final year of recover, for calculation purposes the cash inflow is assumed to be evenly distributed throughout the year, such that the remaining unrecovered portion of the initial investment may be computed pro-rata to determine the fractional portion of the year. The calculation of the payback period for each proposal is shown in the following Tables 2 to 6. Table 2: Payback period calculation for Proposal 1 Table 3: Payback period calculation for Proposal 2 Table 4: Payback period calculation for Proposal 3 Table 5: Payback period calculation for Proposal 4 Table 6: Payback period calculation for Proposal 5 1.2 Net Present Value Method (NPV) The net present value, or NPV, method is anchored upon the discounted cash flow, or DCF, technique (Brigham & Ehrhardt, 2008:380). This technique takes into account the time value of money, with the discount rate being specified or assumed at the beginning in order to carry out the discounting calculations. The NPV is arrived at by finding the present value of all future cash inflows based on the specified discount rate, to the time when the initial investment is incurred. The initial investment is thereafter offset against the present value of the future cashflows, and the result is the net present value of the proposal. The NPVs are calculated for each proposal in the following Tables 7 to 11. The firm’s requisite 10% rate of return is used as the discount rate for the calculations. The present value is arrived at by multiplying the cash inflow by the discount factor for 10% and the number of years in the future. Table 7: NPV calculation for Proposal 1 Table 8: NPV calculation for Proposal 2 Table 9: NPV calculation for Proposal 3 Table 10: NPV calculation for Proposal 4 Table 11: NPV calculation for Proposal 5 1.3 Internal Rate of Return (IRR) The internal rate of return is the discount rate that causes the present value of the cash inflows of the investment (in this case, of the proposal) to be equal to the initial investment on the project (McAllister, 2009:663). Seen another way, the IRR is defined as “the discount rate that forces the projects of NPV to equal zero” (Brigham & Houston, 2007:363). The IRR is computed using an iterative method, where an originally estimated return is worked out in a series of net present value calculations and adjustments thereon made, until an NPV equal to or as close as possible to zero is reached. The following Tables 12 to 16 show the IRRs obtained for the five proposals, showing the initial investment as a negative cash flow in the present (year = 0). The table shows the final test calculations for the NPV, which should be equal to or very close to zero. The PV is calculated to three decimal places, while the computed IRR is shown up to four decimals places, in percentage. Table 12: IRR calculation for Proposal 1 Table 13: IRR calculation for Proposal 2 Table 14: IRR calculation for Proposal 3 Table 15: IRR calculation for Proposal 4 Table 16: IRR calculation for Proposal 5 2. An assessment of the proposals, with a view to advising the directors of the criteria applicable in ranking the investment proposals The payback period is the estimate of the time duration until recovery of the initial investment. In business, the recovery of the capital investment is important in that such capital may be allocated for other investments, and any cash inflows realized thereafter already forms the net benefits of the project. The criterion therefore for assessing projects through the payback period is that the shorter the payback period, the higher it ranks among the alternative proposals (Needles, Powers & Crosson, 2008). Table 17: Payback period calculation summary and ranking (Initial investment in £) Table 17 preceding shows the proposals in order of ranking, with the proposal with the shortest payback period ranked highest and that with the longest ranked lowest. Their respective payback periods and initial investments are also shown. Inasmuch as the total funds that may be invested amounts to only £ 300,000, this limit acts as a constraint on the number of proposals that may be accepted. In Table 17, Proposals 5 and 3 are the top two ranked proposals based on payback period, and their initial investments total £ 270,000. Proceeding to the third project brings the total investment to £ 310,000, which exceeds the available funds. Therefore, only Proposals 5 and 3 are actually accepted under the payback period method. Table 18 following shows the ranking of the proposals based on the NPV criterion, which favours the proposals with the higher valuation. The NPV was arrived at using the management-specified rate of return of 10%. Thus, the minimum acceptable value for the NPV should be zero, since this is the point at which the cost of the project is recovered, taking into account the time value of money (Brigham & Ehrhardt, 2008). All five proposals have positive NPVs, therefore all are acceptable had there been sufficient funds. Table 18: NPV calculation summary and ranking Applying the £ 300,000 constraint, only Proposals 5, 2 and 4 may be accepted, with the total investment amounting to £ 290,000. While Proposals 3 and 1 are ranked higher than Proposal 4, they could not be accepted as their initial investments would entail funds the firm could not afford. Proposal 4 requires an investment that, when added to those of Proposals 5 and 2, still comes within the constraint. Therefore, rather than have the remaining (after Proposals 5 and 2) £ 50,000 merely idle and unproductive, Proposal 4 may as well be accepted, since it comes within the 10% rate of return minimum limit of the investors. Finally, Table 19 following shows the ranking based on the IRR method, with the higher IRR proposals being more attractive than those with lower IRR. As criterion for determining proposals acceptable for investment, the IRR higher than the specified minimum rate of return is considered acceptable (Polimeni, Handy & Cashin, 1994:157). In the ranking shown, all proposals have IRRs higher than the requisite 10%, therefore all proposals are acceptable per criterion. Table 19: IRR calculation summary and ranking The maximum investment constraint is now applied, limiting the proposals to be accepted to a total investment of only £ 300,000. Proposals 5 and 3 may thus be accepted, however Proposals 4, 2 or 1 may no longer be accepted, as the inclusion of any one of them will bring the total initial investment to beyond the constraint criterion. 3. Other factors which the directors may wish to consider before coming to final conclusion. There are many other factors which the directors may factor in which are not part of the considerations inherent in the quantitative method. For instance, the risks associated with the different proposals should also be considered by the decision makers, such as projects that are situated abroad or that utilize raw materials the supply of which is not regular or steady. The level of technology used by a proposal is another consideration, with some technologies either passing into obsolescence while others possibly being at an experimental stage. The level of expertise and the availability of this expertise that is associated with a proposed project is another consideration, as manpower skills may be an operational constraint. Even without these extraordinary considerations, when a product line is new, it is possible that the necessary discount rate or future cash flows would be too uncertain to predict at the beginning. 4. Reasons for the relative popularity of the IRR, and for the superiority of the NPV method Polimeni, et al. (1994) views the IRR as having several advantages over other capital budgeting methods that make it a popular unit of measuring profitability. Firstly, it acknowledges the time value of money, making it a more realistic method for the assessment of investment alternatives in terms of today’s financial considerations. Secondly, it recognizes income over the entire duration of the project, thus taking into account the full benefit the project affords the firm. Thirdly, it is expressed as a percentage return, making it more easily comparable to the returns of other financial investments and the costs of capital, which are quoted in percentage. One may say also that in the case of the IRR, there is no need to assume a theoretical or benchmark rate of return by which to discount the cash inflows, an advantage it enjoys over the NPV. There is, however, a disadvantage in using the IRR. It assumes that earnings realized in the interim are also invested at the internal rate of return, which in most cases would exceed the prevailing interest rate for that class of investment (Polimeni, Handy & Cashin, 1994:157). This weakness is not evident in the case of the Net Present Value. The advantage of the NPV is that as long as a desirable or standard rate of return is identified with certainty (that is, the discount rate is more than just a theoretical assumption), then there is no need to assume that the interim returns from the project are invested at an equally high rate of return (as in the IRR). In the case of AP plc, the minimum rate of return on any approved investment is 10%, therefore it may be stated with certainty that the firm shall be reinvesting interim returns at this discount rate at least, a more realistic presumption than that of the IRR. References Brigham, E F & Ehrhardt M C 2008 Financial Management: Theory and Practice, 12th edition. Thomson Higher Education, Mason, OH Brigham, E F & Houston, J F 2007 Fundamentals of Financial Management, 11th edition. Thomson Higher Education, Mason, OH Gropelli, A A & Nikbakht, E 2006 Finance, Barron’s Educational Series, Inc., Hauppauge, NY McAllister, E W 2009 Pipeline Rules of Thumb Handbook, 7th edition. Gulf Professional Publishing, Jordan Hill, Oxford Needles, B E; Powers, M; & Crosson, S V 2008 Principles of Accounting, Houghton Mifflin Co., Boston, MA Polimeni, R S; Handy, S A; & Cashin, J A 1994 Schaum’s Outline of Theory and Problems of Cost Accounting, McGraw-Hill Weygandt, J J; Kimmel, P D; & Kieso, D E 2010 Managerial Accounting: Tools for Business Decision Making, John Wiley & Sons, Inc., Hoboken, N. J. Read More