The Prime Reason Behind Selecting the IRR Method of Appraisal - Research Paper Example

The importance of capital investment decision cannot be ignored in today’s dynamic economy where every company is striving to earn the best return on its investments. [Abeysinghe, R. L., 2010]. Capital investment can be interpreted as an investment venture of considerable larger amount which is on long term basis and is likely to generate revenue for the company over that particular term. In today’s world, a brief analysis will present the fact that companies have separate departments equipped with experts in the fields of financial appraisal and decision making. The sole job of these financial analysts is to identify whether a particular investment is likely to bring inflow or outflow of benefit to the company. Investment appraisal techniques Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the tradeoff between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different.[ Berkovitch, E., 2010] The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow.[Financial Modelling Guide, 2010] For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several time over the period. The IRR method does not incorporate this fact into calculation, and thus is not suitable for long term investment appraisal. In NPV method the discount rate is known and is singular which makes it easier to evaluate the feasibility of the investment [Investopedia, 2010a] An investment with a negative value represent an unattractive investment where as a positive value represents otherwise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. [Grayson, G., 2010] Based on the discussed fact, NPV method of appraising investment is more practical and precise. Recommendations for decision making While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The case study does not include any relevant information about the price inflation over the five year period which can significantly impact the expected rate of return. The director must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flows in the future for the payment of these finance charges. In order to commence any investment venture, the director must take approval of the shareholders. Although certain investment might appear to be rewarding and worthwhile to invest, do not get shareholders attention that easily. Shareholders, who are often short sighted and tend to ignore the long term feasibility, disapprove the decision of the board based on the fact that the cost of investment will weaken the financial outlook of the organization in the year of the investment. The director while making the investment decision must keep into consideration whether it is of a capital nature or would be reflected in the profit and loss of the company as an expense. Other factors which the directors need to put into consideration are the source of funding for the capital expenditure. In order to finance any project, a company needs to raise capital in the form of revenue funds, short term finance, long term finance, running finance etc. Raising capital can be a significant and crucial task for any company as several technicalities and procedures are involved. It is generally observed in an economic scenario that the company with a good credit history and uplifted financial outlook is likely to raise funds easily as compared to the otherwise. Raising capital significantly affect the gearing of a company. [Saching, 2010] Both modes of financing i.e. equity and debt, comes with their advantages and disadvantages. Several factors, such as statutory rules and requirements, terms and conditions imposed by the counter party and general economic conditions are analyzed before selecting one of the options. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank o financial institution by filing an application for the sanctioning of the loan. The bank or any other financial institution, after evaluating the necessary details such as credit history, financial outlook for assessing the ability of the entity to repay the loans in future, and the purpose of the project for which the loan application was filed, sanctions the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a pre defined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. There is another drawback of raising finances through issuance of equity. There is always an uncertainty that the shares will not be completely subscribed by the public, whenever they are floated in the market, and thus the company would not be able to raise the required funds. Whereas, in the case of loan, the financer usually communicates to the organization about the sanctioning of the loan. In contrast, in equity financing, the company has to wait for a considerable longer period of time for the funds to become available for their utilization. The cost of acquisition of funds, in the form of loan, is quite less if compared to the cost of raising financing through shares or bonds. Initial cost pertaining to the raising of equity financing includes printing of shares, cost of listing of shares on the stock market and professional charges paid to financial advisor for conducting the due diligence of the issuance of shares. Whereas, no or very minimal cost is expended in the acquisition of short term or long term financing. The biggest advantage of financing through shares or bonds is that no subsequent cost arises after the issuance. In case of debt financing, subsequent cost arises in the form of interest payments which is spread over the period of the term of the loan. Although, initially the cost of raising equity financing would be much higher, but the burden put on by the debt financings, in the form of interest payments, would significantly affect the net earnings of the company for a longer period. Moreover, if a company finds itself in a stringent economic condition and the repayment of interest charges and principal becomes difficult for it, the credit rating of the company would be adversely affected which in turn would affect its financial outlook. Thus based on the above discussion it would be in the best interest for the company to issue equity shares in order to raise the funds for financing the project. Answer to question no. (b) Investment Analysis Year In thousand £ Particulars 0 1 2 3 4 Sales in units - 30 50 80 40 Sales 3,300 5,500 8,800 4,400 Cost of sales Plastic - (240) (400) (640) (320) Bought in sub assembly - (660) (1,100) (1,760) (880) Other materials - (120) (200) (320) (160) Assembly labor - (1,200) (2,000) (3,200) (1,600) Other variable production - (600) (1,000) (1,600) (800) Administrative Cost (275) (275) (275) (275) Lease payment (100) (100) (100) (100) - Plant and installation cost (1,200) - - - - Sale proceed on disposal - - - - 200 Working capital (140) - - - 140 Net Cash inflow / (Outflow) (1,440) 105 425 905 705 Discounting Factor 1.000 0.909 0.826 0.751 0.683 Present Value (1,440.00) 95.45 351.24 679.94 481.52 Net Present Value 168.16 Note 1: Depreciation is not included in the above cash flow projections as depreciation is a non-cash item and is irrelevant for NPV decision making. It must also be noted that taxation rate is also not provided in the above scenario. If the taxation rate would be given, the tax-shield on depreciation would have been taken in the cash flow projection. Also, the cash flow would have been reduced by the amount of tax paid.[ Smith, F., 2010] Note 2: The allocated administrative cost of £ 150,000 is a sunk cost. It means that whether or not the project is undertaken or not, the cost would be incurred. Thus it is irrelevant for the purpose of cash flow projection. In addition, the increase in the administrative cost of £ 275,000 would be taken as the relevant cost as it is a direct result of the capital expenditure. Southampton Appliance Limited is in the process of evaluating the financial feasibility of a capital expenditure which pertains to the investment in a project. The investment appraisal department of the company after careful deliberation and consideration has forecasted the cost and revenue pertaining to the project. Future cash flows have been forecasted and are presented as net cash inflows. The cash outflows comprise of lease rentals, variable cost of production, working capital requirements, administrative expenditure etc. Whereas, the cash inflows includes the expected total revenue generated by the product over the useful life of the machines. It is assumed that all the projected cash flows include the impact of expected inflation. The capital expenditure pertaining to the purchase of machine has been decided to be funded through internally generated funds. Therefore, keeping into consideration the limited amount of the funds, the directors of the company must make prudent investment decision so to achieve the most lucrative and appropriate results. The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate of the company. As per the treasury department of the company, the cost of capital of the company is 10%, which is used as the discount rate in calculating the NPV of each project. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the capital expenditure. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture on an investment where the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one Following table presents the IRR of the project Year In thousand £ Particulars 0 1 2 3 4 Sales (in units) - 30 50 80 40 Sales   3,300 5,500 8,800 4,400 Cost of sales           Plastic - (240) (400) (640) (320) Bought in sub assembly - (660) (1,100) (1,760) (880) Other materials - (120) (200) (320) (160) Assembly labour - (1,200) (2,000) (3,200) (1,600) Other variable production - (600) (1,000) (1,600) (800) Administrative Cost   (275) (275) (275) (275) Lease payment (100) (100) (100) (100) - Plant and installation cost (1,200) - - - - Sale proceed on disposal - - - - 200 Working capital (140) - - - 140 Net Cash inflow / (Outflow) (1,440) 105 425 905 705 IRR 14.20% The current discount rate of the company is 10% whereas the internal rate of return (IRR) of 14.20 is higher. This shows that the investment decision is feasible and lucrative for the company. Another method to analyze the investment decision is through payback period. Payback period is another method utilized in investment appraisal which calculates the time taken by the investment to generate enough cash inflows to recover the initial cost of the investment. Year In thousand £ Particulars 0 1 2 3 4 Sales in units - 30 50 80 40 Sales   3,300 5,500 8,800 4,400 Cost of sales           Plastic - (240) (400) (640) (320) Bought in sub assembly - (660) (1,100) (1,760) (880) Other materials - (120) (200) (320) (160) Assembly labor - (1,200) (2,000) (3,200) (1,600) Other variable production - (600) (1,000) (1,600) (800) Administrative Cost   (275) (275) (275) (275) Lease payment (100) (100) (100) (100) - Plant and installation cost (1,200) - - - - Sale proceed on disposal - - - - 200 Working capital (140) - - - 140 Net Cash inflow / (Outflow) (1,440) 105 425 905 705 Payback Period 3.01 The payback period is around 3 years, which is less than the useful life of the project of 4 years. This also advocates the fact that the project is financially feasible. CONCLUSION Based on the above investment appraisal, it is financially viable for the company to invest in the project. References Abeysinghe, R. L., 2010. Nature and introduction of investment decision. [Online] Available at [Accessed 10 Mar 2013]. Berkovitch, E., 2010. Why the NPV criterion does not maximize NPV. [Online] Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=138643> [Accessed 10 Mar 2013]. Financial Modelling Guide, 2010. Capital Budgeting and pros and cons of IRR and NPV. [Online] Available at < http://www.financialmodelingguide.com/valuation-concepts/capital-budgeting-irr-npv/> [Accessed 10 Mar 2013]. Grayson, G., 2010. Internal rate of return: An inside Look. [Online] Available at [Accessed 10 Mar 2013]. Investopedia, 2010a. Net Present Value - NPV. [Online] Available at [Accessed 10 Mar 2013]. Investopedia, 2010b. Which is a better measure for capital budgeting, IRR or NPV. [Online] Available at [Accessed 10 Mar 2013]. Saching, 2010. What influences investment decision. [Online] Available at [Accessed 10 Mar 2013]. Smith, F., 2010. Investment appraisal and capital budgeting: NPV and IRR. [Online] Available at [Accessed 10 Mar 2013]. Rfs.oxfordjournals.org (2004). Why the NPV Criterion does not Maximize NPV. [Online] Available at: http://rfs.oxfordjournals.org/content/17/1/239.short [Accessed: 14 Nov 2012]. Langfield-Smith, K., Thorne, H. & Hilton, R. (2012). Management Accounting 6E. 6th ed. McGraw-Hill. Abeysinghe, R. (2007) Nature and Introduction of Investment Decisions. [online] Available at: http://ezinearticles.com/?Nature-and-Introduction-of-Investment-Decisions&id=3540685 [Accessed: 10 Mar 2013]. Peavler, R. (2013) Debt and Equity Financing. [online] Available at: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm [Accessed: 10 Mar 2013]. Qfinance.com (2010) Appraising Investment Opportunities - QFINANCE. [online] Available at: http://www.qfinance.com/business-strategy-checklists/appraising-investment-opportunities [Accessed: 10 Mar 2013]. Read More