FINANCIAL DECISIONS

Explaining the factors that determine demand and supply of houses in the UK during the above period Last 6 years trends in house prices and market (before and after recession)

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Table of Contents
Q.1 Investment Appraisal methods importance to business................................................................. 2 NPV (Net Present Value) ..................................................................................................................... 2 PBP (Pay Back Period) ......................................................................................................................... 3 IRR (Internal Rate of Return)............................................................................................................... 3 Q2: Calculating each projects payback, NPV and IRR ............................................................................ 5 NPV: .................................................................................................................................................... 5 Payback Period .................................................................................................................................... 6 IRR ....................................................................................................................................................... 6 Q.3: Which project needs to choose for every method calculated above? ........................................... 8 Q.4: Changed Cost of Capitals affect on Projects NPVs ........................................................................ 8 Q.5: Changed Cost of Capitals affect on Projects IRR: .......................................................................... 8 Q.6: Why NPV of longer project is more sensitive to cost of capital changes ........................................ 9 Q.7: Comparison of NPV and IRR ............................................................................................................ 9 References: ........................................................................................................................................... 10

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Financial Decisions
Q.1 Investment Appraisal methods importance to business
Investment appraisal methods are the basic financial tools which are used in making business decisions. A business frequently needs to decide about critical issues relevant to investments and also accurate judgement is required to make in order to produce profound on its future welfare and success. It also helps in choosing between the projects when it is the matter of selecting the most feasible option among many. Even project appraisal methods can suggest regarding any independent project as well whether the proposed project is worthwhile depending on the limitations provided. Investment appraisal methods cannot only add value to business present wealth but the future wealth be having the good effects as well. By using investment appraisal methods, a businesss most complex decision involving cash outflows and inflows can be taken in least time and more efficiently. Along with other advantages, one important point is that every technique in investment appraisal has a different set of priority which is aimed for different objective so the project can be opted considering different objectives of an organisation (Wilks et al, 2009). A business needs to take critical decisions at different stages whether it is the matter of taking up new assets, holding assets or investing surplus funds anywhere. Business needs to take all these decisions in consideration of getting more profits in order to survival of business, re-investment, and retained profit needs. Appraisal methods also guide the company to take right decisions. Moreover, company needs to take a decision for making the investment according to the projects over a period of time and appraisal methods guide the company to take the decision for a long term basis (Amram, 1999). There are different methods company uses to make an investment in any venture. There are certain recommendations for every method mentioned below with relevant limitations as well.

NPV (Net Present Value)

Net present value is the present value or worth of both incoming and outgoing cash flows of a particular time series. In NPV method, cash flow sequences and discount rates are inputs

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while price is an output. It converts total inflow minus outflow into the present value of the investment benefit and guide in the real manner (Jaffe, 2004). There are certain advantages for NPV i.e. it is easy to calculate, time value of money is also considered in its calculations and lastly its biggest advantage is that it gives value in terms of present value which is easy to compare in current circumstances helping in taking difficult decisions in complex scenarios. The only disadvantage that associated with NPV is the miscalculation that can be done while ascertaining the cost of capital (discount factor). But mostly NPV is preferred over other investment appraisal methods due its comprehensiveness (Brealey, 1996).

PBP (Pay Back Period)

This technique focuses on the payback period of the investment. It is done by calculating the duration of time required to meet the cost of the project. Under the guidelines of the method, the investment which can cover its cost most early is the best one. The payback period is expressed in years. The investment which can meet its initial cost in least years is termed as a better option (Crosson et al. 2008). The advantages of payback period are ease of calculations, and informing exactly what time period is required to meet the amount of investment involved in the project. On the other hand the feature of payback becomes its major drawback that once investment is met, it does not consider the future inflow of the project which can mislead the management while choosing between declining return project and increasing return project. Moreover, it does not consider the time value of money as well so the payback period method is not considered feasible for investment projects; rather it is used while investing in assets or machinery to assess its efficiency (Brennan, 1986).

IRR (Internal Rate of Return)

IRR is one of the tools that can be used to in capital budgeting to estimate and compare the profitability of the investment. It is also named as effective interest rate. (Brigham et al, 2006). IRR basically provides the base rate that is expected from the project and then it is compared with WACC to know how feasible the project is in terms of returns. If an IRR is
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equal to WACC, then it guides the investor that project only meets its cost. A higher IRR than WACC shows more profitability of the project. The main advantages of the IRR are that it not only consider the time value of money but also it compares the project output with project cost (i.e. WACC) so considered important in the eyes of investors but complexity involved in this method is the main hurdle in using this method. Lastly IRR does not give accurate results while determining rates in the scenario of irregular cash flows (Coy, 1999).

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Q2: Calculating each projects payback, NPV and IRR

For the purpose of this work, two projects are assumed. One project that is relevant to the addition of new product line is assumed to have initial a heavy cash outflow while the inflow of cash at an increasing rate. Other project is assumed to be just an add on to existing product which involves less incremental cost and relatively consistent cash inflow. The first project is named as X and other is Y with following assumed results:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Project X -1,000,000 200,000 300,000 400,000 500,000 600,000

Project Y -600,000 200,000 225,000 250,000 275,000 300,000

Calculations as per all required methods:

NPV:
NPV for both projects are calculated hereunder: NPV for the projects are calculated by using the discount factor of 10.64%. First PV of all cash flows are calculated by using this factor and then summed up to arrive at the figure of NPV.

0 1 2 3 4 5 NPV

DF @ 10.64% 1 0.90 0.82 0.74 0.67 0.60

Project X -1,000,000 200,000 300,000 400,000 500,000 600,000

PV (project X) -1,000,000 180,766 245,074 295,341 333,673 361,902 416,756

Project Y PV (project Y) -600,000 -600,000 200,000 180,766 225,000 183,805 250,000 184,588 275,000 183,520 300,000 180,951 313,631

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As per the calculations, Project X is better than Project Y as it is giving NPV of 416,756 as compared to 313,631.

Payback Period
Project X Payback -1,000,000 200,000 200,000 300,000 500,000 400,000 900,000 500,000 1,400,000 600,000 3.20 years Project Y Payback -600,000 200,000 200,000 225,000 425,000 250,000 675,000 275,000 300,000 2.77 years

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Payback period:

As per payback period, Project Y is more feasible as it needs lesser time to return its investment. It just needs 2 years and 9 months as compared to project Xs time of 3 years and 3 months.

IRR
There are two methods of calculating IRR. First is to find a rate at which NPV becomes 0 straightaway. Other method is to find two random rates; fist gives positive NPV and second gives negative NPV. Then iL + [(iU-iL)(npvL)] / [npvL-npvU] is used to find IRR that is the expected rate of return for the project. IRR for Project X:
Project X -1,000,000 200,000 300,000 400,000 500,000 600,000 DF @ 15% 1 0.87 0.76 0.66 0.57 0.50 PV @ 15% -1,000,000 173,913 226,843 263,006 285,877 298,306 247,945 DF @ 25% 1 0.80 0.64 0.51 0.41 0.33 PV (project Y) -1,000,000 160,000 192,000 204,800 204,800 196,608 -41,792

0 1 2 3 4 5 NPV

IRR = iL + [(iU-iL)(npvL)] / [npvL-npvU] = 23.55% IRR for Project Y:

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0 1 2 3 4 5 NPV

Project Y -600,000 200,000 225,000 250,000 275,000 300,000

DF @ 15% 1 0.87 0.76 0.66 0.57 0.50

PV @ 15% -600,000 173,913 170,132 164,379 157,232 149,153 214,810

DF @ 30% 1 0.77 0.59 0.46 0.35 0.27

PV (project Y) -600,000 153,846 133,136 113,792 96,285 80,799 -22,142

IRR = iL + [(iU-iL)(npvL)] / [npvL-npvU] = 28.59% IRR also suggests that project Y is a better option to invest as compared to project X, as it has higher than the WACC.

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Q.3: Which project needs to choose for every method calculated above?
Project NPV Payback period IRR X 416,756 3.20 year 23.55% Y 313,631 2.77 years 28.59% Preferable X Y Y

There are three methods which are used for these two projects feasibility calculations. NPV gives the current value of net output of investment. It gave project Xs NPV as 416,756 & project Ys NPV as 313,631 which means that project X is a better option to opt. The payback period is considered to be good with a lesser time period. As per the result, project Y is better to choose as it needs less time to return its investment. Lastly IRR is considered best with maximum difference as compare to WACC. Calculations show that IRR for project Y is better as it has 28.59% IRR which is far ahead than WACC i.e. 10.64%. Although project Y has better results than project X in two methods but the project has superiority as per NPV which is considered as the most preferred method in investment appraisals while deciding about the projects feasibility so project X needs to be chosen (McKinsey, 2010).

Q.4: Changed Cost of Capitals affect on Projects NPVs:

Yes, NPV is changed due to changes in the cost of capital. Cost of capital determines the discount factor which is used in determining the present value of cash flows and ultimately net present value, In case cost of capital rises, the NPV of the projects will decrease and if it get decreased then NPV will rise (Megginson, 1996).

Q.5: Changed Cost of Capitals affect on Projects IRR:

There are two methods of determining IRR in the investment appraisal methods. One method of IRR is independent of the cost of capital in its calculations but results interpretation is definitely being affected by an increase/decrease in cost of capital. But the other method of calculating IRR is affected by any change in cost of capital not only in calculations but also in interpretations of results. In this work, the later method is used for the purpose of calculating IRR (Jaffe, 2004).

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Q.6: Why NPV of longer project is more sensitive to cost of capital changes
The long term project is more sensitive to discount rate changes as a larger proportion of cash flows are discounted multiple times at the discount rate, reducing the overall NPV value. The cash flows generated from the project as assumed (by the NPV method) to be re-invested at the discount rate. Higher cash flows earlier in the project's life allow more re-investment income to be generated and thus higher NPV (Verhoog, 2003).

Q.7: Comparison of NPV and IRR

NPV is preferred over IRR because of the following reasons: 1. The IRR will give results in percentages which can tricky sometimes for investors

although managers do like to know the feasibility of any project but NPV tell us the actual figures that will add to the firms value, which is the most concern of the investors. As investors are the most important stakeholders of the business so thats why NPV gets major importance too. 2. Most of the times both methods of NPV and IRR give the same results but sometimes

when there is an irregularity in cash flows exist or negative and positive cash flow exist in the projects life IRR starts giving two IRR for same cash flow due to these reason analysts always give more importance to the net present value method than IRR. Furthermore it is worth considering that NPV method can appraise big long-term projects better as compared to the IRR which is more accurate on short term projects but with the condition that inflow or outflow figures are consistent (Watson, 2007).

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References:

1. Amram, M, and Kulatilaka, N. (1999). Real Options: Managing Strategic Investment in an Uncertain World, Boston: Harvard Business School. 2. Brealey R.A. and Myers, S.C. (1996). Principles of Corporate Finance. New York: McGraw-Hill. 3. Brennan, M. J. and Schwartz, E. S. (1986). The Revolution in Corporate Finance. Oxford: Basil Blackwell, p. 80 4. Brigham, E, F., and Ehrhardt, M, C. (2006). Financial Management: Theory and practice. Cengage Learning 5. Businessdictioary.com, available online at: http://www.businessdictionary.com/definition/profitability-index.html 6. Coy, P. (1999). Exploiting Uncertainty: The Real-Options. Revolution in DecisionMaking, Business week 7. Crosson, S, V., Powers, M., and Needles, B, M., (2008). Principles of accounting. 11th edition, Cengage learning, USA 8. Jaffe, R, W., (2004), Corporate Finance seventh edition, The McGraw Hill Companies, USA 9. McKinsey, Koller, T., & Wessels, D., (2010). Valuation: Measuring and Managing the Value of Companies. University Edition, John Willey & sons 10. Megginson, W. L. (1996). Corporate Finance Theory. Addison-Wesley, p10. 11. Verhoog, W. and Keuleneer, L. (2003). Recent Trends in Valuation. England: John Willy & Sons 12. Watson, D. and Head, A. (2007). Corporate Finance: Principles and Practice. 4th Edition, FT Prentice Hall, p. 222223. 13. Wilks, C., Burke, L. and Avis, J., (2009). Management accounting and decision making. CIMA Publishing, USA

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