ADMT Assignment

 

Content

Question A…………………………………………………………………………… 03

Question B…………………………………………………………………………… 03

Question C…………………………………………………………………………… 04

Question D…………………………………………………………………………… 04

Question E…………………………………………………………………………… 05

Question F…………………………………………………………………………… 06

Question G…………………………………………………………………………… 06

Question H…………………………………………………………………………… 08

Question I……………………………………………………………………………. 08

Reference……………………………………………………………………………… 10

Question A

Investment appraisal process is an important part to look at the potential capital investment by measuring its potential value to the firm. There are 3 methods of investment appraisal: Payback, net present value annual (NPV) and average rate of return (IRR), each different method also allows the potential return on the investment to be examined in a different way. As the cash flows associated with a particular project may span a considerable period of time, it is the fact that level of inflation during that time will affect considerably the profitability of a project. It is inflating cost of specific items which are to be taken into account in investment appraisal. The cost of these specific items will exhibit different rates of change and the prices of products which containing element of the specific items of costs. Effectively, the existence of a lag between rise in cost and rise in price may considerably decrease the profitability of a project under conditions of inflation. As the rate of inflation increases, this problem may become more acute. For this reason, firm entering into fixed-price contracts extending over a long period of time should be able to arrange for cost-escalation clauses to mitigate the impact of inflation. Therefore, the investment appraisal can deal with key considerations in making investment decisions which are:

–         How much will the invest cost and whether funds are available?

–         How long will it be before the investment starts to yield returns?

–         How long will it need to pay back the investment?

–         What are the expected profits from investment?

–         Could the money which is being ploughed into the investment yield higher returns?

This is the reason why the investment appraisal process is so important.

Question B

  1. Pay back of project A:
Year Net cash flow (£,000) Cumulative
1 38 38
2 42 80
3 48 128
4 50 178
5 70 240

Because the identical initial outlays of £115,000, the payback will be cover in more than 2 years and less than 3 years

Payback A = 2 +  2.73 years  2 years 9 months

  1. Pay back of project B

Payback B =    2.67 years  2 years 8 months

So, if AP Ltd imposes a 3 year maximum payback period, both of these projects can be accepted. However the project B should be chose because it takes less time to cover than project A.

Question C

There are three problems of payback period:

Firstly, the appropriate payback period is just subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not due to discount cash flows to determine whether they add to the company’s value. Instead, the appropriate payback period is simply the maximum acceptable time over which management decides that a project’s cash flows have to break even.

Secondly, the appropriate payback period cannot take fully into account the time in the value of money and to consider differences in timing explicitly in applying the payback method, the discounted payback period is sometimes used. It is found that the first calculating the present value of the cash inflows at the appropriate discount rate and then finding the payback period by using the present value of the cash inflows.

Finally, the third problem of payback period is its failure to recognize cash inflows that occur after the payback period.

Question D

–         The cost of capital is 11.5%, so the discount each year should be:

Add: 1+ 0.115 = 1.115

Year 1 =    0.897

Year 2 =  =    0.804

Year 3 = 0.721

Year 4 =   0.647

Year 5 = 0.580

–         Net present value (NPV) of project A:

Year NCF Discount rate PV
1 38 0.897 34.086
2 42 0.804 33.768
3 48 0.721 34.608
4 50 0.647 32.350
5 70 0.580 40.600
Total PV 175.562

= 175.562 – 115 = 60.562 or  = £60,562 (Can be accepted)

–         NPV of project B:

Year NCF Discount rate PV
1 43 0.897 38.571
2 43 0.804 34.572
3 43 0.721 31.003
4 43 0.647 27.821
5 43 0.580 24.970
Total PV 156.907

= 156.907 – 115 = 41.907 (Can be accepted)

–         All the NPV are can be accepted because: NPV is an indicator of how much value an investment or project adds to the company. With a particular project, if net cash flow is a positive value, the project is in the situation of discounted cash inflow in the period of time. If net cash flow is a negative value, the project is in the situation of discounted cash outflow in the period of time. Appropriately, risking projects with a positive NPV could be accepted. This does not mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost. Comparing with other available investments, in financial theory, if there is a choice between two mutually exclusive alternatives, the one yield the higher NPV should be selected. And both of projects A and B are positive, all of them are higher than 0, in case it is lower than 0, it cannot be rank and be rejected. Although both of two projects can be accepted, the project A should be chosen because   > .

Question E

 

The NPV method is based on logical approach and the logic behind the NPV method is straightforward: If a project has NPV is zero, the project will generate exactly enough cash flows to recover the cost of the investment and to enable investors to earn their required rates of return. If NPV is 0, in a financial sense, the project will break even. If the NPV is positive, more than enough cash flow will be generated. If NPV > 0, the project will be generate a larger amount of cash that required to service debt and to allow a return to shareholders. So if the firm takes on projects that have positive NPV, the wealth of shareholders will increase, entice them to increase their investment in the firm. The NPV method dictates that all independent projects which have positive NPV should be accepted. The logic behind that assertion arises from the idea that all such projects adds wealth, and that should be the overall goal of the manager in all respects.  If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value.

 

Question F

 

A project can have a positive NPV if it is part of a normal capital budget, but the same project might have a negative NPV if it is part of an unusually big capital budget.  This means that the cost of capital may depend on the size of the capital budget. The NPV of a project is dependent on the cost of capital using. Therefore, if the cost of capital changed, the NPV of each project would change. NPV fall as cost of capital rise, and NPV rises as cost of capital fall. In addition, investors often perceive extremely large capital investments to be riskier, which may also grow up the cost of capital as the size of the capital budget increases.

Question G

 

–         IRR of project A:

at 25%

Year NCF Discount rate (25%) PV
1 38 0.800 30.400
2 42 0.640 26.880
3 48 0.512 24.576
4 50 0.410 20.500
5 70 0.328 22.960
Total PV 125.316

=>  at 25% = 125.316 – 115 = 10.316 or  at 25% = £10,316

at 30%

Year NCF Discount rate (30%) PV
1 38 0.769 29.222
2 42 0.592 24.864
3 48 0.455 21.840
4 50 0.350 17.500
5 70 0.269 18.830
Total PV 112.256

=>  at 30% = £2,744

So, Internal rate of return (IRR) of project A:

= 25%      5% = 28.95%

–         IRR of project B:

at 25%

Year NCF Discount rate (25%) PV
1 43 0.800 34.400
2 43 0.640 27.52
3 43 0.512 22.016
4 43 0.410 17.630
5 43 0.328 14.104
Total PV 115.67

at 25% = £670

at 30%

Year NCF Discount rate (30%) PV
1 43 0.769 33.067
2 43 0.592 25.456
3 43 0.455 19.565
4 43 0.350 15.050
5 43 0.269 11.567
Total PV 104.705

at 30% = £10,295

So IRR of project B:

= 25%      5% = 25.305%

Question H

 

IRR method measures a project’s profitability in the rate of return sense: If a project’s IRR equals its cost of capital, its cash flows will be just sufficient to provide investors with their required rates of return. An IRR greater than cost of capital implies an economic profit, which accrues to the company’s shareholders, while an IRR less than cost of capital indicates an economic loss, or a project that will not earn enough to cover its cost of capital. Projects’ IRRs are compared to their costs of capital, or hurdle rates. The recommendations given are only good for 10% cost of capital.

 

Question I

The NPV method is often regarded to be superior to the IRR method because the IRR has got 2 main weaknesses:

The first one is multiple IRR problems; a multiple IRR problem occurs when cash flows during project lifetime are negative. Therefore we do not know which IRR to use.

The second one is reinvestment assumption: As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. There is also NPV and discount rate comparison for two mutually exclusive projects. IRR assumes reinvestment of interim cash flows in projects with equal rates of return. Therefore, IRR overstates the annual equivalent rate of return for a project which has interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, because there is frequently not a second project available in the interim that can earn the same rate of return as the first project.

 

 

 

 

 

 

 

 

 

 

 

Reference

Barry Elliott, Jamie Elliott (2007) Finacial Accounting and Reporting (11th and) Prentice Hall.

J.R. Dyson 1997, Accounting for non-Accounting students, Fiancial Times Pitman Publishing-UK

Horngren, Harrision, Bamber Best, Fraser, Willett , 2001, Accounting, Prentice Hall-Australia

M.W.E. Glautier & B. Underdown , Accounting Theory and Practice, 7th edn, Fiancial Times Pitman Publishing-UK

Ray Proctor, 2009, Managerial accounting for business decisions, 3th edn., Practice Hall-UK

Ross Westerfield Jordan (ISBN 0-07-121507-7) Essentials of Corporate Finance (International edn) MC Graw Hill

Wood, Frank and Sangster, Alan (2008) Business Accounting 1, (11th edn) Prentice Hall

Wood, Frank and Sangster, Alan (2008) Business Accounting 2, (11th edn) Prentice Hall

http://www.finaid.org/loans/npv.phtml

http://www.thetimes100.co.uk

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