Investment Appraisal Techniques

The assignment discusses two mutually exclusive projects, Project A and Project B, and uses three investment appraisal techniques: Net Present Value (NPV), Internal Rate of Return (IRR), and Accounting Rate of Return (ARR) to analyze them. The results show that both projects have positive NPVs, but Project A has a higher NPV, IRR, and ARR than Project B. Therefore, it is advisable for the management to invest in Project A. However, the assignment also highlights the limitations of these techniques, including inaccurate estimation of future cash flows, uncertainty about machine duration, contradictory results, and ignoring unexpected events.

(a)
Calculation of Depreciation
Machine A = 125000 - 25000
3
= 100000
3
= 33333
Machine X = 60000
5
= 12000
Machine B = 125000
6
= 20833
Calculation of Cash Inflow of Project A
2016 2017 2018 2019 2020 2021
Net Profit 60000 60000 60000 50000 50000 40000
Add: Depreciation 33333 33333 33334 12000 12000 12000
Cash Inflow 93333 93333 93334 62000 62000 52000
Calculation of Cash Inflow of Project B
2016 2017 2018 2019 2020 2021
Net Profit 20000 30000 40000 70000 80000 65000
Add: Depreciation 20833 20833 20833 20833 20834 20834
Cash Inflow 40833 50833 60833 90833 100834 85834
Calculation of Net Present Value
Project A
Year Cash Flow PVF@20% Present Value
of Cash Flow
-125000 1
-
1,25,000
2016 93333 0.833

77,746
2017 93333 0.694 64,773
2018 93334 0.579 54,040
2018 -35000 0.579
-
20,265
2019 62000 0.482 29,884
2020 62000 0.402 24,924
2021 52000 0.335 17,420
24000 0.335 8,040
NPV of
Project A 1,31,563
Project B
Year Cash Flow PVF@20% Present Value
of Cash Flow
-125000 1 -125000
2016 40833 0.833 34013.889
2017 50833 0.694 35278.102
2018 60833 0.579 35222.307
2019 90833 0.482 43781.506
2020 100834 0.402 40535.268
2021 85834 0.335 28754.39
NPV of
Project B 92585
Calculation of IRR
Internal Rate of return of project is the rate of return at which Net present value of project will be zero.
Project A
Let us assume that rate of return is 59.50 %
Year Cash Flow PVF@59.50
%
Present Value
of Cash Flow
-125000 1
-
1,25,000
2016 93333 0.626 58,454
2017 93333 0.393 36,680

2018 93334 0.246 22,960
2018 -35000 0.154
-
5,398
2019 62000 0.097 5,996
2020 62000 0.061 3,759
2021 52000 0.038 1,977
24000 0.024 572
NPV of
Project A 0
So IRR of Project A is
59.50%
Project B
Let us assume that rate of return is 37.85 %
Year Cash Flow PVF@42.18
%
Present Value
of Cash Flow
-125000 1 -125000
2016 40833 0.703 28719.02716
2017 50833 0.495 25145.63529
2018 60833 0.348 21164.81814
2019 90833 0.245 22226.82348
2020 100834 0.172 17353.98323
2021 85834 0.121 10389.86645
NPV of
Project B 0
So IRR of Project B is
42.18%
Calculation of ARR
ARR = Average accounting profit
Initial Investment
Project A
Average Accounting Profit = 60000 + 60000 + 60000 + 50000 + 50000 + 50000
6
= 330000
6
= 55000

ARR = 55000
125000
= 44.00%
Project B
Average Accounting Profit = 20000 + 30000 + 40000 + 70000 + 80000 + 65000
6
= 305000
6
= 50833
ARR = 50833
125000
= 40.67%
Company has opportunity to invest in two mutually exclusive projects. We can use various
investment appraisal techniques to analyze these projects. We have used three techniques namely
Net Present Value (NPV) , Internal Rate of Return (IRR) and Accounting Rate of Return (ARR) . On
analysing outcome of above techniques, we can find that both projects have positive NPV however
NPV of Project A is more than The NPV of Project B. Further IRR and ARR of Project A is also higher
than Project B. On the basis of above techniques we can say that Project A is showing better future
outcomes. So it is advisable to management to Invest in Project A.

(b)
There are various types of investment appraisal techniques to analyze Projects. Some of them are
Net Present Value, Internal Rate of return, Payback period, Accounting rate of return, discounted
cash flow methods and discounted pay-back period. These investment techniques provide greater
insight to management about Project in which management have opportunity to invest. These
techniques help management to decide about investing in Projects however these techniques have
certain limitations. Some of them are as follows:
1. It is not always possible for management to accurately estimate future cash flow from a
project.
2. Duration of cash flow from a project or machine cannot be estimated with accuracy.
Sometimes it is seen that a machine still remains useful even after its useful life.
3. Sometimes different appraisal technique provides contradictory result from other technique.
So management have to decide on which technique they want to rely.
4. Every appraisal technique use a fix cost of capital to discount cash flow from future years.
However in future years, management may have low cost source of fund. So they can
replace present debt with low cost debt.
5. All techniques ignore unexpected and unusual events that may affect project in future.