Evaluation Methods for Investment Decision Making - Business Case Study 2

The report discusses the methods of evaluating projects to guide Pinto Limited for making an investment decision. It assesses the five major methods of capital budgeting along with its risk and sensitiveness. It also provides a recommendation for acceptance of the project.

ACC00716 Finance Session 3, 2018
Assessment 3: Business Case Study 2

TABLE OF CONTENTS
Introduction................................................................................................................................3
Explanation of project evaluation methods................................................................................3
Net Present Value...................................................................................................................3
Internal Rate of Return...........................................................................................................3
Payback Period Method.........................................................................................................3
Discounted Payback Period....................................................................................................4
Profitability Index..................................................................................................................4
Risk assessment of project on the basis of three sensitivities modelled....................................4
Reduction in sales volume by 10%........................................................................................4
Reduction in sales price by 20%............................................................................................4
Increase in initial investment by 10%....................................................................................4
Recommendation for acceptance of project...............................................................................4
References..................................................................................................................................5

INTRODUCTION
In the present report, the methods relating to evaluating the projects are discussed to guide
Pinto Limited for making an investment decision. In this aspect, the five major methods of
capital budgeting are assessed in the report along with its risk and sensitiveness. After
discussing and estimating the net present value, internal rate of return discounted payback
period and profitability index of the project the recommendation is provided regarding
whether the company should continue with the project or not.
EXPLANATION OF PROJECT EVALUATION METHODS
Net Present Value
Net present value (NPV) method refers to the present value of the future net cash flow from a
project in which the company is invested. The NPV of the company can be calculated
through discounting of cash flows with the accurate rate of interest which is the capital cost
of the company. Positive net present value shows that the project is beneficial for the
business.
Internal Rate of Return
The internal rate of return (IRR) can be defined as a discount rate at which the NPV of the
investment proposal is zero. In simple words, the situation when the sum of projects’
expected cash inflows and amount of initial investment is equal. This method depends on the
discounted cash flow technique (Ghiyasi, 2018). Furthermore, it is broadly used in capital
budgeting as well as while taking the investment decisions whether to selecting or to
repudiate the proposal. It is significant to consider that the project which exceeds the desired
rate of return of a company should be accepted.
Payback Period Method
Payback period assists the firm to assess the extent of time needed to recuperate the initial
cash expenditure in investment proposal. In other words, by application of this method, the
company can calculate the extent of time to recover the cost incurred on the proposal by
succeeding cash inflows (Schlegel, ] Frank and Britzelmaier, 2016). Under this method, the

cash flows are calculated which has resulted from investment every year of the life of the
project. The same is accumulated every year until they get equal to the original investment
amount of the project. In addition to this, it also assists in ranking the investment proposals.
Discounted Payback Period
Discounted payback period (DPP) refers to a capital budgeting process utilised to assess the
productivity of the proposal. This method relies on the discounted cash flows technique. It is
utilised to evaluate the project as a supplemental screening criterion. Further, it is the number
of years required to recuperate cash outflows or initial cost incurred in a project from its
future cash inflows (Nawaiseh et al. 2015). The project which has less payback period than
the targeted period should be selected. In addition to this, it represents the length of time
required to break even in a proposal based not only on what cash flows arise but also when
they arise along with the existing rate of return in the market.
Profitability Index
Profitability index can be defined as a financial analysis which helps the company whether to
accept the project or not. This method utilises the concept of time value. It also assists the
firm to give rank to proposals so that the best proposal could be selected (Rossi, 2015). When
the profitability index is higher than 1, it implies that the present value of future cash inflows
from the investment will exceed the initial investment and company will earn profits through
that particular investment.
RISK ASSESSMENT OF PROJECT ON THE BASIS OF THREE
SENSITIVITIES MODELLED
Reduction in sales volume by 10%
Sales volume is a contributing factor in deciding the fate of the company’s profits. It’s seen
frequently that the companies struggle to meet their target volume of production due to two
main factors, which are: -
 Underutilisation of the Resources – If the personnel deployed for the job work
aren’t well versed with their tasks, then it is highly likely that they may not be able to
grind the maximum output out of the available resources (Borgonovo and Plischke,

2016). The abnormal wastage goes up, which ultimately leads to lower input-output
ratio.
 Lack of Market Space – If the market is at a saturation point or the product doesn’t
have enough demand, then it adds friction in the company’s progress. Thus, the
company is forced to curb its production which ultimately cuts short the sales output.
Reduction in sales price by 20%
Sales price is a governing factor in the product’s demand. As the law of demand states,
“Higher the price, lower is the demand and vice versa”, the demand is directly proportional
to the increase or decrease in the sales price of the product (Nagle and Müller, 2017). So, if
the company pulls down the sale price by 20%, then it may significantly increase the demand
for the product.
Increase in initial investment by 10%
The net result of the project depends upon the present value of all the future cash flows when
compared with the initial investment. If the initial investment increases with no change in the
cash flows, then the NPV (Net Present Value) will be reduced to the extent of the increase in
the initial investment (Grant, 2016). If, however, the cash flows increase to some extent due
to the increased charge in initial investment (say an expenditure for improved machinery),
then the NPV might gain heights than the previous level achieved with the old machinery.
RECOMMENDATION FOR ACCEPTANCE OF PROJECT
By considering the application of capital budgeting techniques and sensitivity analysis
following results has been obtained:
With the given
information
Reduction in
sales volume
by 10%
Reduction in
sales price by
20%
Increase in initial
investment by
10%
NPV $5,596,502 $3,521,143 $1,445,783 $286,954
Payback period 3.38 years 3.55 years 3.76 years 3.91 years
Discounted payback period 3.17 years 3.40 years 3.68 years 3.88 years
Profitability index 1.31 1.20 1.08 1.02

IRR 21.1% 17.3% 13.1% 10.6%
Above statement shows that the company will be able to earn positive returns despite adverse
impact on three crucial factors of proposals. On the basis of this aspect, the proposal should
be accepted by the company as even if estimated projections are not favourable in the near
future then also invested amount in the proposal will deliver positive returns.

REFERENCES
Borgonovo, E. and Plischke, E., 2016. Sensitivity analysis: a review of recent
advances. European Journal of Operational Research, 248(3), pp.869-887.
Ghiyasi, M., 2018. Performance assessment and capital budgeting based on
performance. Benchmarking: An International Journal, (just-accepted), pp.00-00.
Grant, R.M., 2016. Contemporary strategy analysis: Text and cases edition. John Wiley &
Sons, United States.
Nagle, T.T. and Müller, G., 2017. The strategy and tactics of pricing: A guide to growing
more profitably. Routledge, Oxon.
Nawaiseh, M.E., Al-nawaiseh, H., Attar, M.D. and Al-nidawy, A., 2017, September. The Use
of Capital Budgeting Techniques as a Tool for Management Decisions: Evidence from
Jordan. In International Conference on Engineering, Project, and Product Management (pp.
301-309). Springer, Cham.
Rossi, M., 2015. The use of capital budgeting techniques: an outlook from
Italy. International Journal of Management Practice, 8(1), pp.43-56.
Schlegel, D., Frank, F. and Britzelmaier, B., 2016. Investment decisions and capital
budgeting practices in German manufacturing companies. International Journal of Business
and Globalisation, 16(1), pp.66-78.