Investment Appraisal Techniques

This assignment delves into the world of investment appraisal techniques and their influence on business profitability. Students will examine various methods used to evaluate investments, such as net present value (NPV), internal rate of return (IRR), and payback period. The impact of these techniques on the financial performance of companies will be analyzed through case studies and real-world examples. Further, the importance of working capital management in supporting investment decisions is highlighted.

Business Finance
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TABLE OF CONTENTS
INTRODUCTION ..........................................................................................................................4
PART 1............................................................................................................................................4
1 Differentiating between profitability and cash flow.................................................................4
2 Application of Working Capital Management..........................................................................6
3 Measures to improve Working Capital Management...............................................................8
PART 2............................................................................................................................................9
I. Understanding the stages of capital budgeting process and investment appraisal methods.....9
ii. Application of these methods to the project under consideration.........................................11
iii. Analyzing most appropriate method for decision making...................................................13
CONCLUSION..............................................................................................................................14
REFERENCES..............................................................................................................................15
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Illustration Index
Illustration 1: Source : The crocodile of the moat : The Float(Part II)............................................7
Index of Tables
Table 1: Payback of both project...................................................................................................11
Table 2: ARR of both projects.......................................................................................................12
Table 3: Net present value of both projects...................................................................................12
Table 4: IRR of both projects.........................................................................................................12
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INTRODUCTION
Finance is a tonic to bring a new life into the business and its operations. Wild Frontiers
Builders Limited, being engaged in works contract related to property maintenance is running
into profits despite the fact of facing liquidity crunch. Working capital being most important part
of business finance functions facing issues therefore measures to be adopted are explained.
Further Report is applying capital budgeting decision regarding launching the new projects by
Eye Watering PLC, a company engaged in designing video games. Applying investment
appraisal methods will depict a clear picture and helps in deciding the acceptance or rejection of
the project. However selection of best alternative or combination is directly related to
profitability as the projects involve huge cash flow and also great caution as the projects are
irreversible and long period of time is involved.
PART 1
To : Shareholders
From : Accountant
Respected shareholders
This is to draw a clear picture of Wild Frontiers Business Limited in front of you. This
report explains the cash flows and profitability of the business . Further working capital
management issues currently faced by the company and feasible remedies are recommended to
improve the liquidity crunch of the company.
1 Differentiating between profitability and cash flow
Cash flow is lifeline of business and profits are heart of business therefore both are very
crucial concept with different identity and existence in the business. Cash flow refers to flow of
cash from the business or into the business. Net cash flow is calculated as net cash inflow less all
the cash outflows from the business. Profitability refers to all the revenues after deducting direct
and indirect expenses and considering all the incomes whether realised or not. Cash flow
represents only the transactions which involve cash as a component such as cash sales, salary
paid to employees, cash purchases, payment of certain expenses etc. Cash flow and profitability
are both two very different concepts it is not necessary that business generating cash is always
profitable or a profitable business is always keen on generating cash(Novy-Marx, 2013).
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Cash flow reflects the difference between and receipts and payment of the business on the
contrary, profitability statement reflects the difference between revenues and expense of the
business. Cash flows ignores all the expenses and income in the transaction and records only the
cash portion of the same. For example: Wild Frontiers have performed the services for Vulture
estates but didn't received cash therefore this transaction will not be recorded but products or
services procured from other contactors on cash basis will only be recorded. Therefore cash
flows does don't demonstrate the clear profits generated by business for the shareholders. Profits
are presented when service is rendered and cash flow is recoded when actual payment is realised.
WFB is profitable company consistently with negative cash flows . Cash flows are very
important in short run as payment of certain expenses are periodic and necessary for smooth
functioning of business such as payment of employee salaries, raw material purchases, sundry
expenses etc. whereas in long profitability comes into picture. Profitability is calculated the end
of the year and there are various decisions based on profitability regarding continual of business
or shut down. In case of WFB company is running into profits but has certain receivable and
payables due which adversely impact the cash flow and profitability in long run. Probability of
certain legal cases coming up will impact the reputation and goodwill of business and credit
worthiness of the entity in market will decline thereby closing the doors of financial lenders.
Also building up piles of spare parts and plumbing supplies etc. will impact the inventory and
and warehousing cost.
Cash flow statements and Profitability Statement are bother part of company's Annual
financial statements. Cash basis is followed for preparation of Cash flow statement and only
transactions realised in cash are recorded whether profitable or not(Edelman, Jaffe and
Kominers, 2016). On the other hand profitability of the company is observed form Income
Statement which follows accrual concept of accounting and transactions are recorded as and
when they occur irrespective off the fact that cash is realised or not. Net cash balance of the firm
after considering all the outflows and inflows are treated as current assets in the Position
statement. However Profits of the year after deducting all the expenses including interests and
taxes and dividends are added to the capital of the shareholders in the form of reserves or
retained earnings or balance of profits. Therefore outstanding balances from Vulture estates and
Weasel Properties will be reflected as service rendered in income statement and outstanding
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balances as debtors in balance sheet however same will not be reflected in cash flow
statement(Robinson and Sensoy, 2013). On the other hand overdraft balance of bank account
since nine months will be shown in current liabilities of the position statement. However it is
very difficult to have good liquidity without sufficient profitability in the business.
2 Application of Working Capital Management
Financial health of the business is the decisions and structure of working capital of the
business. Working capital is all about managing the current assets and current liabilities of the
business. Monitoring and managing the cash inflow and outflow is major concept to ensure
enough liquidity in the business. Application of working capital plays a major role in success if
the company and determines its growth and development. Maintaining the debtor turnover ratio
and inventory turnover ratio in addition with creditors payable period is necessary for attracting
customers and establishing credit worthiness. Every business should set policies and guidelines
to maintain a fixed collection and payment period and unusual translations to be looked with
scepticism.
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Financial health of the business is the decisions and structure of working capital of the
business. Working capital is all about managing the current assets and current liabilities of the
business. Monitoring and managing the cash inflow and outflow is major concept to ensure
enough liquidity in the business. Application of working capital plays a major role in success if
the company and determines its growth and development. Maintaining the debtor turnover ratio
and inventory turnover ratio in addition with creditors payable period is necessary for attracting
customers and establishing credit worthiness. Every business should set policies and guidelines
to maintain a fixed collection and payment period and unusual translations to be looked with
scepticism(Armstrong and Taylor, 2014).
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Illustration 1: Source : The crocodile of the moat : The Float(Part II)

One of the important concept of working capital management is inventory management.
Effective utilisation of inventory and also avoiding the unnecessary piling up of inventory is a
crucial aspect of business. In case of WFB company has huge stock of inventory which is
causing double cost in the forms of warehousing cost as well as blocking the working capital and
loss of opportunity cost on it. Account receivables management is crucial part of company and
however the same is not properly managed by WFB as it has debtors outstanding since six
months which is along span of time and therefore bringing liquidity crunch to the company. Also
creditors should be paid to timely basis to maintain the goodwill in the market and proper cycle
to be maintained and also stimulating the credit raising in future. Therefore seen at the condition
of WFB it can be observed that WFB is poor in working capital management and effective
measures should be taken to improve the situation and likely legal cases coming up.
3 Measures to improve Working Capital Management
Working capital management is a serious concern for WFB and needs to be worked upon
by the the organisation as whole ion coordination. Working capital forms substantial part of the
company's assets and therefore is an important aspect(Ding, Guariglia and Knigh, 2013). Since
the working capital management of the company is poor following measures are suggested to
improve the same.
 Renegotiating with the creditors : WFB is facing great issues related with fluidity of
cash despite the fact that it is running into profits. Due to extended period of credibility
one of the contractor is posing a threat of legal suit therefore WFD should try to
renegotiate the terms on a friendly note and avoid such legal proceedings which is
wasteful in terms of efforts an time. Also WFD should extend the time and generate
source of finance internally by selling the extra stock in warehouse and pay off the
creditors.
 Receivables Management : Debtors collection period is to be paid great attention by
WFD to realise the payments on early basis. Early payment can be encouraged by
offering them discounts if paid in certain period of time. This will stimulate the clients to
pay on early basis a reduced amount(Michalski, 2012).
 Inventory management : Measures should be employed for managing the inventory in a
better and effective manner . Since WFB is having excessive supplies it should be
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managed properly and sold at discounted rates and realise early cash to paint a good
picture of company's liquidity. WFB can better utilise the inventory by accepting the
orders on immediate basis and performing services therefore resulting in better revenues
and ultimately profitability(8 ways to...improve working capital, 2013).
 Alternative Funding : Alternate sources of finance which are cheaper should be devised
such as bringing in more capital by shareholders or using the retained earnings so as to
repay the outstanding overdraft and the interest compounding there upon(Brigham and
Ehrhardt, 2013). Bank overdraft outstanding since nine months is not a good indicator
and therefore a great problem for credit ratings of the company and distracted customers.
Moreover Neil can raise funds from fiends and relatives for easy payment terms and
discounts therefore avoiding the interest payments.
 Controlling the expenses : Sundry expenditures should be avoided for the time being till
then WFB gains back its original flow of cash. Certain expenses which are unnecessary
for the business should be controlled such as excessive expense on stationary or
employee perks etc should be analysed and cost control to be conducted.
PART 2
I. Understanding the stages of capital budgeting process and investment appraisal methods
According to the given scenario EyeWatering Inc is the large video hame design
company which tend to product varied best selling products for major console games. The
company is looking for two projects such as Call of the Assassins Part XXIII and Caolmining &
Oil Extraction. Here, company follows effective capital budgeting process which is explained as
follows- Identifying and evaluating potential opportunities-It is the first and foremost under
which appropriate project is selected. According to the given scenario, EyeWatering Inc
is planning to expand its venture and the other project is about development of new
market (Olawale, Olumuyiwa and George, 2010). Estimating operating and implementing costs-Under this step operating and
implementation cost is identified by business. For example, as per the given case Call of
the Assassins Part XXIII which needs investment worth 10 million dollar whereas other
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project related to market development require cost of 6 million dollar. These cost figure
are identified under the project so as to introduce project in an effectual manner. Forecasting cash flow-Under this step management forecast the cash flow generated by
each project. However, the current information does not reflect cash flow generated by
project. For this purpose, estimated values are taken in order to complete the project in a
best possible manner (Baum and Crosby, 2014). Assessing risk-The risk assessment procedure is considered as the most important under
which chances of project failure are estimated in a advance. It facilitates to determine
degree of risk as well as benefits for the corporation. The given case scenario is showing
that call of the Assassins Part XXIII and coalmining & oil extraction of risk.
 Implementing-It is the last procedure under which all related projects are implemented in
accordance assessed risk and other related project. It would be effective to implement the
most effective project so as to select the best alternative.
Investment appraisal techniques are applied by using following methods. These are explained as
follows- Net present value method-It is the most important technique which present the net
present valid derived from the project. It facilitates to select the most effective method
for the project so that accordingly project can be selected. However, project is selected
on the basis of rate of return (Willcocks, 2013). It indicates that both projects has
significant impact on return generated by where focus is laid on amount left out after
deducting initial investment from total present value. Internal rate of return-Under this method rate of return of each project is calculated
through which it becomes easy to select the best project. However, selection of project is
based upon higher rate of return. For this purpose, two discounting rates are considered
so that accordingly analysis can be done by selecting the most appropriate project. Apart
from this, comparison is made by focusing of selected project of EyeWatering. Payback period-It is another important method of calculating cost of project wherein
time required to recover cost of project is estimated (Irani, 2010). Here, companies focus
upon lower time period so as to recover cost of production or initial investment. It can be
critically evaluated that two projects are considered and then comparison is made
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between time of recovery of initial investment. It proves to be effective to meet the
purpose of corporation in an effectual manner.
 Accounting rate of return-It is another method of calculating rate of return generated by
particular project. For this purpose, cash flow as well as initial investment of each
project is calculated through which it becomes easy to derive valid of project.
ii. Application of these methods to the project under consideration
The following table is showing calculation of each project which assists management of
business to select the most effective n order to meet purpose of the same effectively. According
to the given scenario, all information related to both projects are presented with application of
varied techniques (Cooremans, 2011). These methods consists of payback period, net present
value method and internal rate of return. Along with payback period method is also considered
so as to select the most appropriate techniques by focusing upon all of the techniques. It proves
to be effective to utilize limited resources in a most effective manner.
The following mentioned tables are calculated with the help of certain assumption. These
are explained as follows-
 Cash flow generated from each project are assumed
 Initial investment of project has been taken as it is from the given scenario
 Call of the Assassins Part XXIII is denoted by project A and Coalmining & oil extraction
is denoted by project B.
Table 1: Payback of both project
Project A
Cumulative
cash flow Project B
Cumulative
cash flow
Initial investment -10 -6
1 1 -9 3 -3
2 3 -6 2 -1
3 4 -2 4 3
4 8 6 5 8
5 7 13 4 12
6 5 18 2 14
Project A
a+b/c
3+-2/8=2.75
Project B
2+-1/4=1.75
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Table 2: ARR of both projects
Project A Project B
Initial
investment 10 6
1 1 3
2 3 2
3 4 4
4 8 5
5 7 4
6 5 2
Total 28 20
Average 7 3
ARR 4.00% 6.66%%
Table 3: Net present value of both projects
Project A
Present
value
@12% Present value Project B PV @10%
Present
value
Initial
investment 10 6
1 1 0.893 1 3 0.893 3
2 3 0.797 2 2 0.797 2
3 4 0.712 3 4 0.712 3
4 8 0.636 5 5 0.636 3
5 7 0.567 4 4 0.567 2
6 5 0.507 3 2 0.507 1
Total 18 14
NPV 8 8
Table 4: IRR of both projects
Project A Project B
Initial
investment -10 -6
1 1 3
2 3 2
3 4 4
4 8 5
5 7 4
6 5 2
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IRR 30.31% 47.72%
iii. Analyzing most appropriate method for decision making
According to the application of above mentioned tools, most appropriate method internal
rate of return can be considered. The main reason behind selecting the most appropriate project is
to recover cost of project in an effectual manner. According to the aforementioned table, it has
been found that project B can be recovered with higher rate of return. This reflects that business
can easily cost of production so as to ensure optimum utilization of limited resources. It can be
critically evaluated, that project B is the most appropriate aspect for increasing overall rate of
return in relatively less time span. It would be effective for business to deliver good quality of
services to large number of buyers. It can be critically evaluated, selection of project can be done
with the help of all investment appraisal techniques (Al-Ajmi, Al-Saleh and Hussain, 2011). It is
because all projects bring forth the same kind of results in accordance with rate of return as well
as cost.
According to the collected information, it can be suggested to management of project that
Project B should be selected as it generates higher rate of return. Not only this, but time required
to recover the initial investment is also lower for this particular project. Hence, it should be
selected for betterment of the business. Therefore, investment appraisal techniques are the most
effective aspect for deriving valid results as per the collected data. It aids to save overall cost and
enhance profitability of the project. Thus, Coalmining & oil extraction can be considered as the
most effective aspect through which it becomes easy to generate higher rate of return. Owing to
this, EyeWatering will go for Minecraft project which tends to meet expectations of buyers and
also determine long run growth and development of business in the marketplace. Owing to this,
above mentioned project is structured whereby it becomes easy to accomplish purpose of the
business effectively. This will be most appropriate in order to create competitive edge in the
marketplace.
CONCLUSION
The aforementioned report reflects that investment appraisal techniques play important
role for bringing valid outcome of the business. It assists management to select the most suitable
project whereby it becomes easy to reduce cost of project and at the same time meet expectations
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of buyers in an effectual manner. It can also be said that effective working capital is the most
important aspect behind long run success of the business as it it aids to maintain consistent flow
of production. It is the foremost reason behind difference between cash flow and profitability
which are defined by business in a different manner.
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REFERENCES
Journals and books
Al-Ajmi, J., Al-Saleh, N. and Hussain, H.A., 2011. Investment appraisal practices: A
comparative study of conventional and Islamic financial institutions. Advances in
Accounting. 27(1). pp.111-124.
Armstrong, M. and Taylor, S., 2014. Armstrong's handbook of human resource management
practice. Kogan Page Publishers.
Baum, A.E. and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage
Learning.
Cooremans, C., 2011. Make it strategic! Financial investment logic is not enough.. Energy
Efficiency. 4(4). pp.473-492.
Ding, S., Guariglia, A. and Knight, J., 2013. Investment and financing constraints in China: does
working capital management make a difference?. Journal of Banking & Finance.37(5).
pp.1490-1507.
Edelman, B., Jaffe, S. and Kominers, S.D., 2016. To groupon or not to groupon: The profitability
of deep discounts. Marketing Letters. 27(1). pp.39-53.
Michalski, G., 2012. Accounts receivable management in nonprofit organizations. Zeszyty
Teoretyczne Rachunkowości.(68). pp.83-96.
Novy-Marx, R., 2013. The other side of value: The gross profitability premium. Journal of
Financial Economics. 108(1). pp.1-28.
Olawale, F., Olumuyiwa, O. and George, H., 2010. An investigation into the impact of
investment appraisal techniques on the profitability of small manufacturing firms in the
Nelson Mandela Metropolitan Bay Area, South Africa. African Journal of Business
Management. 4(7). p.1274.
rani, Z., 2010. Investment evaluation within project management: an information systems
perspective.. Journal of the Operational Research Society. 61(6). pp.917-928.
Robinson, D.T. and Sensoy, B.A., 2013. Do private equity fund managers earn their fees?
Compensation, ownership, and cash flow performance. Review of Financial Studies.
26(11). pp.2760-2797.
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Willcocks, L., 2013.. Information management: the evaluation of information systems
investments. Springer.
Online
8 ways to improve working capital, 2013. [Online]. Available through<http://www.fm-
magazine.com/feature/list/8-ways-%E2%80%A6-improve-working-capital#>. [Accessed
on 24th december, 2016].
The Crocodile of the Moat: The Float (Part II), 2016. [Online]. Available
through<http://www.gurufocus.com/news/241783/-the-crocodile-of-the-moat-the-float-
part-ii>accessed on 24th december, 2016.
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