Investment Appraisal Techniques in Global Manufacturing Firm

The assignment discusses different investment appraisal techniques, including the average rate of return method and risk management techniques such as expected values, decision tree, maximax, minimax, and sensitivity analysis. The average rate of return method is used to calculate the profitability of a project, while risk management techniques are employed to evaluate the uncertainty associated with investing. The report highlights the advantages and limitations of each technique, including the ease of calculation and provision of indication related to profitability, as well as issues related to deprecation and scrap value and the lack of focus on time value of money. Based on the scenario provided, it is recommended that the global manufacturing company invest in Machine B due to its higher rate of return.

FINANCE AND DECISION
MAKING

Table of Contents
1. INTRODUCTION.......................................................................................................................3
2. Explanation and evaluation of investment appraisal techniques.................................................3
Net Present value.........................................................................................................................4
Internal Rate of Return ..............................................................................................................5
Payback........................................................................................................................................7
Average rate of return..................................................................................................................8
3. RISK AND UNCERTAINTY...................................................................................................10
Expected values and decision tree.............................................................................................10
Maximax....................................................................................................................................10
Maximin.....................................................................................................................................10
Sensitivity analysis....................................................................................................................11
Conclusion.....................................................................................................................................11
REFERENCES..............................................................................................................................12

1. INTRODUCTION
Management of financial resources is the most important task for global manufacturing
organization. It assists management of corporation to access cost effective sources of finance in
order to reduce cost of production and ensure long run success of firm with increased rate of
return (Shim and Siegel, 2008). Present report is based on global manufacturing company that
require major investment in capital equipment. Further, investment approach techniques are
selected to assess viability of project in the light of requirement of corporation. In addition to
this, risk and uncertainty has also be explain which might affect business in long run.
2. Explanation and evaluation of investment appraisal techniques
Investment appraisal techniques are used to assess the viability of investment project and
to identify the best project among various alternatives. In other words, it can be said that
investment appraisal tactics are used for identifying the attractiveness of an investment. These
tactics are also called as capital budgeting tactics. There are four major tactics of investment
appraisal such as Payback period, Net present value method, internal rate of return and Average
rate of return (Investment appraisal techniques. 2016). Here, in the given scenario, a case of
global manufacturing company is given which is considering a major investment in capital
equipment. There are two machinery available in which they want to invest, the cash projection
and project information is given below:
Table 1 Business proposal
Machinery A Machinery B
Initial Investment 40000 40000
Cash Flow for Location A Cash Flow for Location B
Year 1 20000 20000
Year 2 25000 10000
Year 3 15000 5000
The business entity is going to make use of make use of such calculation to assess the
viability of project.

Net Present value
The cited method is the most famous method of calculating the viability of and
investment appraisal. This method considered the time value and money associated with the
projects to assess their viability. However, the major issue associated with the NPV is that it relies
heavily upon multiple assumptions and estimates such as investment costs, discount rate and
projected returns.
Year Machinery A Discounted rate 15%
Present value on discount factor
rate
Investment Cash flow (£)
1 20000 0.869 17380
2 25000 0.756 18900
3 15000 0.657 9855
Total present
value 46135
Initial investment 40000
Net present value 6135
Machine B
Year
Machine B
Discounted rate 15%
Present value on discount factor
rate
Investment Cash flow (£)
1 15000 0.869 13035
2 25000 0.756 18900
3 20000 0.657 13140

Total present
value 45075
Initial investment 39000
Net present
value 6075
On the basis of NPV, Machinery A is to be considered as a viable investment option as
NPV for Machinery A is higher than Machinery A
Internal rate of return
Internal rate of return (IRR) is an alternative method of NPV which is used commonly used.
The cited method uses IRR calculations and assume a neutral NPV (a value of zero) and instead
solves for the discount rate. The higher value of IRR to acceptable for a project but the limitation of
using this method is that it can be misleading if used alone (Disadvantages of the IRR Method.
2016). The calculation of IRR is as follows
Internal Rate of Return
= R1 +
NPV1 x (R2 - R1)
(NPV1 - NPV2)
Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)
Year
Machine A
Discounted rate 10%
Present value
on discount
factor rate

Investment Cash flow (£)
1 20000 0.909 18180
2 25000 0.811 20275
3 15000 0.731 10965
Total present value 49420
Initial investment 40000
Net present value 9420
IRR for Machinery A
6135*5/6135-9420
9.33%
Year
Machine B
Discounted rate 10%
Present value
on discount
factor rate
Investment Cash flow (£)
1 15000 0.909 13635
2 25000 0.811 20275
3 20000 0.731 14620
Total present value 48530
Initial investment 40000
Net present value 8530
IRR for Machinery B=6075*5 /6135-8530
= 13.4%

On the basis of IRR Machinery B is to be chosen as is has increased internal rate of return with
13.4%. (Internal rate of return. 2011)
Payback
It is the most important technique to calculate time require for initial investment of a
company. It assists corporation to select the most suitable project which save overall cost
associated with the project. The calculation of payback in case of inform cash flow is done
through dividing cash inflow by cash outflow (Payback Period PB Explained, 2016). However,
in case of uneven cash flow corporation require to find the exact time require to recover initial
investment. Under such case cumulative cash flow is calculated so that accordingly formula can
be applied to assess viability of project. However, the project with less time will be preferred for
business purpose so that global manufacturing corporation can create its competitive edge in the
marketplace.
Advantages
 Payback is very to calculate and understand by every party associated in the finance
department
 It does not require special training The liquidity risk of project is highlighted with the project
Disadvantages
 Payback period does not consider time value of money
 Does not consider return to business after payback period It does not consider rate of return
Evaluation of payback
According to the following table Machine B should be accepted because its cost can be
recovered in relatively less time.
Year
Cash flows (£000) of
Machine A Cumulative
Cash flow
Initial investment -40000
1 20000 -20000

2 25000 5000
3 15000 20000
Year
Cash flows (£000) of
Machine A Cumulative
Cash flow
Initial investment -39000
1 15000 -24000
2 25000 1000
3 20000 21000
Machine A
A+B/C
= =1+20000/25000
=1.8 years
Machine B
A+B/C
=1+24000/25000
=1.96 years
Average rate of return
This is another effective method to calculate cost of project under which average of
investment is calculated and average of cash flow is also derived. Here, the cash flow is divided
by investment in order to get percentage of return remain for organization (Average rate of
return, 2016). Furthermore, averages investment provide change to select one of the best

techniques for the purpose of purchasing new machinery to meet long as well as short term
objectives global manufacturing firm.
The following table is showing that machine B will be accepted by global manufacturing
organization due to higher rate of return. It assists corporation to expand business and cater need
of large number of buyers. However, machine is not giving proper return hence it will not be
accepted.
Years
Cash flow of
machine A
Cash flow
of machine
B
1 20000 15000
2 25000 25000
3 15000 20000
Average cash flow 20000 20000
Average investment 20000 13000
ARR 100
153.846153
8462
Advantages
 This is quite easy to understand and calculate Provide indication related to profitability of business
Disadvantages
 Issues related to deprecation and scrap value is faced Does not focus upon time value of money

3. RISK AND UNCERTAINTY
Risk management techniques in investment appraisal can be discussed and evaluated.
These techniques are the proven methods with the help of which risks and uncertainty that are
associated with investing can be evaluated. It is important to evaluate risks and uncertainty
associated with investment because failure to do so could make a project as unsuccessful. There
are various risk management techniques such as expected value, decision tree, maximax etc.
these can be evaluated below:
Expected values and decision tree
These are two investment appraisal risk management techniques which can be utilized by
managers. In this technique, the managers use probabilities for weighing the possible outcomes
of various events. This technique is beneficial as it helps in ruling out the effect of those factors
which are of seasonal nature (Fakhfakh, Zouari and Zouari-Hadiji, 2012). Another advantage of
using this technique is that it would offer the global manufacturing company flexibility. This is
as it can e used in a variety of formats and degrees. However, it can be evaluated that this
technique cannot be practically applied in today’s scenario of the world economy.
Maximax
This is another risk management technique which are be used by global manufacturing
company in the given scenario. Maximax technique is based on the assumption to maximize all
the possible returns which takes into account the implications of occurrence of any bad event.
This technique is beneficial as it would provide the global manufacturing company with an
opportunity to select that alternative with the help of which highest possible outcome can be
achieved (Carroll, 2007). Another benefit is that it allows for the preparation of a payoff table
through which all the possible outcomes of a particular decision can be outlined under different
scenarios.
Maximin
This is the technique in which that option is selected which maximizes the payoff. Hence,
with the help of this technique, the manager of the global; manufacturing company will be able
to assemble all the worst outcomes. Out of them, the best outcome can be selected. However, this
is called as a pessimistic approach to investment appraisal. This approach has a different

perspective in which it is assumed by the managers that worst will happen. Following this,
measures are taken by them to overcome the worst situation (Carmichael, 2011).
Sensitivity analysis
This is a technique which involves a question and answer session. This is also called as
“what if” analysis. It deals with determining the effect that increase in operational cost has on
NPV of a project. This technique is used for determining the ways in which a particular
dependent variable is impacted by different values of an independent variable. However, this is
done under a given set of assumptions (Shim and Siegel, 2008). Sensitivity analysis is a useful
technique which can be used by global manufacturing firm to determine the impact that
investment will have on the company and its operations. Another advantage of this technique is
that it is a simple technique with the help of which ri9sk measure can be calculated by the global
manufacturing firm.
Conclusion
The report explained advantages and limitations associated with different investment
appraisal techniques. Similarly, assumption and critical evaluation in also done thereby
competitive edge of firm can be created by offering good quality of services to end users in
reasonable price. On the basis of given scenario and evaluation , it can be said that global
manufacturing company can go for investing into Machine B as it will be an profitable option.