Comprehensive Financial Analysis: Investment Appraisal and WACC

This report delves into the significance of investment appraisal processes within financial analysis and management. It provides a comprehensive overview of various techniques used by companies to determine project profitability, including Net Present Value (NPV), Internal Rate of Return (IRR), Accounting Rate of Return (ARR), Profitability Index, Payback Period, Discounted Payback Period, Equivalent Annuity, and Adjusted Present Value methods. The report critically evaluates each technique, highlighting their strengths and weaknesses in assessing investment decisions. Furthermore, it emphasizes the importance of the Weighted Average Cost of Capital (WACC) in investment appraisal, discussing its role in financial decision-making for both companies and investors. The report concludes by underscoring the crucial role of WACC in evaluating projects with different risk profiles and its significance in techniques like NPV and IRR. Overall, the analysis provides valuable insights into effective financial analysis and management practices.

Financial Analysis and
Management

Table of Contents
INTRODUCTION...........................................................................................................................1
1. Significance of investment appraisal process.....................................................................1
2. Critically evaluate the techniques employed in investment appraisal process...................3
3. Importance and weighted average cost of capital (WACC)...............................................7
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Financial analysis and management implies the process of evaluation of budgets,
projects, businesses and other finance related organisation for determination of their suitability
and performances. In general, the financial analysis process is performed in order to analyse the
stability, liquidity, solvency and profitability of the business organisation. This Project report
will discuss about the significance of investment appraisal process and techniques or measures of
investment appraisals that are adopted by the companies for determining the profitability of the
company (Ahi and Searcy, 2013) Finally, the discussion regarding the importance of WACC in
investment appraisal process is discussed.
1. Significance of investment appraisal process
Decisions which are linked to the investments are crucial and major decisions for any
business firm. Making an investment is the crucial way to enhance and optimise return on the
stockholders’ wealth. Although, having right decisions is one of the crucial challenge or
constraints which management faces. Investment decisions are simply means that the initial
investments are made in order to expect that the project would give the return in near future.
Investments could be assessed from diverse perspectives such as its suitability as per the firm’s
objective, social cause, environmental concern and so on. But only cash flows are considered
while deciding the soundness of the project. This can be considered by using various investment
appraisal techniques as it has been use as utmost important ways to get complete information
about the project growth and stability.
Here are some of the benefits of investment appraisal techniques which are mentioned as
under:
Cash Flow and Time Value of Money: While considering investment appraisal
procedure, forecasting of cash inflows and outflows are the primary objectives which is required
to know while knowing the project sustainability and react accordingly. This is because, existing
needs for any project will be determined as per the needed finance that could be considered.
While on the other hand, in case of forecasting of furniture, all figures are forecasted on relying
on certain condition that are related with the company. The forecasting amount can be presented
in an organisation to measure such forecasted cash amount in accordance with current value.
Once these forecasted figures are accessible, organisation measure in accordance with terms and
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condition that are based on present values. It is simply mean time value of money. which is
simply elaborates by quoting an example of pound which say that today’s value of pound does
not equal to the tomorrow’s value of pound. By putting time value of cash, stockholder requires
to be rewarded for positive features or components. Henceforth, this is rightly said that the future
value is converted into present value in order to find out the current worth of the cash outflows.
(Alviniussen and Jankensgard, 2015)
Other inputs: There are various components that are needed to be adopted for measuring
of cash flows. For aiming of measure accurate cash flows, an accurate time frame is required to
be known while cash flow has occurred. Although, depreciation cannot cover additional amount
related business. Henceforth, this can’t be comprised at the time of measuring cash flow. Other
one is calculating working capital. Apart from huge and certain depreciable assets, investment
does likewise form in the working capital. This comprises items such as cash, account
receivables, inventory that are part of organization’s assets and creditors are the part of the
organisation’s liabilities. Other crucial component is the interest and this could be seen from two
aspects. Firstly, if organization is employing its own funds. In such a case, this is losing interest
that it would have earned, by depositing capital in the bank. This does not need any kind of
treatment here, as this has simply been adopted as the opportunity cost and treated accordingly.
Discount rate:
It has been found that the current value of estimated cash inflows can be taken into
account as more reliable for getting better outcomes in case the discount rates. It included the
time value of company. It is the risk free rate in addition with risk premium. Risk premium
includes the risk which has been arise in execution of specific project activities. There are some
methods in which time value of money are not considered such as payback period method, and
accounting rate of return. In these methods, the discount rate is not required.
Risk Free Rate:
It includes expected inflation rate along with the interest on capital which is considered as
the opportunity cost of capital. According to the Arnold, the risk free rate forms the bedrock for
the time value of money.
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Risk Premium
It is the extra return provided to the investors who tolerate extra risk on their investment.
Is like a compensation which is given to investors for the risk they are facing on their investment.
For example, investment in well-established corporations involves less risk due to which the
return on such investment are also less. Whereas investment made in less established companies
involves high risk due to uncertainty of profitability this getting high return on their investment.
2. Critically evaluate the techniques employed in investment appraisal process
Capital investment appraisal techniques also called as the capital budgeting process is
basically a planning tool which assists the companies in choosing the investment projects for the
company by evaluating the profitability of the given projects. The components of firm which are
included under this investment appraisal process includes new plants and technologies, research
and development, and advertising campaigns. (Babalola, and Abiola, 2013)
The factors related to the investment appraisal process are implemented by taking into
consideration the priorities and preferences of stakeholders and decision makers of the company.
This available broad criteria of investment appraisal process are undertaken with a view to
enhance the overall long term growth of the form and the short-term profitability of the
company. For this purpose and to achieve a proper understanding of the investment appraisal
process the companies uses various techniques of investment appraisal which are discussed
as under:
 Net present value method(NPV): The net present value of any project is calculated as
present value of inflows minus present value of outflows. This is the most common
techniques that is adopted by every organisation in order to evaluate the profitability of
the project. According to this method all the projects whose NPV turns out to be positive
is selected and that project is considered to be profitable. The NPV Turns out to be
positive only when the Inflows of any project are greater than the outflows of the project.
The NPV method works in every project type whether the projects are independent or
mutually exclusive. In case of independent projects, all those projects are selected whose
NPV is positive and in case of Mutually exclusive projects that project is selected which
have the highest NPV among the given projects. That is why NPV is the most suitable
and easy method of analysing the profitability of a project.
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NPV= P.V. Of inflows – P.V. Of outflows
 Internal rate of return: The internal rate of return is the return at which the present
value of outflows is equal to present value of inflows. This technique of selecting the
project is also efficient but it requires the analyst to have information regarding the cost
of capital of the company, because for determining the profitability of the project the
IRR is need to be compared with the cost of capital of the firm. The projects with the
IRR greater than the Cost of capital are considered as profitable and the projects with
the IRR less than the cost of capital are rejected as it decreases the shareholder’s wealth.
 Accounting rate of return: This techniques of investment appraisal assists the
managers in comparing the profitability of the given projects according to the initial
investment that is done in the projects and accordingly chooses those projects which
have high profitability and whose initial outlays are low. This is the common rule in the
selection of projects that projects who have higher rate of return are preferred firstly
then projects with a lower rate of return. ARR is a non-discounted technique of capital
budgeting where the time value of money is not considered in determining the
profitability of the project. (Brigham, and Houston, 2012)
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Profitability Index: The profitability index of the project is calculated Present value of inflows
divided by present value of outflows. According to this technique all those projects whose
Profitability index comes out to be more than 1 are considered profitable and selected by the
company. And the projects with the profitability index less than 1 are rejected by the company as
it will decrease the wealth of the shareholders. (Chandra, 2011).
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 Payback period: The payback period is that period which the company calculates to
know in how much time the company will recover the amount of outflow that the
company have incurred on a particular investment. The payback period is considered as
one of the easiest technique of invest appraisal. In this those projects are selected whose
payback period are shorter as compared to the longer payback period projects.
Payback Period = Initial investment/Cash flow per year
Payback period = 3.144 years
 Discounted pay-back Period: This investment appraisal technique is similar to the
payback period but the only difference in this technique is that it considers the time
value of money in the calculation of payback period. The selection criteria is same in
this technique as payback period, those projects are selected whose discounted pay back
period are shorter as compared to longer payback periods (Fredrick, 2013).
Discounted Payback Period = - ln (1 - investment amount × discount ratecash
flow per year) /ln(1+rate)
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 Equivalent Annuity: In this technique the capital investment appraisal is done with the
assistance of equivalent annuity which compares project with different life spans. In the
conditions where the life spans of projects are different the NPV analysis will not give a
justified analysis of the profitability of the projects and it will not be considered as a fair
comparison. Under this technique, it divides the value of NPV with the annuity factor
which results in expressing the NPV according to annualised cash flow (Lee, Lin, and
Shin, 2012).
 Adjusted present value method: This method of investment appraisal overcomes the
issues and problems of the net present value method and also evaluates the projects on
the basis of the risk also that is associated in undertaking that particular investment.
3. Importance and weighted average cost of capital (WACC)
The significance and utilisation of weighted average cost of capital as tool of financial
analysis is important for both the companies and investors. This is significant for the companies
in order to come at a financial decision and evaluating the projects who have similar and
dissimilar risk in the market. For the calculation of important investment appraisal techniques
like NPV and internal rate of return requires the WACC. The weighted average cost of capital is
equally important for the investors for taking various decision regarding whether or not to invest
in the projects of the company. The calculation of weighted average cost of capital requires all
the different cost of capital from where the firm has acquired the capital such as cost of equity,
cost of debt, cost of preference shares and cost of retained earnings. In other words, the WACC
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is that return which the company at least has to earn in order to cover the cost of the capital that
is acquired from the market. Whereas from the investors point of view it is the opportunity cost
of their capital. If the returns that are earned by the companies are less than the weighted average
cost of capital then it means that is destroying the value and investors and shareholders will
discontinue their investment in the company (Seuring and Gold, 2012).
The following points will explain the significance of WACC and how it is utilised by the
company and various investors to reach at certain decisions:
 Investment decision by company: The weighted average cost of capital is broadly used
by the organisation for determining the profitability of the company in certain ways
which are discussed below:
Evaluating the projects with same risk: When the new projects that are opted by the
company are of similar risk like the current projects of the company, the WACC works as an
appropriate benchmark rate in deciding whether to accept or reject these projects.
Evaluating projects with different risks: Weighted average cost of capital can be used as a
suitable measure to that can be utilised to evaluate a project given that two underlying
assumption are correct. These assumptions are similar capital structure and same risk. What the
companies can do in this situation is that they can perform certain modification in WACC with
respect to the risk and capital structure of the firm.
Discount rate in net present value calculations: The net present value method is a widely
used method for the evaluation of profitability of the projects and investments in the
organisation. The calculation related to net present value considers WACC as the discount rate
and hurdle rate. The cash flows that are discounted for the calculation of net cash inflow are done
with the use of weighted average cost of capital.
Calculate Economic Value Added (EVA):
EVA are find out through making calculation in which cost of capital has been deducted
from the net profits of an organisation. While calculating the EVA, WACC will be treated as
company's cost of capital. Due to this, WACC are also known as a measure of value creation
(Liang and van Dijk, 2011).
Valuation of company:
Before investing amount in company, the investors first find out the actual financial
position of company in order to determine whether the company are capable to provide them
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future returns on their investment. On the basis of fundamentals, the investor will first determine
the future cash flows and discount them using the WACC and divide the result by number of
equity shareholders. Thus, the investors will get the amount of per share value of the company.
Through analysing whether the investing in such company will bring maximum return on their
investment in near future, it is important as an investor to compare the per share value with the
current market price of company so that an effective decision can be made regarding making
investment. If the valuation is higher than current market price, then the scrip is under-pricing
whereas if it is less than current market price then the scrip is overpricing. For example, if the
value is 25 and current market price is 22 then the investor may have option to invest at 22 with
an expectation of increasing prices to maximum of 25 and vice versa (Scarborough, 2016).
Important Inferences that can be Derived from WACC:
Some of the important reasoning that can be derived from the WACC to understand various
issues that the organisation of management should address are as follows:
 Effects of leverage: With the consideration of the net income approach it can be seen
that the effects of leverage are reflected in the WACC. So it can be said that the WACC
of the company can be optimised by changing the debt related component of the capital
structure. The lower the WACC of the company the higher will be the return or valuation
of the company. The low rate WACC also enables the company in choosing projects
which have low rate of return and still earning a return on them.
 Optimal capital budgets: the increasing the magnitudes of the capital of the company
will increase the WACC also. With the assistance of the schedule of WACC and project
schedule an capital budget which is optimal will work out for the company(Pirson and
Turnbull, 2011).
CONCLUSION
It can be concluded from the above project report that importance of investment
appraisals plays an significant role in making analysis about the projects of the company and
uses of invest appraisal techniques such as NPV, IRR, ARR , payback method , profitability
index with the examples of how to use them are done in this report. Finally, the role of Weighted
average cost of capital in the process of investment appraisal has also been done here.
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REFERENCES
Books and Journals:
Ahi, P. and Searcy, C., 2013. A comparative literature analysis of definitions for green and
sustainable supply chain management. Journal of cleaner production. 52. pp.329-341.
Alviniussen, A. and Jankensgard, H. , 2015. Enterprise risk budgeting: bringing risk management
into the financial planning process.
Babalola, Y. A. and Abiola, F. R. , 2013. Financial ratio analysis of firms: A tool for decision
making. International journal of management sciences. 1(4). pp.132-137.
Brigham, E. F. and Houston, J. F. , 2012. Fundamentals of financial management. Cengage
Learning.
Chandra, P. , 2011. Financial management. Tata McGraw-Hill Education.
Fredrick, O., 2013. The impact of credit risk management on financial performance of
commercial banks in Kenya. DBA Africa Management Review. 3(1).
Lee, P. T. W. , Lin, C. W. and Shin, S. H. , 2012. A comparative study on financial positions of
shipping companies in Taiwan and Korea using entropy and grey relation analysis.
Expert Systems with Applications. 39(5). pp.5649-5657.
Liang, X. and van Dijk, M. P. , 2011. Economic and financial analysis on rainwater harvesting
for agricultural irrigation in the rural areas of Beijing. Resources, conservation and
recycling. 55(11). pp.1100-1108.
Pirson, M. and Turnbull, S., 2011. Corporate governance, risk management, and the financial
crisis: An information processing view. Corporate Governance: An International
Review. 19(5). pp.459-470.
Scarborough, N. M. , 2016. Essentials of entrepreneurship and small business management.
Pearson.
Seuring, S. and Gold, S., 2012. Conducting content-analysis based literature reviews in supply
chain management. Supply Chain Management: An International Journal. 17(5).
pp.544-555.
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