Benefits and Limitations of Investment Appraisal Techniques

This document discusses the benefits and limitations of investment appraisal techniques such as payback period, net present value, and internal rate of return. It explores how these techniques impact decision-making and profitability. Additionally, it highlights different funding sources for businesses.

Financial Analysis Management
& Enterprise

Table of Contents
TASK 1............................................................................................................................................3
Critically evaluating several benefits and limitations attached with investment appraisal
techniques ...................................................................................................................................3
TASK 2............................................................................................................................................8
Highlighting different funding sources ......................................................................................8
REFERENCES .............................................................................................................................13

TASK 1
Critically evaluating several benefits and limitations attached with investment appraisal
techniques
a. Payback Period
Interpretation- From the above table it is analysed that shorter the payback period, less
time the project will take to recover an initial outlay and vice versa. As the value of small
development projects is less in comparison to other proposals, it indicates that this development
would recover an initial cost in 3.33 years.
b. Net present value
Payback period (in years)
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
3.33
4
4.44
Small
Medium
Large

Interpretation- The above analysis reflects that all the three projects are generating
positive value of NPV which that all the projects are viable and desirable.
c. Internal Rate of Return
NPV (£m)
0
1
2
3
4
5
6
7
8
4
6
7.5
Small
Medium
Large

Interpretation – From the above tables and graphs it has been presented that higher the
IRR, more the project is feasible. As the size of the property increases, IRR also rises which
means that large scale development will generate higher rate of return as compared to other
developments.
Advantages and disadvantages of capital budgeting tools -
Payback period- It referred as the time needed for recouping the funds that are invested
or expended in investment or in reaching out the point of break-even (Mentari and Daryanto,
2018). In other terms, it determines length of the time needed in recovering an initial investment
cost within the project.
Merits Demerits
Simplicity- This method seems as very easy
and simple in terms of understanding. It means
that it does not need particular knowledge and
the accounting rules for applying. Therefore,
this technique is applied universally in
evaluating the proposals.
Ignores the concept of time factor- It does
not count time value of the money which is
seen as the major limitation as it does not
shows accurate time period.
IRR (%)
0
5
10
15
20
25
30
35
30
25
22.5
Small
Medium
Large

Decision-making- Company could choose the
most suitable project by making use of this
method that is having the lowest period of
payback and rejects the project with longer
payback period.
Ignores Profitability- It focuses on the
liquidity and the speedy recovery of an
investment but entirely ignores the
profitability.
Suitable for the small & new companies-
This method is found as useful for the small
firms and the new entities having less cash or
weaker liquidity position.
Disregard the cash flow after the PBP- This
tool provides more focus on cash flow prior to
payback period (de Vries and Veurink, 2017).
It does not consider cash flow after the period
of payback.
Emphasize on risk- It is the method that focus
on risk factor so it is seen as the most
appropriate for the company that does not take
any risk.
Overlooks cost of capital- This method
emphasize on only the capital cost and ignores
the interest factor.
Focus on the liquidity- This capital budgeting
tool mainly emphasize on the liquidity and
helps in attaining speedy or quick returns from
investment (Levy and et.al., 2018).
NPV- It is revealed as present value of future cash inflows from investment project and
reflects the firm's estimate of possible profit from investment in the proposal.
Merits Demerits
Simple to use- The NPV method as easy in
applying to real business proposals if cash
flows and the rate of discount is known
(Chisholm and et.al., 2016).
Forecasting errors- At the time of analysing
viability of the long-lived proposal, an
anticipation of the cash flows might not deem
as accurate for later years.
Considers Time value of the money- It takes
into account an effect of the inflation on
ascertaining profitability of the future project
Minimum contribution to wealth
maximization- High NPV does not mean as
increasing the value of share so it contributes

through estimating time factor concept. very little in maximizing the shareholders
value.
Customization- In this technique, discount
rate could be adjusted as per risk prevailing in
industry with several other factors for
obtaining an adequate output.
Dependent on discount rates- As this tool is
based on the discount rates, even a little change
might result to entirely different value of NPV.
Determines value of an investment- The
profits throughout project's life could be
accounted by making use of this method. It
helps the company in knowing future value of
the particular investment.
Neglects sunk cost- It relates to R&D and trial
cost which incurred prior to starting of the
project is seen as high (Kind, Baayen and
Botzen, 2018). Such cost is entirely ignored
under calculation of NPV.
Measures profitability- It is seen as the most
proficient technique of identifying actual
profitability that the project will generate in its
lifetime.
IRR- It is the metric that is used in investment appraisal for estimating profitability of
specific investment (Monnappa, 2020). It means the discount rate which makes NPV of all the
cash flows from specific project equating to 0.
Merits Demerits
Considers time factor- This capital budgeting
method considers time value of the money
even in case when the annual cash receipts is
uneven or even.
Based on assumption- It assumes that
earnings are been reinvested at IRR for
remaining life of project. In case ARR does not
result close to IRR, profitability of project does
not justifiable.
Considers profitability- It takes into account
project's profitability over economic life of
proposal. In this manner, true value
profitability is been evaluated.
Only focus on profitability- IRR provides
importance only to profitability and does not
count earliest recouping of the capital
expenditure (Huat and et.al., 2019). This is

because in some cases IRR favours the project
that comparatively needs long period in
recouping capital expenses.
No need to determine cost- Under this
technique there is no requirement of pre-
determining the capital cost or the cut-off rate.
Therefore, IRR is found as better than NPV.
Differed results- The evaluation of NPV and
IRR might differs when project under an
evaluation differs in life, size and the timing of
the cash receipts.
Facilitates ranking- In this ranking of the
project proposal is considered as very easy
since it depicts percentage rate of return.
Maximize wealth- IRR focuses on
maximizing wealth as higher return leads to
increased value of shares.
TASK 2
Highlighting different funding sources
Finance is counted as significant for the business because it could not carry out the
operations even for the single day without raising finance. Therefore, it is crucial to search for
the sources from where the funds could be gathered. Selecting the funding source depends on
amount of the funds needed, repayment period, equity-debt mix and nature of the business.
Choosing the source depends on purposes for which the funds are required (Tsusaka and et.al.,
2016). For raising 30 million Euros as a capital for building the new supermarket store, company
can raise the funds through various mediums that are as follows-
Shares- A large amount of funds needed is been collected by issuing shares to the public.
It could be issued for any of the purposes like expanding the existing business concern ,
reorganizing etc. In this firstly the amount that is to be collected by the shares is decided on first
and then value of the shares are been issued to public which must not exceed the predetermined
value. There are different types of the shares which could be issued to public that are indicated as
follows-

 Preference shares- An individual holding such shares has the is been entitled for getting
fixed rate of the dividend and gets priority in context of receiving dividend and
repayment at the time of winding up against the equity shareholders (Bellavitis and et.al.,
2017). However, they would not be having the right to vote and would not be getting
higher than fixed amount of dividend even in case the profit is of large amount.
 Ordinary shares- It means issuing of such shares on which the amount of dividend will
be distributed only after making payment of fixed dividend to the preference
shareholders. The major benefit for holders of an ordinary shares is stated as there is not
any limit on the amount of dividend & therefore they could get higher rate of dividend, in
case the profits are of very large amount. In case there resulted a loss then holder of
ordinary shares does not receive dividend.
 Deferred shares- This type the shares which have their claim at last of all the other
shares and the holders of such shares receives the dividend only after dividend payment is
made to all the other class of the shares (Zhaofeng, 2016). These kinds of shares are
mainly issued to promoters and an individual who enabled in formation of an entity.
Debentures- When the firm desires in raising finance by way of loans rather than sale of
the shares then the debentures are been issued. In this manner, it is benefited because the
debenture holders could not claim for the ownership and is required to paid only a fixed rate of
interest amount. Debentures might be issued for the starting needs of an entity or for extensions
& development. Holders of debenture does not have any liabilities and under this finance is been
provided for the particular period and company could adjust the financial plan based on it.
Public deposits- Company can raise their funds through accepting deposits direct from
public for the fixed terms that is 6 months – 7 years. Normally, fixed capital is been raised by
long run deposits whereas working capital through the use of short period deposits. This method
has benefit of enabling the company in keeping its share capital as low & to borrow at the
cheaper rates. This provides payment of the higher dividends than it would be possible in case an
entire money was taken in form of share capital (Cumming and Groh, 2018). It is also very
useful as banking assistance perks are not seen as appropriate for the industries. On other note,
this technique or source could not be relied on, specifically during depression period when an
industry is falling. At this time, industry needs more amount of money but depositors panic and
withdraw the funds that creates embracive position for business concern.

Managing agents- This funding sources plays a vital role development and setting up of
the new stores in an industry. Managing the agents facilitated fixed amount and working capital
by arranging the funds through other types of sources that includes inducing the relative and
friends in purchasing debentures & shares, arranging the loans from the bank and the public
deposits. It played crucial role in financing, managing and promoting the industrial concerns.
Bank Loan- This is considered as the biggest source of finance where the banks provide
finance to the company going for expansion or new project (Singh and Maiti, 2019). It is an
amount of the money borrowed for the set period in an agreed or specified schedule of
repayment. Company can use this source as suitable part of its financial structure and in fact,
bank loan tends to be more available for the well-established & growing businesses. This source
of finance deemed as suitable as once the owner has repaid the loan amount, he or she does not
have any obligation or financial burden with regard to interest payments. Comparing with equity,
this source is better as in issuing equity the firm needs to pay dividends as long the business
exists. The interest payments under bank loan are counted as tax-deductible and the fixed interest
amount is to be paid only till the period of repaying loan. The major limitation of bank loan is
that company needs to go with complex process unless the business has the substantial track or
the valuable collateral like real estate.
Ploughing the earnings back- It is considered as ideal method of the financing for an
improvement and the extensions in which part of profits are been re-invested. Under this the
capital reserved built on during the constant spell of the prosperous period could be used as the
working capital (Vinczeova and Kascakova, 2017). This system facilitates a sound FM and
helps company in accumulating funds for developing or growing their business even in period of
depression in economy.
Leasing- It reflects the manner of financing use of the assets without buying them
outright. It is one of essential source of the medium and the long term finance where owners of
asset provides the right to other person in using the asset against the periodical payments. In this
lessee is been given right for using an asset but ownership lies with lessor and at end of lease
contract, asset is been returned to lessor or option is been given to lessee either for purchasing an
asset or renewing lease agreement. In this case, lessor transfers all reward & risk that is
incidental to an ownership to lessee without transferring ownership of an asset, thus ownership
lies with lessor. Ownership under leasing agreement lies with lessor, the tax benefit is mainly

enjoyed by lessor through depreciation in context of the leased assets (Cumming and Vismara,
2017). The demand for this financing source is increasing because it is indicated as efficient
source comparing to other sources. Economic growth could be maintained even during a period
of depression and thus growth potentiality of the leasing is seen as much higher in comparison to
other kinds of business. On other side, lease financing is counted as more expensive as compared
to other funding medium as lessee need to pay the lease rental and expenses incidental to
ownership of an asset.
Profit flow-back- In this the profits are not been distributed to shareholders or the owners
& is retained for the growth and financial expansion of business enterprise. This would help the
firm in not raising the funds from outside so that financial burden is not been created with
respect to paying interest or distributing dividends. It also helps in saving cost and time which is
been involves while issuing the shares and debentures. Moreover, dilution of ownership would
not be resulted by using the profits for setting up the supermarket (Finance sources, 2020).
However, it has also seen that by retaining the profits for further expansion, the reserves and
profits will decline and the wealth will not be increased as shareholders would not be receiving
their dividend income. This results to decrease in the value of company's shares.
Credit facilities- It is the most crucial source of the short term finance in which the
company could get its goods and the services for their new supermarket store on credit. In this
case if the cash discount is been offered, the discount forgone becomes as the cost of the trade
credit.
Trade credit- This source of finance shows the assistance available from the other firms
from whom the company has the dealings such as suppliers. If the company has already dealing
with its suppliers and good relationships, then it could take loan from them in order to open one
more branch (Tsusaka and et.al., 2016). It is seen as simplest and economic financing source as
it does involve any kind of the risk and finance related burden as bank loan has in relation to
paying interest payments at a specified interval of time.
Bonds- It is the special type of source in raising the funds as under this debt instrument
are been issued by an enterprise. It seems as different from other debt financing instrument as in
this the firm specifies interest rates and the particular time period after the corporation would pay
back principal amount. In this company do not have make any type of payment on principal till
specified or mentioned maturity date. Price paid for bond at time of issuing is referred as the face

value and when the firm issues the bond it guarantees for paying back principal along with
interest. From the financial perspective, issuing the bond offers an entity with great opportunity
for accessing the funds without paying back till it successfully applied funds. Under this risk for
investors is that if company would default or insolvent before maturity date then the money of
the invested by the stakeholders would go in bad debts. On the other note, as bonds are the debt
instrument, they are seen as ahead of the equity holders for assets of the firm.
Warrants- It means as the special type of the instrument that is been used as the long
term source of finance. They seem as useful for the companies seeking for opening new store for
encouraging an investment by minimum downside risk whereas facilitating upside potential. It is
reflected as security that grants the right to owner of warrant in buying the stock in issuing firm
at the pre determined price at future date. Its value shows the relationship of stock's market price
to purchase price of stock. In case if market price of stock increases above warrant price, holder
could exercise warrant. It involves purchasing stock at price of warrant in which it facilitates
purchasing of stock at the price below the present market price (Zhaofeng, 2016). Contrary to it,
If CMP of stock lies below warrant price, it is seen as worthless because exercising warrant
would count to be same as buying stock at the price higher than CMP and due to this warrant
expires. This security consists of the particular date of expiry in case if it is not exercised up-to
that date.
Angel investors- They are the individuals & business that has interest in enabling the
company to grow and their main objective might be more than focusing on the economic returns.
Although the angel investors often have mission focus, they still have interest in the profitability
and the security for their respective investment. They also have interest in economic
development of the specific geographical area within which they are been located. Angel
investors emphasize on the earlier stages of financing and the smaller amount of financing in
comparison to the venture capitalists.
Government grants- The state & Federal government often have the financial assistance
in form of the grants or the tax credits for the start-up or for the expanding businesses.
Life insurance policy- The main feature of such policy is an owners' ability in borrowing
against cash value of policy (Huat and et.al., 2019). This could be used by tshe company for
meeting its needs regarding the funds for building its new store of the supermarket.

REFERENCES
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Cumming, D. J. and Vismara, S., 2017. De-segmenting research in entrepreneurial
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Huat, J. and et.al., 2019. Benefits and limits of inland valley development to enhance
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Online
Finance sources. 2020. [Online]. Available through
:<https://www.yourarticlelibrary.com/financial-management/lease-financing-types-
advantages-and-disadvantages/43833>