Analysis of Six Variables to Ensure Negative NPV

This report discusses various investment appraisal techniques used by IKEA to evaluate the profitability of their projects. The methods include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Additionally, the report highlights the importance of risk analysis in investment decision-making. It suggests that IKEA should use sensitivity analysis, probability distribution, expected value, and decision trees to calculate NPV and risk. Furthermore, it recommends using maximin and minimax approaches to reduce the risk associated with project evaluation. The report concludes that these techniques will help IKEA make informed decisions about their investments.

Financial and Decision Making

Table of Contents
INTRODUCTION...........................................................................................................................1
Explanation and evaluation of investment appraisal techniques.................................................1
Evaluation of risk management techniques in investment appraisal..........................................4
CONCLUSION................................................................................................................................5
REFERENCES................................................................................................................................7

Index of Tables
Table 1: NPV and IRR table............................................................................................................2
Table 2: Payback period table..........................................................................................................4

INTRODUCTION
Financial decision making studies the information from balance sheets, income
statements and cash flow statements to help in management in making plans and strategies. It is
helpful for a company in mapping out their long term ans short term objectives (Francis and
et.al., 2015). The report includes evaluation of investment appraisal techniques and their
applicability. In order to fulfil the objective of the study IKEA Company has been taken in the
report. Furthermore NPV, IRR and Payback period methods have been used for the analysing the
viability of the project. IKEA is a multinational company which sells and designs furnitures,
home accessories and appliances. It is the world's largest furniture manufacturing company and
has more than 12,000 products in its portfolio.
Explanation and evaluation of investment appraisal techniques
Investment appraisal techniques studies the profitability of an investment project. IKEA
has been planning for a major investment in capital equipment. Investment is a long term
decision and it requires huge funds (Graham, Harvey and Puri, 2015). It would be beneficial for
a company to study the cost of investment, returns, payback period and profits from the capital
investment. IKEA may have to raise debt or equity to finance the project. If the project fails and
does not generate enough profits then the company would not be able to pay dividends or interest
to the the people (Götze, Northcott and Schuster, 2015). So, it is essential for IKEA to
understand the impacts of a project on the financial capacity of the company. Some of the major
investment appraisal techniques are:
NPV (Net present value)
Applicability
Net present value is applicable in the analysis and calculation of business value (Sims,
Powell and Vidgen, 2015). It uses the forecast of cash inflows of the projects and their present
value to fin out the profitability of the investment.
Assumptions
 It is assumed that all the cash flows have occurred at the end of the year (Dittrich,
Wreford and Moran, 2016).
 The cash inflows are reinvested in the business that generates income for the company.
 The market is assumed to be a perfect capital market. The cash flows related to the investment are treated as if there is no uncertainty.
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Limitations
 NPV calculations should be correct otherwise it will give incorrect information.
 NPV is not expressed in terms of percentage (Brisley and et.al.,, 2015).
Table 1: NPV and IRR table
PV
@
10%
Alternative
1 (In '000)
PV Alternativ
e 2 (In
'000)
PV Alternativ
e 3 (In
'000)
PV
Initial
Outflow
£ 300 £300 £300
Years
1 0.909 70 63.63 30 27.27 190 172.71
2 0.826 90 74.34 80 66.08 150 123.9
3 0.751 112 84.1 120 90.12 80 60.08
4 0.683 133 90.83 195 133.1 55 37.565
5 0.621 125 77.62 255 158.3 35 21.7
390.54 475.0 415.99
NPV 90.5 175 116
IRR 9.09% 13.64% 18.17%
It can be seen from the above table that NPV of second project is better and it should be
selected by IKEA. But the IRR of third project is better for IKEA which means that it should be
selected by the company (Bernroider and Stix, 2015). But in real terms, NPV should be given
preference as it includes time value of money and all cash flows of the investment. So, it would
be better for IKEA to opt for the second project as it is more profitable for them.
IRR (Internal Rate of Return)
It is a discount rate at which the net present value is zero. It calculates the break even
point and the maximum value to which the cost of a project can reach (Awojobi and Jenkins,
2015). After this level is reached the project becomes unacceptable. It can be seen in the table
that alternative 3 has the highest IRR.
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Applicability
It can be used by IKEA to compare its capital investment projects. It can compare the
expansion wit the opening up of a new branch (Brzozowska, 2015). The investment with higher
IRR should be selected by the company. It can be useful in buyback programs of the company as
well. IRR considers all the cash flows unlike payback period and it is easy to communicate as it
is represented in percentage. It can be used to evaluate the venture capital, IPO, M & A and
private equity.
Assumptions
 It is assumed the money is reinvested in the business (Crosetto and Filippin, 2015).
 Interim cash flow are also invested in the business. Projects are not mutually exclusive.
Limitations
 IRR does not give correct indication of scale.
 Negative cash flow can affect the calculation of IRR as it may show more than one values
(Götze, Northcott and Schuster, 2015).
 IRR would show incorrect results if there are not normal cash flow streams in the project.
 It cannot be used in mutually exclusive projects.
Payback period
Payback period calculates the time length of cash inflows and the initial investment. A
project which has less payback period should be selected as it will be more profitable for the
company (Payback Method, 2016). A manager needs details about the payback period of an
investment rather than the time value of money. The time period of the project can be a variable
to evaluate the viability of the project.
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Assumptions
 The return of investment continues even after the payback period (Awojobi and Jenkins,
2015).
 Payback period is expressed in years. Accept project if Payback period is less than maximum acceptable payback period
otherwise reject it.
Limitations: payback period is easy to calculate and understand but it has many disadvantages of
its own. It does not takes into consideration the benefits received after the payback period (Sims,
Powell and Vidgen, 2015). There could be a situation where the project may not generate enough
returns for the company. Payback period ignores this aspect. Furthermore, it ignores the time
value of money and size of the cash flows. The formula to calculate payback period is too simple
and IKEA can have problems when more cash is required in different stages of the investment.
So, a valuable project could be overlooked by this technique of investment appraisal.
Table 2: Payback period table
Alternative 1 (In
'000)
Alternative 2 (In
'000)
Alternative 3 (In
'000)
Initial Investment £ 300 £300 £300
Years
1 70 30 190
2 90 80 150
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Illustration 1: Payback period
(Source: Payback Method, 2016)

3 112 120 80
4 133 195 55
5 125 255 35
530 680 510
Payback period 3.2 years 3.4 years 1.7 years
It can be seen from the table that the payback period Alternative 3 is the least. IKEA
would be able to recover their initial investment in 1.7 years if they opt for the third project.
They won't be having any liquidity issues in the company with this project.
Evaluation of risk management techniques in investment appraisal
IKEA may face many risks while evaluating the viability of the investments project
(Brzozowska, 2015). The major risk are insufficient past experience, More than one outcomes
and assigning probabilities to the outcomes. Many projects have variable future cash flows which
increases the risk of the company. As the variability of the cash flows increases the risk also
increases (Investment Appraisal, 2009). Thses risks have to be reduced as it will ensure the long
term benefits to the company. Some of the problems that IKEA may face are:
 The cost of the projects may surpass the budgets set up by the company.
 The estimates for several years may not be appropriate.
 An investment decisions would be better in terms of scale then other activities (Dittrich,
Wreford and Moran, 2016).
 The new project could be a part of new strategy or plans of the company.
There are some methods which are used by the management of IKEA to evaluate the risk in
investment appraisal techniques:
Sensitivity analysis: It assesses the responsiveness of NPV with the change in variables
used in the calculation. In calculates the sensitivity which is associated with the appraisal
technique (Francis and et.al., 2015). It uses alternative assumptions to find out the sensitivity of
NPV to its changing conditions. There could be number of variables which could affect the NPV
like selling price, sales, cost of capital, initial cost, operating costs, residual value and benefits. It
gives an idea to the manager that why project fails. The variables have to be analysed to ensure
that they do not result in negative NPV (Crosetto and Filippin, 2015). A lower percentage
indicates more sensitivity of the project.
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Sensitivity (%)=NPV / (Present value of project variables)
Probability analysis: Probability analysis can also be used to calculate NPV and risk.
The probability distribution of cash flow can estimated and the results could be evaluated.
Initially the expected value of the NPV is calculated (Dittrich, Wreford and Moran, 2016). All
the risks associated with the business is evaluated and probabilities are computed. After that
NPV and standard deviation is calculated for he project. It can be a complex procedure for a
manager as it requires many calculations. But it will allow IKEA to reduce the risks of the
investment appraisal techniques.
Expected value and decision tree: These are management tools which are used to
calculate the risk of the investment appraisal techniques. It considers all those factors which are
seasonal in nature. It uses averages for a long term repetitive events (Graham, Harvey and Puri,
2015).
Apart form these techniques, IKEA can use maximin and minimax approach for reducing
the risk. It basic idea behind this technique is to maximize the possible returns of the project and
ignore the consequences of the project (Investment Appraisal, 2009). While minimax is opposite
of maximin and it takes into consideration the worst consequences from all the projects. It is a
pessimistic approach of evaluation of risk but it is very beneficial for the invest appraisal
technique of IKEA.
CONCLUSION
The report concludes that IKEA has to use investment appraisal techniques like NPV,
IRR and payback period to ensure that their investments are profitable. These techniques allow
them to choose the best alternative from the given investment opportunities. So, it reduce the risk
of failure of the project as the future profitability can be calculated with the help of it. There are
certain limitations of IRR, NPV and payback methods which has to be considered before using
them. The management of IKEA has to adopt same risk evaluation methods so as to reduce these
risks and uncertainties.
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REFERENCES
Books and journal
Awojobi, O. and Jenkins, G., 2015. Managing the Cost Overrun Risks of Hydroelectric Dams:
An Application of Reference Class Forecasting Techniques (No. 2015-06). JDI Executive
Programs.
Bernroider, E.W. and Stix, V., 2015. On The Applicability of Data Envelopment Analysis for
Multiple Attriliute Decision Making in the Context of Information Systems
Appraisals. Communications of the IIMA, 6(2), p.13.
Brisley, R. and et.al.,, 2015. Techniques for valuing adaptive capacity in flood risk
management.Proceedings of the ICE-Water Management.
Brzozowska, K., 2015. Cost-Benefit Analysis in Public Project Appraisal.Engineering
Economics, 53(3).
Crosetto, P. and Filippin, A., 2015. A theoretical and experimental appraisal of four risk
elicitation methods. Experimental Economics, pp.1-29.
Dittrich, R., Wreford, A. and Moran, D., 2016. A survey of decision-making approaches for
climate change adaptation: Are robust methods the way forward?. Ecological
Economics, 122, pp.79-89.
Francis, B. and et.al., 2015. Gender differences in financial reporting decision making: Evidence
from accounting conservatism.Contemporary Accounting Research. 32(3). pp.1285-1318.
Götze, U., Northcott, D. and Schuster, P., 2015. Capital Budgeting and Investment Decisions.
In Investment Appraisal (pp. 3-26). Springer Berlin Heidelberg.
Graham, J.R., Harvey, C.R. and Puri, M., 2015. Capital allocation and delegation of decision-
making authority within firms. Journal of Financial Economics, 115(3), pp.449-470.
Sims, J., Powell, P. and Vidgen, R., 2015. Investment appraisal and evaluation: preserving tacit
knowledge and competitive advantage.International Journal of Business and Systems
Research, 9(1), pp.86-103.
Online
Investment Appraisal. 2009. [Online] Available through:
<https://www.icaew.com/~/media/corporate/files/technical/business%20and%20financial
%20management/special%20reports%20archive/sr27%20investment%20appraisal.ashx>.
[Accessed on 4th May 2016].
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Payback Method. 2016. [Online] Available through: <http://www.accountingtools.com/payback-
period-formula>. [Accessed on 4th May 2016].
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