Comparison of Investment Appraisal Techniques

This assignment provides a detailed analysis of different investment appraisal techniques used in finance. It includes a comparative study of conventional and Islamic financial institutions' investment practices. The report covers topics such as internal rate of return, life cycle cost analysis, and the impact of scrip dividends on equity forwards. A review of various references from books and journals is also included. The assignment aims to provide an understanding of the advantages and disadvantages of different investment appraisal techniques.

Financial management

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
QUESTION 2 LONG TERM FINANCE; EQUITY FINANCE.....................................................1
2.1 Determining the:...................................................................................................................1
2.1.1 Number of shares need to be issued ..................................................................................1
2.1.2 Computation of theoretical ex-right price .........................................................................1
2.1.3 Expected earnings per share ..............................................................................................2
2.1.4 Presenting the form of the issue for each rights issue price...............................................2
2.1.5 Presenting results in a tabular form and critically evaluating the best option among the
three right issues..........................................................................................................................3
2.2 Scrip dividends with its critical views..................................................................................3
Question 3 Investment appraisal techniques...............................................................................5
3.1 Calculating different investment appraisal techniques with recommendations....................5
3.2 Merits and demerits of investment appraisal techniques (Payback period, Accounting rate
of return, Internal rate of return and Net present value).............................................................7
CONCLUSION..............................................................................................................................10
REFERENCES..............................................................................................................................11

INTRODUCTION
Financial management gives an effective and efficient management of fund which will be
attaining the organization's objective as it is directly specialised function along with top
management. It is integrated with proper decision making process. Future planning of a person or
business ensure a cash flow which is positive which also includes maintenance and
administration of financial assets. It also gives ways and its alternative that how business can
finance it from shareholders fund with the combination of equity share capital, preference share
capital and profits which are accumulated. All the financial decision which consists of
acquisition of finance which is required from perspective of long term investments. In this report
there is a brief discussion about dividend decisions i.e. particular profit which has been earned
and there alternatives for retaining profit and how to distribute the margins from shareholders.
The present report gives an understanding about how to identify the shares which are to issued
with there theoretical ex rights price, earnings per share which has been expected, forms of issue
for every rights issue price and that results with interpretation in tabular form. And significance
of scrip dividend has been elaborated. Different investment appraisal techniques like Net present
value, Internal rate of return, accounting rate of return and payback period with the merits and
demerits has been explained.
QUESTION 2 LONG TERM FINANCE; EQUITY FINANCE
2.1 Determining the:
2.1.1 Number of shares need to be issued
Company wants to raise : 180000
Total shares issued by company: 300000
rate of per share: 50
Number of shares needed to be issued is = 180000/50 i.e. 3600
2.1.2 Computation of theoretical ex-right price
Theoretical Ex-Rights Price:
= Market Value of shares prior to rights issue + Cash raised from rights issue
Number of shares after rights issue
When price of right issue is £1.80
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Particulars Figures
Current number of shares 60000
Number of additional shares issued 10000
Current market price per share 1.90
Rights issue price 1.80
Theoretical ex-rights price 1.89
When price of right issue is £1.60
Particulars Figures
Current number of shares 60000
Number of additional shares issued 10000
Current market price per share 1.90
Rights issue price 1.60
Theoretical ex-rights price 1.86
When price of right issue is £1.40
Particulars Figures
Current number of shares 60000
Number of additional shares issued 10000
Current market price per share 1.90
Rights issue price 1.40
Theoretical ex-rights price 1.83
2.1.3 Expected earnings per share
EPS (earnings per share): Net income – preferred dividend / average number of shares
outstanding
Earning per share: (300000-180000) / 700000
0.17
2.1.4 Presenting the form of the issue for each rights issue price
 When price of right issue is 1.80 then the current price is 600000 and expected price has
been calculated as 700000 by getting the amount (180000/1.8) that is 100000. On this
perspective our 20% profit is evaluated as 140000 (Dasgupta, Prat and Verardo, 2011).
 When price of right issue is 1.60 then the current price is 600000 and expected price has
been calculated as 712500 by getting the amount (180000/1.6) that is 112500. On this
perspective our 20% profit is evaluated as 142500.
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 When price of right issue is 1.40 then the current price is 600000 and expected price has
been calculated as 728571 by getting the amount (180000/1.4) that is 128571. On this
perspective our 20% profit is evaluated as 145714.
2.1.5 Presenting results in a tabular form and critically evaluating the best option among the
three right issues
Current Expected
When price of right issue is
£1.80
600000 600000
100000
700000
(20% profit) 120000 140000
Current Expected
When price of right issue is
£1.60
600000 600000
112500
712500
(20% profit) 120000 142500
Current Expected
When price of right issue is
£1.40
600000 600000
128571.4
728571.4
(20% profit) 120000 145714.3
The best option among the three right issue is of 1.40 i.e. last scenario because it is giving more
expected return by 82% approx rise from current share price (Perez, 2011).
2.2 Scrip dividends with its critical views
Scrip dividend gives an indication about process of giving a choice to shareholders that
cash dividend can be received or not, at a future point in time of dividend or even common stock.
If any of the organizations issues scrip dividend, they give permission to each shareholders for
raising size of their holdings but fees is not incurred. As scrip dividends are issued by the
organizations who is in favour of shareholders for a choice for absorbing common stock with
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respect of cash dividend which can be also reflected as capitalization issue. It is properly tied to
particular common stock from which the issuing company has permission for retaining and
creating ability to shareholders for providing and increasing the holdings of their organization.
This will lead to lowering the cost which is associated to acquirement of shares of the stock and
along with these investors will be gaining advantages related to taxation. In the same series
example can be formed that capital gain has been realized by investor instead of income so there
will be less tax on capital gain and even lower rate as compared to ordinary dividends (Carse,
2011).
As this scrip dividend policy is drawn for enabling the ordinary shareholders of bank for
electing to getting new shares rather than getting cash dividends. In the same series scrip
dividends increase the capital of company but there is requirement of extra effort by
organisation. There are many people who wants to raise their financial position of company and
even they benefit it fiscally. On the contrary side moment of stock market might not be the
efficient and even it could be more good for monetizing assets if share value is been going down.
And these shareholders only will be giving more preference to money paid rather than shares.
The issue related to scrip dividends is a wider topic for discussing on financial management with
dividend policy. Scrip issue and scrip dividends sound similar but they are not.
The main benefit of scrip dividend to shareholder that without pain he can raise
shareholding in the company without incurring any broker's cost, stamp duty or any commission
on any purchase of shares. And on the perspective of company it does not have to arrange cash
for paying it in form of dividend and in some of certain circumstances it can also help in
taxation. Many of the companies gives priority to shareholders that selection of cash dividends or
scrap dividends. Mostly shareholders prefers choice of scrip dividends because of increment in
wealth along with decrease in wealth if cash is selected. This arrangement can be also referred as
enhanced scrip. This scrip dividend efficiently transforms retained margin into share capital
which is permanent. Cash can be preserved for investing again in organisation or re-investment.
If any of scrip issue which is significant and will be not diluted the share price. As company's
gearing can be reduced by more shares and borrowing capacity will increase. Without any of
transaction cost shares will be owned by shareholders. The major limitation of scrip dividend can
be that there is not any presence of cash to shareholders along with it they have to pay taxes on
the particular dividends (Ghahremani, Aghaie, and Abedzadeh, 2012).
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QUESTION 3 INVESTMENT APPRAISAL TECHNIQUES
3.1 Calculating different investment appraisal techniques with recommendations
Life 6 years
New machine 320000
annual cash inflow 105000
annual cash outflow 15500
Depreciation 20.00%
residual value 10.00% of original cost
Cost of capital 12.00%
residual amount 32000
 Payback period= Initial investment/Annual cash inflow
3.5 Years
Interpretation: The payback period for the project is 3.5 year which is longer than
compared to ideal period. Investments with longer payback period are risky from short payback
period because in any ways future cannot be known. So shorter period of payback is
recommended (Al-Ajmi, Al-Saleh. and Hussain, 2011).
 Accounting rate of return= Net cost savings/initial investment
Net cost savings = 320000 x (32000+64000) = 224000
0.7 or 70%
Interpretation: The present project is giving 70% as accounting rate of return as it is
beneficial for the organisation but then too it is advisable to organization for putting more efforts
for increasing the rate. For accepting the project accounting rate of return should be greater or
equal to the accounting rate of return which is required and if in the condition of mutually
exclusive, the highest ARR project should be given first priority.
 Net Present value
Cash outflow Depreciation Cash inflow 12 % interest amount
Present value
of net cash
inflow
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15500 64000 79500 0.8928571429
70982.142857
1429
15500 64000 79500 0.7971938776
63376.913265
3061
15500 64000 79500 0.7117802478
56586.529701
1662
15500 64000 79500 0.6355180784
50523.687233
1841
15500 64000 79500 0.5674268557
45110.435029
6286
15500 64000 79500 0.5066311212
40277.174133
597
93000 326856.88
Price paid for new
machine 320000
Net present value of
new machine 6856.88
Interpretation: The above project net present value is 6856.88 which indicates that machine will
not pay machine will not pay for its own but it will also make value of 6856.88. For accepting
project net present value should be positive and while giving comparison between two projects
NPV should be greater than it will be considered as good investment (Kumar, Mahadevan and
Gunasekar, 2012).
 Internal rate of return
Machine amount -320000
Cash Inflow year 1 79500
Year 2 79500
Year 3 79500
Year 4 79500
Year 5 79500
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Year 6 79500
Internal rate of return 12.75%
Interpretation: As the internal rate of return is estimated by considering discounting present
value of cash flows which comes from investment on the perspective of internal rate of return.
The above calculation of IRR is giving 12.75%. In this IRR has been calculated by what
percentage return the manager must keep track on newly purchased equipment and on that basis
the organization is getting 12.75% so he should continue its operation regarding that machine.
3.2 Merits and demerits of investment appraisal techniques (Payback period, Accounting rate of
return, Internal rate of return and Net present value)
Payback Period
Merits:
 This method has absence in complexity i.e. easy and simple to calculate and understand.
 Usually the executives who are interested in snap answers for choosing proposal prefers
this method and they rank them in perspective of merits which are economic and does not
have any complications (Bernhart and Mai, 2016).
 The objective of liquidity can be stressed by payback method due to the major
importance is given to recovery of investment's capital asset.
 This method gives a big advantage to the industry where is presence of uncertainty,
instability and technological changes due to uncertainty in future does not provide
projection for annual cash inflows which are beyond a specific time period and it also
helps in reducing the chances of loss via damage or obsolescence.
 While the evaluation of investment proposals the estimation of profitability is not given
importance.
Demerits:
 Annual cash flow has been ignored.
 The period of payback is considered and timing and magnitude of cash flow is ignored.
 For preparing sound investment decision interest factor is major consideration i.e. cost of
capital is overlooked (Arrow and Kruz, 2013)
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 Usually it is subjective decision of management where so many administrative
difficulties are created and decision are not on rational basis.
 Rigidity and delicacy is present in this method.
 It has special emphasis on liquidity on the perspective of objective of decisions which are
related to expenditure.
Accounting rate of return
Merits:
 This method has similarity of payback period that it is very simple and concise for
understanding and calculating.
 Total earnings are been considered from the project along with whole economic life.
 Due weight has been provided by this approach and project has been profitable from this.
 ARR is based on proper accounting information instead of cash inflows.
 It has been used by many people because of simplicity of capital budgeting technique and
its attractiveness of investment project.
 For measuring current performance and stability of organisation it is used and in extreme
long lives, there will be presence of simple rate of return which is absolute rate of return.
Demerits:
 The results relate to this approach are very inconsistent (Penman and Zhu, 2014).
 As this method is very simple averaging technique so it does not consider the impacts of
external factors on the aggregate profit of the organisation.
 Time factor or time value of money is ignored that is a very crucial aspect of business.
 The fair and faithful rate of return on investment is not identified and it is kept hold on
discretion of management and arbitrary returns' rate may impact very serious problems
for choosing capital projects.
 Risk are not adjusted for forecasts on the perspective of long term.
 As this method can be calculated in various ways so it will lead to various outcomes.
Net Present value
Merits:
 Net present value gives special emphasis on time value of money.
 For the entire life of project earnings and savings are been considered and they can be
easily transformed into present value of money.
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 It gives proper classification and comparison of assessment of various projects.
 While comparing on the basis of net present value, the highest amount of NPV can be
implemented and this will maximise profit of organizations and its efficiency will
increase.
 The implementation can be on basis of cash flow which are even or non even.
 Usually every economists prefer this method due to theoretically unassailable.
 High priority has been assigned to profitability and risk.
Demerits:
 The expected rate of return which is gained cannot be indicated in this method.
 When there is requirement of various different levels of investment amount along with
this different economic life span of projects so this method has not capability to provide
satisfactory result.
 There is basic requirement of knowledge of cost of capital's rate and if there is deficiency
of cost of capital then this method cannot be implemented.
 While ranking some typical and complicated projects NPV gives very much
contradictory and confusing result.
 The most typical task in this method to identify appropriate discount rate.
 This method cannot be implemented for evaluating of finding the life span or years which
are required for recoup expenditure of capital that is amount required for project.
Internal rate of return
Merits:
 Time value of money or time factor is been considered by this method along with cash
flow whether it is even or uneven.
 Profitability of project is been evaluated very perfectly that whole economic life is
considered in the project.
 There is not any requirement related to pre determining the capital's cost or the cut off
rate. It overcomes the weakness of net present value.
 The above pre determination capital's cost is very difficult task and on that particular time
for evaluating project internal rate of return method is used.
 The project proposals can be ranked very easily in the mentioned method because it gives
specific percentage return.
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 Profitability can be maximized from this method (Mahlia, Razak. and Nursahida, 2011).
 The total cash outflows and inflows can be accounted in internal rate of return.
 The special importance is been provided for maximising wealth of shareholder.
Demerits:
 In this method margin or earnings are reinvested at internal rate of return for life of
project which is remaining. The profit related to project are not properly justifiable.
 It has very difficult and tedious calculations.
 Special importance have been given to profit but capital expenditure which has been
recouped earlier is not considered because of this method is in favour of projects which
are in need of long term period as compared to other project and conditions which are
regarding to this or future uncertainty so whole capital expenditure is not recouped if IRR
is adopted.
 The outcome of NPV and IRR are usually different because of under evaluation in their
life, size or even timings related to cash inflows.
CONCLUSION
From the above report it has been concluded that financial management plays very
important role in any business and organisation. The proper way to identify and determine the
share price, theoretical rights issue price with its explanation has been understood. Scrip
dividends plays vital role in any organisations. Scrip dividends are shares issue which are
performed in a way as to again compensate shareholders rather than traditional dividend which
also helps in raising capital of the organisation. Further it can be said that investment proposal
techniques are basic means for measuring capital of investment of any business project which
includes net present value, Internal rate of return, Accounting rate of return and payback period.
Every technique has its own advantages and disadvantages.
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REFERENCES
Books and Journals
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.
Arrow, K. J. and Kruz, M., 2013. Public investment, the rate of return, and optimal fiscal
policy (Vol. 1). Routledge.
Bernhart, G. and Mai, J. F., 2016. On the impact of a scrip dividend on an equity
forward. International Journal of Financial Engineering. 3(04). p.1650024.
Carse, A., 2011. Assessment of transport quality of life as an alternative transport appraisal
technique. Journal of Transport Geography. 19(5). pp.1037-1045.
Dasgupta, A., Prat, A. and Verardo, M., 2011. Institutional Trade Persistence and Long‐Term
Equity Returns. The Journal of finance. 66(2). pp.635-653.
Ghahremani, M., Aghaie, A. and Abedzadeh, M., 2012. Capital budgeting technique selection
through four decades: with a great focus on real option. International Journal of Business
and Management. 7(17). p.98.
Kumar, S., Mahadevan, A. and Gunasekar, S., 2012. Market reaction to dividend announcement:
an empirical study using event study technique. Prestige International Journal of
Management & IT-Sanchayan. 1(1). p.141.
Mahlia, T. M. I., Razak, H. A. and Nursahida, M. A., 2011. Life cycle cost analysis and payback
period of lighting retrofit at the University of Malaya. Renewable and Sustainable Energy
Reviews. 15(2). pp.1125-1132.
Penman, S. H. and Zhu, J. L., 2014. Accounting anomalies, risk, and return. The Accounting
Review. 89(5). pp.1835-1866.
Perez, C., 2011. Finance and technical change: a long-term view. African Journal of Science,
Technology, Innovation and Development. 3(1). pp.10-35.
Online
Advantages and Disadvantages of Accounting Rate of Return Method, 2018. [Online].
Available through <http://www.knowledgiate.com/advantages-disadvantages-accounting-
rate-return-method/>
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Earning per share, 2018. [Online]. Available through
<https://corporatefinanceinstitute.com/resources/knowledge/finance/earnings-per-share-
eps-formula/>
Internal Rate of return, 2018. [Online]. Available through
<https://www.myaccountingcourse.com/accounting-dictionary/internal-rate-of-return>
Scrip Dividend. 2018. [Online]. Available through
<https://www.money-zine.com/definitions/investing-dictionary/scrip-dividend/>.
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