Capital Budgeting Techniques and Analysis

This assignment examines capital budgeting techniques, focusing on the Accounting Rate of Return (ARR) and Internal Rate of Return (IRR). It analyzes the strengths and weaknesses of each method, highlighting their impact on profitability and decision-making. A case study involving Love Well Limited is presented to illustrate the application of these methods in real-world investment scenarios. Students are tasked with evaluating the company's potential investment in a new machine using both ARR and IRR calculations.

Financial Management

INTRODUCTION
In each and every company financial management is necessary as well as essential as it
helps the investors in making the correct and appropriate decisions. Supervision of finance helps
in flow of money in the effective and efficient manner so that employees of the business entity
can accomplish the goals and objectives. It is the function which is specified in the firm and it is
directly associated with the top management of the enterprise. In the company, finance manager
having the different functions which includes the estimating the amount which requires the
capital. Along with this they have to determine the capital structure and also have to manage the
funds by using the appropriate resources. Financial manager of the business entity have to
provide the proper control so that they can evaluate or analyse the financial performance. For
putting control on the activities they can use Return on Investment method (MSc Business with
Financial Management, 2017). In Question 1, the calculation needs to be done on the basis of
financial statement of Trojan PLC. In question 2, computation needs to be done by using the
distinctive investment appraisal technique and the values to be taken of Love-well Limited
company along with the benefits and limitations.
Question 2
a)
Price earning ratio- It is a common practice for the investors to use this ratio as it assist in
determining the company's stock price whether it is over or undervalued. If companies having
high earning price ratio then it having typically growth shares (Petty and et. al., 2015). Price
earning ratio is also known as earnings multiple and it is one of the most popular valuation
measures which is used by the investors to do analysis. It is calculated by using the formula that
is market price per share which is divided by earning per share.
Ke = Rf + beta(Rm – Rf)
= 5 + 1.1( 11-5)

= 5+6.6
= 11.6
MPS = 1/11.6*100
= 8.62
b)
Dividend valuation method- It is a method which helps in providing a value for the stock
of company and it is based on the theory that means it provides worth of stock which is sum of
all its future payment of dividends and it is discounted back to their present value. Along with
this it is used to the value of shares which is based on the present value of the future dividends. It
helps the investors in making the correct decision so that they can attain the success in the
competitive market (Finkler and et. al., 2016). It also helps in maintaining the relationship
between dividends along with the security values.
P0 = Dividend + growth /Ke – growth
= 13+2% / 11.6+ 2% = 138.125p
value of Trojan PLC = 138.125 * 147/100
= 203.04
c)
Discounted cash flow method-It is a tool or technique which helps in doing the analysis
of finding the value of the project, company along with the asset by using the concept of time
value of money (Brown, 2016). All the cash flows which are estimated for the future and they
are discounted by using or adopting the rate of cost of capital they can give their present values
which will help the business entity in attaining the success.
Particulars Year 1 Year 2 Year 3 Year4 Year 5
Profit before
interest and tax 64 67.2 70.56 74.088 77.792
Interest 6.5 6.63 6.76 6.89 7.02
Profit before
tax 57.5 60.57 63.8 67.198 70.772
Taxation 17.1 12.114 12.76 13.4396 14.1544

Net profit or
FCF 40.4 48.456 51.04 53.7584 56.6176
Growth rate 5.00% 5.00% 5.00% 5.00%
PV at 9% WACC
Present year 1 2 3 4
Discounting
factor 0.917431193 0.841679993 0.77218348 0.708425211
PV of cash
flows 44.45504587 42.95934686 41.51134839 40.10933523
Terminal Value
Sum of PV of FCF for explicit forecast 3
WACC 9.00%
Long term growth in Revenues 5.00%
Present Value of terminal value 1003
Terminal Value as % of Total Value 100.00%
Equity Value
Enterprise Value 1006
- Debt 72
+ Cash 56
Net Debt 128
Equity Value 1134
Intrinsic Value
Equity Value 1134
Diluted Shares 147
Intrinsic Value 7.71

In the above discounted cash flow model growth rate used by an entity over the years is
5% which creates changes in he existing profit of the firm. The application of 5% growth rate
induces the current business performance of an enterprise owner over the years. Role of an entity
gets increases with the passage as in this particular approach quality of all the activities is
increases by utilising various factors in improving its current business conditions, Forecasting
plays a significant role in determining the future position of the firm by analysing the existing
facts and figures as their ultimate aim is to consider all the factors held responsible for inducing
the current performance (Renz, 2016). Interest rate expenses has increases at the rate of 2%
which is 3% less that the growth applied to the current profit of an entity that shows the ability of
an enterprise in generating higher outcomes in the external business environment.
Discounting cash flow model is based on the time value money concept n which present
facts and figures are analysed in relation to several parameters used by them, in inducing the
current business performance. Discounting rate is used in order to determine the future return
generated by a particular business project in a particular time period. In the current case scenario,
profit after tax is analysed on the basis of 9% discounting rate as through this approach an entity
owner will ascertain its future performance in the present as negative cash flows can be rectified
in advance by taking important decisions for the betterment of the business.
d)
Selection of the best suitable technique is based on the existing nature of the business as
how it helps an entity in improving its current business operations. Price earning ratio is not
suitable as it emphasises on the share price of the company which in case of mergers and
takeover gets zero which decreases the return generated by firm. Other technique of valuation is
dividend valuation technique that is also based on the existing income of the business as in
merger of the company the initially firm's capabilities gets reduces which in directly affected the
business performance in a particular financial year. Discounted cash flow model has used as one
of the valuation technique which is based on the profit generated by the firm which also provides
the forecasting effect in the existing firm which is regarded as the best suitable method for the
business in terms of merger and takeover of the firm. It is recommended to Aztec to select this
particular technique as this would help an enterprise owner in knowing its future returns after the
merger of current firm with another.

Recommendation of discounted cash flow model by Aztec as it would emphasise on the
actual business performance of an entity in relation to various aspects to be covered by this
particular technique. Real worth of the business project will be easily evaluated with the help of
the current technique in which present of the firm are used as basic element in determining its
future performance. Mergers is the biggest decision taken by an entity as this technique will help
in verifying the tough decisions taken by the business concern by generating higher business
outcomes.
Question 3
A.
If the manager or owner of Love well Limited company wants to purchase a new
machines and before that they have to use different investment appraisal techniques which will
helps in finding out or analysing that they have to purchase the machine or not and on the basis
of that they can attain maximum profit or not (Egginton, Van Ness and Van Ness, 2016).
 Purchasing new machine - £275,000
 Annual Cash Inflow - £85000
 Cash outflow - £12500 in every six year.
 Depreciation would be charged by using Straight line method and it would be charged on
15%.
 Cost of capital – 12%.
Different appraisal technique which they can use to find that they have to purchase
machine or not. They are pay back period method, accounting rate of return tool, net present
value and Internal rate of return method (Karadag, 2015). Along with this the owner of Love
well limited have to check that this method increase the profitability or economic feasibility by
acquiring the machines.
1. Pay back Period method:
Year Cash Inflow Cumulative Cash inflow
1 72500 72500
2 72500 145000
3 72500 217500

4 72500 290000
5 72500 362500
6 113750 476250
Cash inflow of 1 year: 85000 – 12500 = 72500 and it is same up to 5 year and on 6 year cash
inflow is 126250 – 12500 = 113750.
So, value of Investment lies between 3 or 4 years.
Pay back period = Year + Initial Investment – Cum. Cash inflow lies in year/ Cash inflow
= 3 year + 275000-217500/72500
= 3 year + 57500/72500
= 3 year + 0.79
= 3.8 year
In this 0.79 is equivalent to 8
2. Net Present Value Method:
Year Cash Inflow Cash Outflow Cost of
Capital
@12%
Present
value of
Cash inflow
Present
value of
Cash
outflow
1 85000 12500 0.893 75905 11163
2 85000 12500 0.797 67745 9963
3 85000 12500 0.712 60520 8900
4 85000 12500 0.636 54060 7950
5 85000 12500 0.567 48195 7088
6 85000 12500 0.507 43095 6338
Salvage value 41250 0 0.507 20914 0
370434 51402
Total cash outflow = £275000 + £51402
= £326402
Net present value = Present value of cash inflow – Present value of cash outflow

= 370434 – 326402
= £44032
3. Accounting rate of Return Method:
Annual depreciation = £275000 – 41250/6
= £233750/6
= £38958
Average Accounting Income = 85000 – 38958 – 12500
= £33542
Average rate of return = Average Accounting Income / Initial Investment * 100
= £33542/£275000*100
= 12.1970%
4. Internal Rate of Return Method:
Cash Inflow:
Year Cash Inflow PV@12% PV@18% Present value
of @12%
Present value
of @18%
1 72500 0.893 0.848 64743 61480
2 72500 0.797 0.718 57783 52055
3 72500 0.712 0.609 51620 44153
4 72500 0.636 0.516 46110 37410
5 72500 0.567 0.437 41108 31683
6 113750 0.506 0.370 57558 42088
318975 268869
Internal rate of return = Lower rate of return + PV of 12% - Cash Outflow / PV of 12% - PV of
18% * high rate of return – lower rate of return
= 12 + 318975 – 275000/ 318975 – 268869* 6
= 12 + 43975 / 50106 * 6
= 12 + 5.26
= 17.26%

By doing the computation using investment appraisal techniques, Pay back period is 3.8 year and
it denotes that company earn profit in approx 4 years, Net present value is 44032 and it is
positive, ARR is 12.1970% and IRR is 17.26% and it helps the company in making the decision
to purchase new machine all all positive so Love well company can purchase new machine as it
helps in generating maximum revenue.
B.
There are different appraisal techniques which company and some are stated above.
These techniques help in making the correct decisions and also helps in measuring the
productivity as well as profitability (Chua, Lowe and Puxty, 2015). They are:
Pay Back Period method: It is a part of capital budgeting and it requires the specific period of
time to use the appropriate funds which assist in expanding the investment or to reach at the
break even point.
Benefits
 Pay back period method is a very simple method to understand.
 This method consider as a one of the fastest return on investment which means it helps in
recover the capital in a minimum period of a time.
 One of the major benefit of this method is that it also works effectively in a minimum
amount of investment.
 This method is also implemented without the help of group of employees.
 It is very simple to calculate the pay back period because of their simplest formula which
doesn't requires any specialised persons (Francis, Hasan and Wu, 2015).
Limitations
 The first and foremost disadvantage of the pay back period is that it ignores the time
which means it doest not consider time value of money.
 The other drawback is that it does not consider the cash inflows which may arise after the
recovery of a initial investment.
 One of the major drawback is that pay back period motive is to earn only short term
profitability which means this method is not applicable on the long term projects.
 Absence of skilled and specialised persons due to which hidden problems may arise
which may harm the organization as well as employees (Mulherin and Aziz Simsir,
2015).

Net present value method: It is a type of techniques which is related to investment appraisal as
it succour in measuring the profitability. It is calculated by using the formula that is reducing the
value of cash outflow from the present value of cash inflow within a given time.
Benefits
 The major advantage of the net present value method is that it express the accurate
information about a particular investment by describing their benefits for the company.
This means it helps in determining that project will increase firm's value or not.
 It help the enterprise in understanding that project will maximize profit or not (Mathuva,
2015).
 In fact this method also shows the actual amount incurred or profit of each year to make
effective budgeting with the help of previous facts and figures.
 Apart from this net present value method helps in selecting best alternatives from
available project to maximize their profits.
Limitations
 One of the biggest drawback of this method is that it does not calculate accurate results
which means there is a absence of accuracy which sometime create a problem for
enterprises in a selection of a project.
 In fact this method is a very time consuming method because of their long path of
calculation.
 It requires a expertise advice and specialised person to conduct this method effectively.
 Apart from all the above disadvantages last one is that it is one of the expensive
technique in a capital budgeting (Marciukaityte, 2015).
Average rate of return method: It is ration which denotes the financial condition and used in
the capital budgeting. It is a concept of time and a value of money.
Benefits
 Basically this method is based on the accounting information so that other data and
management reports are not required in average rate of return method.
 ARR is one of the simplest method to understand and it is very simple in calculation.
 In fact this method is mainly based on the profit of accounts so it measures the
investment profits (Bradley and Chen, 2015).

 One of the useful and effective method which covers all the factors visible in the capital
budgeting so that accurate profit and loss must be calculated after tax and depreciation.
Limitations
 The main and foremost limitations is that it did not consider the time value of money.
 This method is calculated in different-different ways which resulted in different outcomes
or results which creates a state of confusion.
 ARR is very much influenced by non cash items for example bad debts, depreciation
while calculating the profit (Nguyen, Nguyen and Yin, 2015).
 Apart from this, this method is one of the complicated technique of calculating average
rate of return on investment.
 Absence of other special reports of the accounting systems which may creates a
inappropriate presence of information and data.
Internal rate of return method: It is also used in capital budgeting and also assist in measuring
the profitability of the potential investments. IRR having a discount rate which makes the net
present values of all cash flows from a specific project to zero.
Benefits
 One of the indispensable technique in a capital budgeting because only this method can
consider the time value of money while evaluation of a project.
 The another benefit is that it is very simple while doing interpretations after calculation of
IRR.
 In fact managers can easily estimate required rate of return and comfortably take the
decisions.
 It covers all the relevant internal and external factors of the budgeting method to calculate
the internal rate of return with the help of discounting rate and present value of the
discounting rate (Financial Management and Risk, MSc, 2017).
 It is not easy to practically apply this method because of their complex nature and broad
concept as well as due to absence of accuracy.
 One of the major limitation of this method is that it ignores the size of the project while
evaluating the projects.

 In fact this method also ignores the future cost which is also one of major drawback
which affect the organization overall capital and fund because capital is the backbone of
every business either small or large.
 It consume extra time and expensive due to their complexity.
 Apart from this it requires a expertise persons to calculate it accuartely.
CONCLUSION
From the above carried out assignment it has been interpreted that they have to proper
management of finance by using the appropriate funds and resources so that they can not any
problems in attaining the success in the competitive market in effective and efficient manner.
Financial management is necessary as well as essential as it helps the investors to invest in the
company or not. In the business entity, finance manager having a responsibility that they have to
analyse or evaluate the financial performance in the market as it helps the investors in making
the correct judgement that they have to invest or not. Moreover, the manager of the firm wants to
make the correct decision to purchase the machine or not then they have to use different
techniques which are related to investment appraisal. As these helps in making the correct
decisions that they have to purchase the new machine or not. By the computation in Question 2,
it has been analysed that the owner of Love well limited have to purchase the new machine as it
helps in the economic feasibility and also succour in increasing the profitability as well as
productivity in the market when they are facing the high competition.