Financial Management: Investment Appraisal Techniques, Benefits and Limitations

This document discusses investment appraisal techniques in financial management, including the calculation of payback period, accounting rate of return, net present value, and internal rate of return. It also explores the benefits and limitations of these techniques and their impact on a company's financial performance.

Financial Management
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Contents
Contents...........................................................................................................................................2
INTRODUCTION...........................................................................................................................3
Q2. Investment Appraisal technique................................................................................................3
Question 3 – Mergers and Takeovers..............................................................................................9
REFERENCES..............................................................................................................................14
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INTRODUCTION
Financial management refers to activity that concerned that planning, controlling and
administering the funds that need to be used in the company (Prihartono and Asandimitra, 2018).
This is area of business management that deals in the usage of certain sources of capital in order
to enable the achievement of goals and objective of the organisation. In this report it is been
discusses about certain investment appraisal techniques that used to take the important decision
and will be useful in enhancing the profitability and efficiency. The need to understand the
importance and will lead to certain benefits to the company if they able to choose the appropriate
appraisal. Apart from it is being discussed about the different financial ratios that will help in
analysing the financial performance of the company. These ratios are very effectiveness to
evaluate the profitability and liquidity in short term and long term and are being used by the
shareholder and other external users.
Q2. Investment Appraisal technique
(a) Calculate (to two decimal places) using the following investment appraisal techniques
The Payback Period- Initial investment/cash flow
Investment- £438,700
Cash flow: Inflow-outflow
= £123,000- £25,500
= 97500
Payback period: 438700/97500
= 4.50 or 4 years and 6 months.
Accounting rate of return = Average annual profit / Initial investment * 100
Year cash inflow
Cash
outflow
Net cash
flow
Depreciatio
n
Accounting
profit
1 123000 25500 97500 100681.65 -3181.65
2 123000 25500 97500 73497.60 24002.40
3 123000 25500 97500 53653.25 43846.75
4 123000 25500 97500 39166.87 58333.13
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5 123000 25500 97500 28591.82 68908.18
6 123000 25500 97500 20872.03 76627.97
268536.78
Average accounting profit: 268536.78/6
= 44756.13
ARR: 44756.13/438700*100
= 10.20%
Working Note:
Calculation of depreciation
Depreciation Expenses = (Net Book Value –
Residual value) X Depreciation Rate
Net book value: 438700
Residual value: 15% of cost 65805
Depreciation rate 27%
Year
Net book
value
Residu
al value Rate
Depreciati
on
1
438700.0
0 65805 27 100681.65
2
338018.3
5 65805 27 73497.60
3
264520.7
5 65805 27 53653.25
4
210867.4
9 65805 27 39166.87
5
171700.6
2 65805 27 28591.82
6
143108.8
0 65805 27 20872.03
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Net present value: Discounted cash flow-investment
Year
Net cash
flow PV factor
Discounted cash
flow
1 97500 0.88 85800
2 97500 0.78 76050
3 97500 0.69 67275
4 97500 0.61 59475
5 97500 0.54 52650
6 97500 0.48 46800
388050
NPV: 388050-438700
-50650
IRR:
Year
Net cash
flow
0 -438700
1 97500
2 97500
3 97500
4 97500
5 97500
6 97500
IRR (Using excel
formula) 9%
(b) Impact on above company:
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Payback period: The payback period is of 4 years and 6 months. This shows that cost of above
investment will be covered in 4.5 years. Though life of project is of 6 years which shows that this
project is useful. If above company will acquire this than it will be useful for them to gain higher
financial advantage.
Accounting rate of return- The ARR of above project is of 10.20% that shows that above project
will generate return or profit with this rate which is higher. If above company will acquire this
project than it will lead to positive impact on company’s financial performance during particular
accounting period.
Net present value- The net present value of this project is negative due to less number of cash
flow. In such case above company needs to rethink before making invest in such project.
IRR- the IRR of above project is positive and higher which is of 9%. It shows that above
company needs to make invest in order to generate higher return from this venture. If above
company will make invest than it will be beneficial for them.
c. Evaluating benefits and limitations of investment appraisal technique
Investment appraisal technique concern with method that business will able to assess the
attractiveness of possible investment or projects that is based on the finding of several different
capital budgeting and financing technique (Jones, Kovner and Mose, 2018). Some are as follows-
Payback period- This refers to the length of time making an investment and the time at which
that investment is broken. This helps in revealing the payback period is the time it takes for the
cash flows of incomes from particular projects to cover the initial investment.
Some of its benefits are as follows-
 Simple and easy to use- This is one of the significant advantages of payback period as it
need very few inputs in the calculation and relatively easier to calculate than other capital
budgeting. This helps the analyst to evaluate the best investment appraisal.
 Quick solution- As, it is easy to use and calculate and hence help the analyst to make the
informed decision quickly and does not waste much time to determine the investment
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proposal. This is effective for the companies who has limited resources and wants better
decision-making technique.
 Beneficial in uncertainty of case- This method is very effective to use when Company is
facing the uncertainties in their business and were not sure about the future circumstances
(Zietlo, Seidner and O'Brien, 2018). Hence, this method is useful in undertaking the
project with short PBP and reduce the chances of loss through obsolescence.
Some of the disadvantages are as follows-
 Ignores time value of money- This is main disadvantages of company that it ignores the
time value of money which is very important for the purpose of business. This method
does not consider the real value and that reduces its efficiency in long period of time.
 Not realistic- This method is as simple in use as it does not consider the normal business
scenarios. Capital investments are not just one-time investments and will need further
investment in following years as well and will leads to project usually have irregular cash
inflows in the company.
Accounting rate of return- The average accounting return formula for the evaluation of
commercial assets is dependent upon an expected yield for that time using the accounting rate for
a given period of years. Usually, the average return approach is used to compare two or more
financial performance with future profitability (Loke, 2017). As other analytical instruments, this
approach is used with its share of advantages and disadvantages.
Advantages- The overall return rate is simple to calculate. Managers will easily see how an
investment potential can be sufficiently profitable to merit further assessment. Go back to the
example of modern machines being purchased to improve production. If, however, investment in
camions to supply goods to consumers would cut the shipping costs by 10% if the initial estimate
indicates that buying only results in a 2% rise in earnings, then the management will have to
consider if decreased shipping costs are a safer investment.
Disadvantage- The time worth for resources is ignored by ARR. The principal flaw of the mean
cash return system is that the time value of the funds is overlooked.
Contrary to other investment assessment approaches, the RRA is focused not on cash flow but on
earnings. The ARR procedure lacks the investment cash balance (Nowicki, 2018). The
corporation will invest in other lucrative investments if an investment provides cash input
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rapidly. But the approach of accounting return relies instead on cash balance on total net
accounting revenue. It is influenced by arbitrary, non-cash items such as the depreciation rate
that you use for benefit calculation.
There are various methods for an ARR calculation that can also be used. The ARR approach
does not take into account the project's final value. You have to make confident that you are
measuring the ARR on a regular basis by using the ARR to compare various investments.
The ARR should not take the pacing of profits into consideration. A return of £100,000 five
years is equal to £100,000 next year after estimating the ARR. Cash inflows that are greater than
accounting earnings are not taken into account. In reality, relatively soon you would like benefit.
Net present value- The Net Present Value (NPV) is a way of deciding whether an investment in
a project or company should be carried out solely for financial analysis. Compared to initial
investments, the current value of potential cash flights (Ward and Forker, 2017). Net present
value is an instrument for the working capital of a project or expenditure to assess the feasibility
of it. The difference between actual cash inflow value and the current cash outflow valuation is
measured over the duration.
Advantages- The main advantage of using NPV is that it takes the idea of the time of money into
account: the stronger dollar, due to its income power, is more than one dollar future. In the NPV
calculation, the reduced net cash flow from a project is taken into account to calculate its
feasibility. Understanding how current values are crucial to the budgeting of resources (Mitchell,
2017).
Disadvantages- The complete calculation of NPV relies on the reduction of potential cash flows
by the necessary rates. There are no criteria for this rate to be established, however. This
proportion is left to the discretion of businesses and instances in which the NPV is unreliable due
to an incorrect rate of return could occur.
IRR- The internal rate of return for estimating the feasibility of future expenditure is a measure
used for fundamental reporting. The intrinsic rates of return are a rate of return that within a
financial analysis equals the net present value (NPV) of all free cash flow to null. Computations
of IRR depend on a formula identical to that of NPV. Notice that the IRR is not the program's
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real dollar value (Nkundabanyanga, Nalukenge and Tusiime, 2017). The present value is
equivalent to zero for the yearly return.
Advantages- the IRR is an easy metric to quantify and offers an easy way of comparing the value
of different programmes. The IRR gives a brief overview of what capital ventures will have the
highest possible cash flow for all small business owners. It may also be used for tax purpose,
including such providing a brief glimpse of the possible benefit or savings of new machinery,
rather than old equipment repair.
Disadvantages- the IRR approach only covers the expected cash flow from capital injections and
excludes future possible expense impacts. For example, potential costs of fuel and repairs, as you
contemplate investment in trucks, may reduce profits because fuel rates fluctuate and repair
demands change. The need to buy unused properties where a fleet of vehicles can park is a
contingent project and these costs are not a consideration in the IRR estimate of cash flows
created by fleet operations.
Question 3 – Mergers and Takeovers
Calculate the value of Dragon PLC using the following valuation methods-
Price/earnings ratio= Net income/total share outstanding
Net income= 42.4
Shares= 147
Price/earnings ratio= 42.4/147
= 0.29 Pence per share
b) Discounted cash flow method
Discounted cash flow method
Yea
r Net Income £m
PV
FACTOR@6%
Discounted cash
flow
1 42.4 0.94 39.856
2 42.8452 0.89 38.132228
3 43.2950746 0.84 36.36786266
4 43.74967288 0.79 34.56224158
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5 44.20904445 0.75 33.15678334
6 44.67323942 0.7 31.27126759
213.35
c) Dividend valuation method
P (Stock price)= D1/(r-g)
P1= 9/(1.05-0.35)
= 9/0.7
= 12.85
P2: 10.5/0.7
= 15
P3: 11/0.7
= 15.71
P4: 12/0.7
= 17.14
P5: 14/0.7
= 20
Dividend valuation model: 12.85+15+15.71+17.14+20
= 80.7
Working Note:
Growth rate: (1 – Dividend Payout Ratio) × Return on Equity
Growth rate: (1-1.33)*1.05
= 0.35%
Dividend Payout Ratio= Dividends/net income
Dividends: 9+10.5+11+12+14
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= 56.5 Pence
= 56.5/42.4
= 1.33
(d) Critically discuss the problems associated with using the above valuation techniques.
Price earnings method- In large part, the P/E ratio is formed in respect to a single market share or
market average by the perceived optimism or negativity of the shareholders (Dwiastanti, 2017).
The explanation for this is that the value of the commodity is a crucial factor in the number (the
top part) and directly influences the ratio results. Since it is common sense, stock markets don't
just rationally adjust. Of course, the typical P/Es historically ranged between 10 and 25. (See
P/on E's the left for history Standard & Poor). Even so, the new web, also called dotcoms and
tech firms in the press and everyone in IT in particular.
Advantages-
It is easy to use and understand the greatest benefit of a P / E ratio. And those who do not receive
a financial background are able to recognise it even while it is just an extremely essential
instrument, it can be used to measure the value of an enterprise's securities. For the actual
valuation of the share, P/E is a far more meaningful way than the price alone. I will prove this
with an instance, to see this easier. A stock of 100 dollars with 10 dollars is so far more "cheap"
than an inventory of 10 dollars with 100 dollars. (Because the two shares belong to the same
industry). P/E is an outstanding instrument to measure both the overall industry and the rivals of
the given firm. The P/E therefore determines the real goals of the customer as another way to
compare. The company's share price tends to be higher if it is anticipated to remain good, thus
increasing P/E (Morozko and Didenko, 2018). The actual P/E of the business stocks can be
contrasted with the company's previous results. For instance, if the corporation's EPS has a
continuous growth (which implies each share produces an increasing amount of profit), yet the
Company's P / E appears to be stagnant and equivalent, which implies that the increase in the
stock market does not suit the increase in productivity of such shares.
Disadvantages-
The first concern is that the main reason for P/E is the subjective essence and "we don't know
how much we can sell in price. The irrational essence of stock markets can partly be certified.
The competitive shares are possibly best represented in the survey done in the Standard & Poor's
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500 or S&P500 index by Kevin P. Coyne and Jonathan W. Witter that now the 40 to 100 most
actively involved investors in a certain corporate account for over 50% of the total trading
volume.
Where market and economic conditions are favourable, investors appear to over-price equity,
raising P/E to a degree which, financially speaking, does not explain the business information.
This might spark a boom, which is considered a bubble, because rates and P/Es are so strong it
will burst or plunge sharply at any moment. This happened with the IT sector in the early and
mid 1990s, particularly internet, securities. It is also possible for the economy and the world of
industry to be looked at inferior to the fact that the P/Es, such as in global recessions, are
underestimated by securities and equity stocks. Regions are still overvalued in terms of P/E,
according to real financial results of the region's greatest firms. Such a sub-P/E-region is Central
and Eastern Europe.
Discounted cash flow method- The quality of an investment potential is calculated with a
discounted cash flow (DCF). DCF analyses use projected free flow estimates and discounts them
to achieve a current valuation that assesses the opportunity for profit often during proper
research, (most often using weighted average capital cost). The incentive could be nice if the
benefit achieved by DCF analysis is greater than the actual investment costs. Discounted cash
flow Assessment is dependent on the company's estimated potential cash flow, which is the
calculation of the company's overall risk and its corresponding discount rate (Bai, Liu and Tang,
2017). This strategy is easier to implement for money, companies, etc. whose free cash flow are
actually positive and are projected to be with some stability and where a risk substitute to receive
discounts is possible because of these required conditions for DCF assessment. The further we
move from this idealised setting, the more challenging and less accurate DCF assessment is.
Advantages-
DCF Assessment captures the main factors behind a company (cost of equity, weighted average
cost of capital, growth rate, re-investment rate, etc.). Therefore, the worth of the asset/business is
estimated as near as possible. DCF depends on Free Cash Flows, contrary to most valuations.
Free Cash Flows (FCFs) are to a greater degree a valid means of eliminating the arbitrary
accounts policy and window dressing of recorded earnings. If an outlay of cash is classified in
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P&L as a cost of operation or capitalised into a balance sheet asset, FCF is a real reflection of
investment money.
Disadvantages-
DCF Valuation is very vulnerable to constant growth and sales price assumptions. Every little
tweak every now and then and DCF evaluation will wildly vary wildly and the fair value will not
be right (Yang, Ishtiaq and Anwar, 2018). It just works well if the potential cash flows rely
heavily on it. Although if the activities of the firm are not visible, revenue, operating and capital
spending cannot be predicted for sure. While it is difficult to predict cash flow in the next few
years, it becomes almost impossible to drive them away permanently (required for DCF
assessment). As a result, if not adequately accounted for, DCF is vulnerable to errors.
Dividend valuation method- The first category of discounted cash flow model we are studying is
the Dividend valuation method. Like every other DCF model, the model essentially reduces cash
flows at a regular price. The distinction is that the formulas of the dividend reduction still regard
"dividends" as valid cash flows.
Advantages- The main benefit of the discount model for dividends is the principle that it is
based. The reasoning is straightforward. A company is an ongoing body. When an investor buys
the share of the company, he or she pays a price today that gives him or her the right to profit
from all the dividends that the company pays over its lifespan. The valuation of the company is
essentially that of a continuous supply of returns, which the purchaser expects to obtain later
over time. Many observers therefore conclude that this model has no subjectivity and the
reasoning is crystalline.
Disadvantages- The model applies only to mature and profitable firms that have an established
record of regularly paying dividends. While it might seem like a positive idea, prima facie, there
is a big deal. Investors who invest only in mature, profitable firms appear to lack fast growth.
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