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Comparative Analysis of Two Projects using NPV, IRR and ARR

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The assignment content discusses various investment appraisal methods, including Net Present Value (NPV), Internal Rate of Return (IRR), and Average Rate of Return (ARR). It highlights the advantages and disadvantages of each method. NPV is widely used as it considers both cash flows before and after, focuses on risk and profitability, and maximizes the value of a firm. IRR determines the rate at which inflow equals outflow and helps in selecting better investments among alternatives. ARR does not consider time value of money and only looks at accounting methods. The assignment also presents a summarized report of two projects, indicating that Project 1 is better than Project 2 based on all three methods.

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Financial Management

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Table of Contents
INTRODUCTION...........................................................................................................................1
PART 1: RATIO ANALYSIS OF TESCO.....................................................................................2
1.1: Calculation of Ratios............................................................................................................2
1.2: Ratio Analysis.......................................................................................................................6
1.3: Summarized Report..............................................................................................................9
PART 2: INVESTMENT APPRAISAL FOR PLC Plc................................................................10
2.1: Project Appraisal................................................................................................................10
2.2: Payback Period Method......................................................................................................13
2.3: Advantages and disadvantages of the investment appraisal methods................................14
2.4: Summarized Report............................................................................................................16
CONCLUSION..............................................................................................................................17
REFERENCES..............................................................................................................................18
APPENDIX....................................................................................................................................19
Financial Statements of TESCO................................................................................................19
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List of Tables
Table 1: Ratios of Tesco..................................................................................................................5
Table 2: Summarized Report...........................................................................................................9
Table 3: Cash Flow for Two Projects............................................................................................10
Table 4: NPV at 10%.....................................................................................................................10
Table 5: NPV of Project 1 at 11%.................................................................................................11
Table 6: NPV of Project 2 at 9%...................................................................................................12
Table 7: Payback Period of Project 1............................................................................................13
Table 8: Payback Period of Project 2............................................................................................14
Table 9: Summarized Report.........................................................................................................16
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INTRODUCTION
Financial management is a very important tool for the managers. Earlier this subject was
limited to raising funds for the companies, but later on its scope widened up and is used by the
organizations for procuring funds and to analyze the effectiveness of resources employed by the
firm. The modern concept of financial management focuses on analytical and conceptual
structure for decision making. Some of the major concerning areas of this subject are: volume of
funds an organization must have, type of assets the company must have, sources of raising funds
etc. Thus, it plays significant role in decision pertaining to investment, dividend policy and
financing (Dittenhofer, 2001).
Financing decision of the company involves analyzing different ratios of the firm. Ratio
analysis helps in evaluating the financial performance and standing of the company. It evaluates
organization’s profitability, liquidity, solvency and efficiency. On the basis of these four kinds of
ratios, performance of any firm can be judged. It not only helps in comparing the current
performance of the company with its past, but also aids in comparing the performance of two
organizations operating in the same sector or industry (Arnold, 2005).
On the other hand, investment appraisal in any business is done by using some of the
capital budgeting methods such as net present value, internal rate of return, profitability index,
average rate of return etc. While net present value and internal rate of return methods follow the
concept of time value of money, average rate of return is not based on it. These methods help in
analyzing any investment made by the company. Through these appraisal methods, organization
can decide whether they should invest in a particular project or not. It helps in determining the
profitability of the project. Simultaneously, these methods also assist investors in deciding in
which project they should invest so as to make maximum profits (Fairchild, 2002).
In the following study, performance of TESCO will be analyzed by determining the
major ratios of the company and comparing them with its past performance. In the second part,
two projects will be appraised by applying capital budgeting tools, so as to identify in which
project the company PLC should invest.
PART 1: RATIO ANALYSIS OF TESCO
1.1: Calculation of Ratios
Solution:
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Profitability Ratios: Profitability of any firm can be determined by calculating different
profitability ratios. These can be categorized in two forms: profitability related to sales and
investment.
Gross Profit Margin: It determines the gross profitability by comparing gross profit of the
company with its sales.
Gross Profit Margin= Gross Profit
Net Sales 100
Net Profit Margin: It tells about the net profitability of the organization by drawing relationship
between net profit and sales (Atrill and McLaney, 2008).
Net Profit Margin= Net Profit
Net Sales 100
Performance Ratios: Performance of the company can be determined by calculating some of the
related ratios such as:
Return on Assets: It exhibits the relationship between net profit and assets of the company. It can
be determined as follows:
Returnon Assets= Net Profit after Tax
Average Total Assets100
Return on Capital Employed: It draws the relationship between net profit and average capital
employed by the company. It can be computed as:
Returnon Capital Employed= Net Profit after Tax
Total capital employed 100
Return on Equity: It tells how much returns the firm is making on the equity capital. It is
calculated as follows:
Returnon Equity= Net Profit after Tax
Total Shareholde r' s Equity100
Earnings per Share: It determines the profit that is available to the shareholders at the end of the
year. It is computed as follows:
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Earnings Per Share=Net Profit available ¿ Shareholders ¿
Number of ordinary outstanding shares
Liquidity Ratio: These ratios tell about the liquidity position of the company. Through these
ratios, it is identified whether a company will be able to fulfill its short term obligations or not.
Or in other words reveals about short term solvency of the firm (Collier, 2012).
Current Ratio: It is the ratio of the firm’s current assets to the firm’s current liabilities and
calculates company’s short term solvency. It draws relationship between organization’s assets
and liabilities. It is calculated as follows:
Current Ratio= Current Assets
Current Liabilities
Quick Ratio: It is very important ratio in determining the liquidity of the company. Quick assets
include those assets which can be easily and anytime converted into cash. It is calculated as
follows:
Quick Ratio= Quick Assets
Current Liabilities
Efficiency Ratio: Efficiency ratios are also known as turnover ratios and tell how an efficient a
firm is in managing. It helps in judging the effective use of assets. Different efficiency ratios are
as follows:
Debtors Turnover Ratio: It tells how many times or how quickly in a year the company can
convert his debtor into cash. It can be calculated as:
Debtors Turnover Ratio= Total Sales
Accounts Receivables
Average Collection Period: It tells in how many days or months the company is able to collect
its cash from his debtors. It can be calculated as:
Average collection Period= 365
Debtors Turnover Ratio
Assets Turnover Ratio: As there are many financial resources employed by the company, so this
ratio tells the firm’s ability to produce sales from it resources. It is determined as:
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AssetsTurnover Ratio= Cost of Goods Sold
Average Total Assets
Inventory Turnover Ratio: It is the ability of the firm to finish its inventory in a particular year.
That is, how many times in a year the company finishes its stock (Atril, 2009). It is calculated as
follows:
Inventory Turnover Ratio= Cost of Goods Sold
Average Inventory
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Table 1: Ratios of Tesco
Ratios Formula 2012 2011 2010
Profitability Ratios
Gross Profit Margin (Gross Profit / Sales) * 100 21.65% 20.31% 18.88%
Net Profit Margin (Net Profit / Sales) * 100 9.00% 5.26% 1.86%
Performance Ratios
Return on Assets (Net Profit after Tax / Average total assets) * 100 8.48% 4.92% 1.55%
Return on Capital
Employed (Net Profit after Tax / Total capital Employed) * 100 10.37% 6.37% 1.85%
Return on Equity (Net Profit after Tax / Total Shareholder's Equity) 10.61% 6.54% 1.88%
Earnings per Share
(Net Profit Available to Equity Holders / Number of
shares) 1.29 0.71 0.19
Liquidity Ratios
Current Ratio Current Assets / Current Liabilities 3.06 2.34 3.09
Quick Ratio Quick Assets / Current Liabilities 1.89 1.45 2.28
Efficiency Ratio
Debtors Turnover Ratio Total Sales / Accounts Receivables 1.82 1.8 1.85
Average Collection Period 365 / Debtor's Turnover ratio (Days) 200 203 197
Asset Turnover Ratio Cost of Goods sold / Average Total Assets 0.74 0.74 0.68
Inventory Turnover Ratio Cost of Goods sold / Average Inventory 3.48 3.66 5.19
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1.2: Ratio Analysis
Solution:
Profitability Ratio:
Gross Profit Margin:
2011-2012 2010-2011
1.34% 1.43%
From the calculated ratios, it is identified that the gross profit margin is continuously
increasing every year. In 2010, it was 18.88% and increased to 20.31% in 2011 and further
increased to 21.65% in 2012. It is good for the company as it is increasing every year, but the
growth from 2010 to 2011 was 1.43% whereas it was 1.34% from 2011 to 2012. This shows
there is slight drop in the margin due to increase in direct expenses. So, the company should try
to bring down theses expenses in order to increase gross profit margin.
Net Profit Margin:
2011-2012 2010-2011
3.74% 3.40%
The above table shows that the net profit of the company is increasing every year. In
2010, it was 1.86%, in the next year it rose to 5.26% and in 2012 it become 9%. This embarks
that the company is able to increase its profit every year. The growth from 2010 to 2011 was
around 3.40% which rose to 3.74% in the next period. It means the company is able to reduce its
operating expenses and simultaneously has reduced its debt due to which the interest expenses
went down (Ahrendsen and Katchova, 2012).
Performance Ratio:
Return on Assets:
2011-2012 2010-2011
3.56% 3.37%
The calculations show that return on assets is continuously increasing every year. In
2010, it was 1.55% and rose to 4.92% next year. Further in 2012, it increased to 8.48%. This
exhibits that company is improving the efficiency of the employed resources every year.
According to it, the increase from 2010 to 2011 was of 3.37% while increase from 2011 to 2012
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was 3.56%. It denotes that with every passing year the company is increasing the efficiency of its
assets.
Return on Capital Employed:
2011-2012 2010-2011
4.00% 4.52%
This ratio tells about the effectiveness with which the funds are utilized by the
organization for long term. It is also increasing every year. In 2010, it was 1.85% and rose to
6.37% next year. Further, in 2012 10.37% was noticed. This shows that every year the company
is effectively utilizing the long term fund which is beneficial for the firm. But, if compared to the
last year’s performance, it was found that from 2010 to 2011 the return is increased by 4.52%,
whereas next year it only increased by 4%. This shows as compared to 2010 to 2011, the
employment of fund was somewhat less effective in 2011 - 2012. So, the company must look
after it and must properly utilize the long term funds (Altman, 2012).
Return on Equity:
2011-2012 2010-2011
4.07% 4.66%
The above calculated ratios reveals that the return on equity is increasing every year. It
shows that company is making enough profits that it can distribute handsome amount to its
equity holders. In 2010 it was 1.88%, which rose to 6.54% next year. In 2012, it rose to 10.61%.
It means that the firm is making profits every year. But, as compared to its last three
performances, it was found the increase was of 4.66% between 2010 and 2011, while it was only
4.07% between 2011 and 2012. This tells that although the company is making profit, but its
returns are declined. From this, it can be concluded that either the liabilities or the operating
expenses have increased due to which its profit is dropping a bit.
Earnings per Share:
2011-2012 2010-2011
0.58 0.52
A company which is distributing handsome earnings per shares shows that it is operating
well. Further, good earnings per share attract more investor towards it. Earnings are distributed
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per share after meeting all the expenses. The table denotes earning per share was $0.19 in 2010
and increased to $0.71 next year. Further, it increased to $1.29 in 2012. It is good that with each
passing year earnings per share is increasing. If it’s past three years data is calculated, a
conclusion can be derieved that the company is distributing good earnings to its shareholders.
The increase was of $0.58 in 2011 – 2012 as compared with $0.52 in 2010 – 2011.
Liquidity Ratio:
Current Ratio: The current ratio of Tesco for the year 2010 was 3.09 which are very high. The
ideal current ratio should be around 2:1. Although, the firm tried and lowered its current ratio to
2.34 in 2011, but again in 2012 it rose up to 3.06. This means the company is not properly
utilizing its assets and just piling up the same. The company needs to look into this matter
seriously as it is not able to draw any benefits from the assets it has acquired revealing that it is
not utilizing its short term financing very effectively. Moreover, it shows the organization is not
able to manage its working capital properly. These can significantly affect the operations of the
firm in short run. It should try to bring it to near about 2.
Quick Ratio: quick ratio of Tesco was 2.28 in 2010 which is area of concern for the company. In
the next year, it was able to reduce it to 1.45 which is still not good figure. In 2012, it again rose
slightly to 1.89. Ideally, the quick ratio of any organization must be around 1.0, but the current
figures are very high as compared to ideal figure. This means, it is not able to invest its funds
properly for expansion or diversification of its operations. Further, if current and quick ratios are
compared simultaneously, it can be concluded that the company has invested lot in its inventory
which is also not good from the firm’s point of view. So, it should try to bring its current ratio to
1.0 and it can achieve it by properly deploying its short term liquidity (Bertoneche, 2001).
Efficiency Ratio:
Average Collection Period: the average collection period tells the rate at which the trade
receivables are received from the debtors. Tesco’s collection period for the year 2010 was 197
days which increased to 203 days in 2010. Further, the organization pulled it down to 200 days
in 2012. This shows it has improved its trade credit management. The trend shows the average
collection period of the firm is near about 6 months and it is able to maintain that. It means the
firm’s debtor has enough liquidity and the organization will not face any difficulty in collecting
its debt. Further, it shows the effectiveness of the company’s trade credit management.
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Inventory Turnover Ratio: It tells about the frequency by which the inventory is restored during a
particular year. In year 2010, the inventory turnover ratio was 5.19, denoting that its inventory is
replaced around 5 times in a year. That is, the company is able to sell its inventory very quickly
in near about 2 months. But, in 2011 it reduced to 3.66 and further lowered down to 3.48 in
2012. It shows that the organization is not managing its inventory properly indicating the poor
inventory management of the firm. Earlier, it used to refill the inventory every third month, but
now it is being done in every fourth or fifth month showing that the sales of the company have
gone down. So, the management must look after this matter and try to improve its inventory
management and must do something to augment its sales (Brigham and Houston, 2009).
1.3: Summarized Report
Table 2: Summarized Report
.Ratios 2012 2011 2010 Remarks
Profitability
Ratios
Gross Profit
Margin 21.65% 20.31% 18.88%
The company should try to maintain the
existing rate
Net Profit
Margin 9.00% 5.26% 1.86%
It is performing well and must continue with
same trend
Performance
Ratios
Return on
Assets 8.48% 4.92% 1.55%
It has improved the efficiency of its resources
and try to maintain it
Return on
Capital
Employed 10.37% 6.37% 1.85% It is effectively employing its long term funds
Return on
Equity 10.61% 6.54% 1.88%
It has consistently improved this and it will
enhance its brand image
Earnings per
Share 1.29 0.71 0.19
the company has delivered good returns in
2012 and must try to maintain the pace
Liquidity
Ratios
Current Ratio 3.06 2.34 3.09 Needs to bring it down to around 2
Quick Ratio 1.89 1.45 2.28 Needs to lower it to 1
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Efficiency
Ratio
Debtors
Turnover Ratio 1.82 1.8 1.85
Average
Collection
Period 200 203 197 Shows effective trade credit management
Asset Turnover
Ratio 0.74 0.74 0.68
Inventory
Turnover Ratio 3.48 3.66 5.19
Shows poor inventory management and firm
must improve this
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PART 2: INVESTMENT APPRAISAL FOR PLC Plc.
2.1: Project Appraisal
Table 3: Cash Flow for Two Projects
Project 1 (£000) 2 (£000)
Initial Outlay -1100 -800
Year 1 -110 -20
Year 2 200 140
Year 3 400 250
Year 4 500 300
Year 5 520 380
Residual
Value 150 80
A: Net Present Value Method
Table 4: NPV at 10%
Year
Project 1
(£000)
Project 2
(£000)
PV Factor @
10%
Present Value of
1
Present Value of
2
Year 1 -110 -20 0.909 -99.99 -18.18
Year 2 200 140 0.826 165.2 115.64
Year 3 400 250 0.751 300.4 187.75
Year 4 500 300 0.682 341 204.6
Year 5 520 380 0.621 322.92 235.98
Residual
Value 150 80 0.621 93.15 49.68
1122.68 775.47
Net Present Value=Present ValueInitial Investment
Net Present Value of Project 1=1122.681100
NPV of Project 1=£ 22680
Net Present Valueof Project 2=775.47800
NPV of Project 2=£24530
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So, on the basis of Net Present Value method, PLC Plc. must invest in project 1 as it is showing
positive net present value (Drury, 2008).
B: Internal Rate of Return Method
Since the NPV of project 1 is coming positive at 10% and NPV of project 2 is coming
negative at 10%, it means the internal rate of return of project 1 will be above 10% and that of 2
will be below 10%. Using hit and trial method, the NPV of 1 is calculated at 11% and that of 2 is
calculated at 9%.
Table 5: NPV of Project 1 at 11%
Year
Project 1
(£000)
PV Factor
@ 11%
Present
Value of 1
Year 1 -110 0.901 -99.11
Year 2 200 0.812 162.4
Year 3 400 0.731 292.4
Year 4 500 0.659 329.5
Year 5 520 0.593 308.36
Residual
Value 150 0.593 88.95
1082.5
NPV of Project 1=1082.51100
NPV of project 1=£17500
Table 6: NPV of Project 2 at 9%
Year
Project 2
(£000)
PV Factor
@ 9%
Present
Value of 2
Year 1 -20 0.917 -18.34
Year 2 140 0.842 117.88
Year 3 250 0.772 193
Year 4 300 0.708 212.4
Year 5 380 0.65 247
Residual
Value 80 0.65 52
803.94
NPV of Project 2=803.94800
NPV of Project 2=£ 3940
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The above two tables show that IRR of project 1 will be in between 10% and 11%, while IRR of
project 2 will be between 9% and 10%.
IRR of project 1:
IRR=10+ 1122.681100
1122.681082.51
IRR=10.56 %
IRR of project 2:
IRR=9+ 803.94800
803.94775.471
IRR=9.14 %
Since the IRR of Project 1 is more than 10% and IRR of Project 2 is less than 10%, PLC Plc.
should invest in project 1 (Mclaney, 2006).
C: Average Rate of Return
Average rate of return of project 1:
Average rate of Return= Average Annual Profits after Taxes
Average Investment
the life of the project
100
Average Annual Profit after Tax=110+200+ 400+500+520
5
Average Annual Profit after Tax=£ 332000
Average Investment=Salvage Value+ 1
2 (Cost of MachineSalvage Value)
Average Investment=150+ 1
2 (1100150 )
Average Investment=£ 625000
Average rate of return= 332000
625000100
Average rate of return=53.12 %
Average rate of return of project 2:
Average Annual Profit after Tax=20+140+250+300+380
5
Average Annual Profit after Tax=£ 226000
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Average Investment=80+1
2 ( 80080 )
Average Investment=£ 440000
Average rate of return= 226000
440000100
Average r ate of return=51.36 %
On the basis of average rate of return method, PLC Plc. should invest on project 1 as its average
rate of return is more than project 2 (Neale and McElroy, 2004).
2.2: Payback Period Method
Payback Period for project 1
Table 7: Payback Period of Project 1
Year
Project 1
(£000)
Cumulative
(£000)
Year 1 -110 -110
Year 2 200 90
Year 3 400 490
Year 4 500 990
Year 5 520 1510
Residual
Value 150
The above table shows that the payback period of project 1 will be between year 4 and 5. Its
exact payback period will be:
1100990
520 12=2.53
So the payback period of project 1 is 4years and two and half months.
Payback Period for project 2:
Table 8: Payback Period of Project 2
Year
Project 2
(£000)
Cumulative
(£000)
Year 1 -20 -20
Year 2 140 120
Year 3 250 370
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Year 4 300 670
Year 5 380 1050
Residual
Value 80
The above table shows that the payback period of project 2 will be between year 4 and 5. Its
exact payback period will be:
800670
380 12=4.11
So the payback period of project 2 is 4years and 4 months (Mao, 2012).
So, on the basis of payback period, project one must be preferred over project two as its payback
period is lower (Sofat and et. al., 2010).
2.3: Advantages and disadvantages of the investment appraisal methods
Net Present Value: Present value method compares the present value of the money with that of
its future value. While comparing value, it takes time value of money into consideration. It the
NPV of any project is positive, the company must go for it. On the other hand, if it is negative, it
must not invest on it. Moreover, while comparing two projects organizations must invest on that
which has higher NPV.
Advantages:
Involves concept of time value of money;
It considers both cash flows i.e. before and after;
Focuses on risk and profitability;
NPV maximises value of firm.
Disadvantages:
Difficult to implement;
In case of mutually exclusive projects, it does not provide accurate results;
Can’t be applied for projects having different life.
Internal Rate of Return: It is the rate at which the difference between inflow and outflow of the
cash becomes zero. That is, at this rate inflow is equals to outflow.
Advantages:
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Use the concept of time value of money;
Does not need to calculate any rate of return;
Both inflow and outflow are considered;
Helps in selecting better investment among alternatives.
Disadvantages:
Complicated to determine IRR;
Does not focuses on economies of scale;
If cash flows are positive and negative, then it becomes more complicated;
Less successful for comparing mutually exclusive projects.
Average Rate of Return: It does not consider the time value of money. This method determine
the rate at which the project will give returns.
Advantages:
Easy to use and understand;
Helps in identifying the attractiveness of investment;
It is based on accounting method, does calculation are easy (Phillips, 2000).
Disadvantages:
It is not based on time value of money;
It also ignores terminal value of project;
Payback Period: It tells about the time in which the investment cost will be recovered by the
project. That project is considered better whose payback period is less.
Advantages:
Most easy method to implement and is universally accepted;
Focuses on liquidity of investment;
Concentrates on risk associated with the investment.
Disadvantages:
Does not follow the concept of time value of money;
Focuses only on payback period and ignores profitability associated with the investment;
Considers only those cash inflow which are generated before payback period.
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NPV and IRR are the most widely used investment appraisal methods. Most of the
organisations and investors use these two techniques over others just because they consider the
time value of money while other techniques do not consider the time value of money. Value of
one unit of money is not going to remain same in the future and is definitely going to change, so
it is very important to consider this fact before making any investment. Net present value and
IRR involves the concept of time value of money providing most accurate results among all. If
both net present value and IRR methods are compared, then in that case, NPV is preferred over
IRR just because it is easy to calculate and unlike IRR, no assumptions have to make in this
method. Moreover, results derived from net present value method are more authentic as
compared to internal rate of return. So, out of net present value and internal rate of return, net
present value method is most widely used (Bennouna, 2010).
2.4: Summarized Report
Table 9: Summarized Report
Project 1 Project 2
NPV £22680 £-24530
IRR 10.56% 9.14%
Payback Period 4 Years and 2 months 4 years and 4 months
ARR 53.12% 51.36%
The above table shows the summarized findings of the two projects. All the methods suggest that
project 1 is better that project 2. So, the PLC Plc. should invest in project 1 rather than project 2.
CONCLUSION
After working on the above two cases, it can be concluded that financial management
plays significant role in analyzing the performance of any company. Moreover, it is also an
important tool for evaluating different investment projects and helps in identifying the better
investment opportunity.
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APPENDIX
Financial Statements of TESCO
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