Investment Appraisal Techniques and Methods

This assignment explores the different investment appraisal techniques and methods used by businesses to evaluate potential investments. The study examines the benefits and drawbacks of each method, highlighting their suitability for specific investment decisions. It also discusses the importance of selecting the best investment proposal, considering factors such as profitability and risk reduction. The assignment references various books, journals, and online sources, providing a comprehensive overview of the topic.

Financial management

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
Question 2 Long term finance – Equity finance..............................................................................1
A) Determination of number of shares, theoretical ex rights price, expected earnings per
shares and form of issue for each right price..............................................................................1
B) Advantages of scrip dividends from the point of view of the company and the shareholders
.....................................................................................................................................................2
Question 3 Investment Appraisal techniques...................................................................................3
1. Calculation showing various investment appraisal techniques...............................................3
2. Critical evaluation of benefits and limitations of different investment appraisal techniques. 6
CONCLUSION..............................................................................................................................10
REFERENCES..............................................................................................................................11

INTRODUCTION
Financial management refers to a process of management that includes planning,
organising, controlling and motoring each financial activity performed by a business organisation
(Bader, Al-Nawaiseh and Nawaiseh, 2018). This system of management ensures the company to
become more financially efficient. With the help of maintaining financial management in the
business, it can ensure effective use of all the financial resources and funds and achieve its goals
and objectives in more effective way. The present study includes various calculations of the
financial management system including calculation related to share price of the company,
calculation showing the various investment appraisal techniques, etc. further, the current study
also recommend the companies to select the best option of various financial management
techniques and option for the purpose of gaining the best result for the company and help the
company in achieving its objectives and set goals of gaining return from the investments and
issue of shares as well.
MAIN BODY
Question 2 Long term finance – Equity finance
A) Determination of number of shares, theoretical ex rights price, expected earnings per shares
and form of issue for each right price
Calculation of number of shares to be issued by Brand Plc
number of Brand's shares, which is:
£200,000 = 400,000 shares
0.5 per share.
Theoretical ex right price
Theoretical ex right price refers to a situation arisen in the business in which the shares
and the list of rights attached with them are separate from each other. In this situation, the
theoretical ex right price of the shares are considered as the deemed value of the shares (Bragg,
2016). This value is attributed to all the shares of the company after occurrence of the right issue
situation.
It can be calculated as under:
Theoretical ex right price = Market Value of shares prior to rights issue + Cash raised from
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rights issue/ Number of shares after rights issue
Therefore, theoretical ex right price = 76000 + 160000/360000 = .65 per share.
Market value per share = 20000/.5*1.9 =76000
number of shares after right issue= 20000+160000/1.9=360000
Calculation of expected earning per shares
Current market value of Brand plc:
400,000 x £1,90 = £760,000
Funds to be raised from right issue = £160,000
Final market value £920,000
Third: Earnings before right issue:
600,000 x 15% = £90,000
Earnings from new funds:
160,000 x 15% = £24,000
Total earning after right issue =_£114,000.00___________
1) Number of new shares /using £1,80/ = £160,000 = £88,889
£1,80
2) Total shares in issue = 400,000 + 88,889 = 488,889
3) Earnings per share = £114,000 = 23,3 p. per share
488,889
4) Theoretical ex-right price = 920,000 = £1,88 per share
488,889
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Calculation of New earnings per share
114,000 x 100 = 23.32 per share
488889
right issue: 400,000 =
88889
1 = 1 x 400,000 = 4.50
88889
The shareholders will be entitled for 1 new share for every 4,50 they currently own.
Comment
From the above calculation, it can be evaluated that in case the Brand plc wants raise the
capital for the expansion purpose, the company need to issue €84210 shares to the public. The
company can issue the scrip dividend by providing the options to the shareholders to either adopt
the option of cash dividend or stock dividend. It will influence the number of shares to be issue
by the Brand plc for its expansion purpose.
Further, the firm can issue the shares at different price to the public. In case, the company
issues its shares @ 1.8 per share, it would get an expected earning of €151578. On the other
hand, if the Brand plc decides to issue the right shares @ 1.6 per share, the company would earn
the expected earning worth €134736.
Whereas, in case the company decides to issue the right share @ €117894, it would result
in earning an expected sum of €117894.
The Brand plc should analyse each situations of the issuing right shares carefully along
with their expected earnings. After analysing each situation, the company should decide the best
option that can provide the company the best return from the issue of shares.
B) Advantages of scrip dividends from the point of view of the company and the shareholders
Scrip dividend
Scrip dividend can be defined as a process in which the company offers its shareholders a
choice at the time of providing dividend. As per the choice, the shareholders have right to either
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get the cash dividend, or get more shares of the company equivalent to the value of cash dividend
of the company (Scrip Dividend. 2019).
The scrip dividend process provides benefit to both company and its shareholders. All the
major advantages of this process to business and stakeholders are as under:
Advantages to company
 This process can help the company in reducing the cash outflow from the business in
terms of the dividend. As the shareholders adopting the option of stock divided are not
required to be paid the cash for the purpose of dividend to the company.
 It helps the company in maintaining the liquidity in the company.
 The firm can be able to utilize the sum of the value not paid by the company due to
selection of the stock dividend option by the company (DeBoeuf and et.al., 2018).
 More adoption of stock dividend also helps the company in enhancing its image and
value in the stock market without occurring any additional cost.
Advantages to shareholders
1. As the shareholders are given the option to either get the cash dividend or the additional
shares of the company, they can take a huge benefit of it. As if the prices of the shares of
the company are going to be rise in the future as per their estimation, they can adopt the
option of taking additional shares (Feito-Ruiz, Renneboog and Vansteenkiste, 2018). It
would help them in earning more benefit from the shares without any additional
investment.
2. In case, the value of shares of the company is being estimated to be fallen in the future,
they can get the cash dividend and reduce the future risk of suffering loss in the future.
3. Further, adoption of stock dividend also reduces the burden of tax over the shareholders
as in case of getting cash dividend, they need to pay tax on the value received by them.
Question 3 Investment Appraisal techniques
1. Calculation showing various investment appraisal techniques
A) Calculation Using payback period technique.
Calculation of annual depreciation
Particular Amount €.
Cost of machinery 275000
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Useful life of machinery 6 years
Amount of annual depreciation (275000/6) 45833
Particular Amount €.
Annual cash inflow 85000
Annual cash outflow 12500
Annual depreciation 45833
Payback period 9.37 years
Interpretation
Payback period can be defined as the time required by the company in recovering the cost
involved in the investment proposal. This method helps the business organisation in determining
the risk involved in the proposed investment.
From the above calculation it can be interpret that if the business invests its sum in
purchasing the cost of 275000 would take 9.37 years in recovering the cost of the initial
investment (Gotze, Northcott and Schuster, 2016). In this regard, it can be evaluated that it is a
long term investment proposal as it needs a long time in recovering the cost of investment by the
firm.
B) Calculation using Accounting rate of return technique
Particular Amount€.
Initial investment 250000
Annual cash inflow 85000
Annual cash outflow 12500
Annual depreciation 45833
Annual profit 26667
Average rate of return (average accounting income/initial
investment *100) 10.66%
Estimated rate of return 15.00%
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Interpretation
The accounting rate of return technique provides help to the business in determination of
the profitability of the investment proposal. It provides the average rate of return from the
proposed project.
From the above calculation it can be evaluated that the average rate of return after
adjusting all the average cash inflows, cash outflows including depreciation is 10.66% which is
less that the estimated rate of return of the business i.e. 15%.
In this regard, it can be evaluated that the company should not investment its fund in
purchasing the machinery of worth 275000.
C) Calculation using Net present value method
Particular Years Cash flows€. 12% factor
Present
value€.
Initial investment 0 -275000 1 -275000
Annual cash flows 1 72500
0.893
64742.5
Annual cash flows 2 72500
0.797 57782
Annual cash flows 3 72500
0.712 51620
Annual cash flows 4 72500
0.636
456110
Annual cash flows 5 72500
0.567
41107.5
Annual cash flows 6 72500
0.507
36757.5
Net present value 64742.5
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Interpretation
The net present value method helps the business in calculating the present value of the
future returns from the investment. It can be defined as a proper method of investment decision
techniques that takes into account the time value of the money (Harrison, 2017). In this method,
the present value of the amount of investment proposal are taken as a base for the purpose of
taking decision for the selection of best project.
In the above calculation, it can be seen that the initial investment of the project is 275000.
On the other hand, net annual cash flow from the project is 72500. After adjusting the sum with
the present value factor @ 12% and adjusting it with the value of initial investment, the sum
comes to 20800. Therefore, the net present value of the return from the investment is 64742.5
which is a positive value.
Therefore, the company should invest its sum into the purchase of the machinery, as the
proposed investment proposal is providing positive sum in the return in the future.
D) Calculation using Internal rate of return technique
Years Cash flows€.
0 -275000
1 72500
2 72500
3 72500
4 72500
5 72500
6 72500
IRR 15.00%
IRR = R1 + [ NPV1 / (NPV1 - NPV2) x (R2 - R1)]
=0.12+[64742/64742-41107]*(0.15-0.12) = 14%
Interpretation
The Internal rate of return method helps the company in determining the rate of return at
which the net present value of the investment becomes equal to zero (Harris, 2017). This method
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enables the business in equating the present value of the investment and future value of the
investment.
From the above calculation, it can be evaluated that, if the company invests its sum in
purchasing the machinery, it would get a return in @ 15% after adjusting all the cash inflows and
cash outflows affecting the investment. The estimated rate of return by the business is also 15%.
company would receive a positive return.
Further, the company would receive a negative return @ 12%. therefore, investing @
14% would provide an economical return to the company. Therefore, the firm can select the
investment proposal. As, it would help the business in achieving its return on investment goals.
Recommendation
From the analysis of all the above calculations of the return on investment from various
techniques of investment proposal, it can be evaluated that the Lovewell limited should purchase
the machinery of worth 275000. The above calculations are showing that although, the
investment is taking a longer period in recovering the cost of investment for the business, but if
the company decides to purchase the machinery, it would provide a positive cash flow to the
business.
Further, the investment decision will also help the Lovewell Limited in achieving the
overall business objective of gaining return on the investment @ 14% as well. In this regard, it is
recommended to Lovewell Limited to purchase the machinery for the business.
2. Critical evaluation of benefits and limitations of different investment appraisal techniques
Payback period technique
Payback period technique is the method used by the firms for the purpose of determining
the best investment proposal in order to gain maximum benefits from the investment
(Karabarbounis and Neiman, 2018). It helps in determining the time required by the investment
proposal in recovering the cost. Investments taking long period in the recoup generally does not
consider desirable in this method.
Following are the advantages and disadvantages of payback period method:
Advantages
 It can be termed as the simplest method for the purpose of taking investment decisions.
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 While using this method, the business focuses on the risk involved in the investment
proposal (Penman and Zhang, 2018). In this regard, it reduces the overall risk of the
company. As with the help of this method, the importance is being given to the investment
providing fast returns, it reduces the risk of lack of liquidity in the firm.
Disadvantages
 This method does not consider the time value of money.
 It ignores the return on investment. Investment taking short period of time in recovering
the cost are considered as the best proposal. Sometimes, proposal taking longer period
can also provide better result to the company. But while using this method, company
would never select those proposals (Feito-Ruiz, Renneboog and Vansteenkiste, 2018)..
 Payback period method ignores the amount of cash flow of the investment.
 This method also does not take into account the return on investment of the proposal.
Accounting rate of return method
This the method that helps the company in predicting the accounting profit that can be
earned by the business from the average investment made by it in the proposed project.
Key advantages and disadvantages of the accounting rate of return methods are as under:
Advantages
 It is also one of the simplest method of investment appraisal technique.
 It makes the company to take into account total amount of profit that can be earned by it
from the investment proposal (Sastry and Balakrishnan, 2018).
 This method helps in comparing cost and profit of the new project with another cost
reducing projects.
 With the help of this method, the business organisation can determine the actual
profitability of the project.
 It also helps in considering the tax and depreciation while determining the earning of
project. Adoption of this technique helps in taking into account the amount of interest involved in
the project. In this regard, this method also leads in providing satisfaction to the owner as
well.
Disadvantages
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 This method simply ignores the time value factor of the investment. In this order, it may
make the company in selecting the wrong proposal for the business.
 Due to this method, the company fails to consider all the external factors that may affect
the profitability of the investment proposal.
 Further, this method also does not consider the amount of cash flow of the project.
 Accounting rate of return method fails in case the investment project needs the amount to
be invested in different instalments.
 The method also ignores the life of the project. Therefore, this may result in taking wrong
decision for the company.
Net present value method
Net present value method is the most commonly used technique of investment appraisal
(Min, 2019). It can be defined as a method that provides the present value of a future investment.
In this method, the company takes decision about the proposal after comparing the present value
of future cash inflows and the future cash outflows.
Advantages and disadvantages of this technique are as under:
Advantages
 It is based on an assumption that future value of money would be less than the present
value. In this regard, the company becomes enable to face the future uncertainties of the
breaking down the value of money.
 While calculating the net present value of the proposal, the company considers all the
major factors influencing the investment decision i.e. cash inflow, cash outflow, life
period of the investment proposal, present value of the future investment, etc.
 Profitability of the business and risk involved in the projects are given the highest priority
in this method.
 It helps the business organisation in maximising the overall value of it. The NPV method also helps the company in becoming more efficient in predicting the
amount of cash flows in the business.
Disadvantages
 The NPV enhances the amount of guess works and predictions of the managers.
 In case, the company wants to compare two or more methods having different size, this
method would become fail to be used.
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 Two project having different life spam can also not be compared while using this method.
 Calculation of appropriate discounting rate of the project is quite difficult to be calculate
with the help of this technique.
 This method is quite difficult to be used.
Internal rate of return method
Internal rate of return provides the company a method to predict the profitability involved
in the investment proposal. The internal rate of return can also be defined as the discounting rate
that makes the net present value of the project zero for all the cash flows.
Following are the advantages and disadvantages of this method:
Advantages
 It makes the business to consider the time value of money of all the projects.
 It helps in considering the profitability involved in the project during the whole life spam
of the project.
 While using this method, the business does not need to estimate the cost of capital of the
project.
 It makes the ranking of investment proposal easy to be determined.
 It helps the company in maximising its profitability. This method gives importance to the shareholder's equity. In this order, with the help of
this technique, company enables to maximise the wealth of its shareholders.
Disadvantages
 It involves some repetitive calculations.
 This method does not consider the size of project while calculating the return on
investment from a particular project.
 Further, the internal rate of return method also does not consider the future cost involved
in the investment proposal. In this regard, it may result in selecting the wrong investment
proposal by the company.
 Further, the formulae used in this method are also not foolproof.
 While using the internal rate of return method, the business assumes that the earnings of
the investment would be reinvested at internal rate of return for the whole remaining life
of the investment proposal by the firm (Brisley and et.al., 2016).
 The profitability of the investment proposal is also not justifiable.
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In this regard, it can be evaluated that there are various methods that can be used by the
company while selecting the best investment proposal. Each method has its own advantages and
disadvantages. The business should carefully analyse the all merits and demerits of various
methods and select the best suitable method for taking the most effective decision for the
business organisation.
CONCLUSION
From the above study, it can be concluded that various techniques of the financial
management process, helps the business in enhancing the efficiency of the company in terms of
the managing the financial resources. The scrip dividend method provides benefit to both
company and its stakeholders as the company can enhance its liquidity in the business and
shareholders can reduce their future risk off holding the shares and enhance their profitability
from the holding of shares of the company as well. Further, the study has also concluded that
there are numerous methods that can be used by the business in taking the decision about
selecting the best investment proposal. This decision can help the business in enhancing its
profitability and reducing the risk involved in the investment as well. As per the study, there are
various advantages and disadvantages of each method of the investment appraisal techniques.
The company should analyse each method carefully in use the best suitable method for the
purpose of taking the best investment decision.
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REFERENCES
Books and Journals
Bader, A., Al-Nawaiseh, H.N. and Nawaiseh, M.E., 2018. Capital Investment Appraisal
Practices of Jordan Industrial Companies: A Survey of Current Usage. International
Research Journal of Applied Finance. 9(4). pp.146-161.
Bragg, S.M., 2016. Cost accounting fundamentals. Colorado, CO: Accounting Tools.
Brisley, R and et.al., 2016. Techniques for valuing adaptive capacity in flood risk
management. Proceedings of the ICE-Water Management. 169(2). pp.75-84.
DeBoeuf, D and et.al., 2018. Purchasing power return, a new paradigm of capital investment
appraisal. Managerial Finance. 44(2). pp.241-256.
Feito-Ruiz, I., Renneboog, L. and Vansteenkiste, C., 2018. Elective Stock and Scrip
Dividends. European Corporate Governance Institute (ECGI)-Finance Working Paper.
(574).
Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. SPRINGER-
VERLAG BERLIN AN.
Harris, E., 2017. Strategic project risk appraisal and management. Routledge.
Harrison, A.J., 2017. The economics of transport appraisal. Routledge.
Karabarbounis, L. and Neiman, B., 2018. Accounting for factorless income. In NBER
Macroeconomics Annual 2018. volume 33. University of Chicago Press.
Penman, S.H. and Zhang, X.J., 2018. Connecting book rate of return to risk and return: The
information conveyed by conservative accounting. Columbia Business School Research
Paper. (14-21).
Sastry, S.V.N. and Balakrishnan, J., 2018, October. Share Re-Purchase, a form of Dividend.
In ICRTEMMS Conference Proceedings (Vol. 630, No. 633, pp. 630-633). Swarna
Bharathi lnstitute of Science and Technology.
Online
Min, M., 2019. Advantages and disadvantages of various investments/projects appraisal
methods. [Online]. Available through <https://quizlet.com/109472251/advantages-and-
disadvantages-of-various-investmentsproject-appraisal-methods-flash-cards/>
Scrip Dividend. 2019. [Online]. Available through
<https://www.money-zine.com/definitions/investing-dictionary/scrip-dividend/>
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