Financial Theories and Investment Appraisal Techniques

The provided assignment delves into the realm of financial theory and its practical applications through investment appraisal techniques. It covers the calculation of Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, highlighting their significance in decision-making processes within organizations. The assignment also touches upon the importance of transparency in financial reporting, making viable the financial structure. It concludes by emphasizing the need for appropriate tools to take informed decisions and justifying them based on these theories.

Financial Management
Theory and Application

Table of Contents
INTRODUCTION...........................................................................................................................1
PART 1 ...........................................................................................................................................1
Investment appraisal method.......................................................................................................1
Financial Theory and its impact of an expansion on the company and stakeholders.................3
Part 2................................................................................................................................................5
TRUE/FALSE.............................................................................................................................5
CONCLUSION................................................................................................................................1
REFERENCES................................................................................................................................2

INTRODUCTION
Financial management means planning, preparing and directing the money activities of a
an organisation such as utilization of funds of the organisation. The main objective of this project
is to understand the means of financial management, as it refers to the management of the
finances of an organisation in objective to achieve its financial goals. An investment appraisal is
a method of collection of technique used by a firm in order to identify the productivity of an
investment. This project cover Sole proprietorship which is a form of business in which only
single individual acquires all the benefits and risk related to an enterprise.
PART 1
Investment appraisal method
The process of analysing whether investment projects are worthwhile or not to an
organisation is called investment appraisal. These are the techniques used for determining
whether an investment is likely to be profitable or not(Admati and Hellwig, 2014).
Method of investment appraisal
There are different techniques used a firm that help to find out the effects of an
investment will have on their business. This is sometimes called investment appraisal and some
common method are such as, accounting rate of return (ARR), net present value(NPV) or
internal Rate of Return (IRR).
Accounting rate of return (ARR)
This method help to compare the profit a company expect to make from an investment
from the amount it need to invest. It is normally calculated as the average profit(annually) over
the life of an investment project, compared with the average amount of capital invested. This
method is based on accounting information due to which other special reports are not required in
the course of determining average rate. This method is comparatively easy and simple to
understand. ARR is a method which is based on accounting profit and hence measures the
profitability of investment. There are few disadvantages of this method also which are this
method ignores value of money and cash flow from investments. Another limitation of this
method is that terminal value of project is not considered (Danthine and Donaldson, 2014). The
calculation of ARR is as follows=annual average profit/ average investments*100%.
ARR= average net profit/average investments*100
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Average net profit = 0.2+0.5+0.6+0.1/4
1.4/4 =
0.35 million
Average investment 0.9 million
ARR= 0.35/0.9*100
38.89%
Net profit for the following year are 0.2, 0.5, 0.6 and 0.1 million respectively and average
net profit is calculated by number of years. Average investment for the years are 0.9 million and
average rate of return from the information is 38.89%. This is calculated from the average net
profit divided by average investment (Hermes and Lensink, 2013).
Net present value
NPV helps to compare the value of invested amount today with the value of that invested
amount in future. It calculate the monetary value now of the project with its future cash flow.
The main objective of any firm is to make profit by using its existing and future resources to
produce goods and services. So in order to make project viable, the total inflow in a project must
exceed the present value of all expected cash outflows. NPV is obtained by calculating expected
outflows per year as a result of the investment, discount for the cost of capital that result is called
present value and then subtract initial investment amount from the result. Ascertainment of Net
present value is important as it helps in measuring profitability of an organisation along with
determining factor risks. Few other benefits of this method is ignoring sunk cost and
consideration of all cash flows (Jerzmanowski and et. al., 2014). The reason behind using this
method by this company is to get beneficial from the accurate and reliable value of profit. NPV
is important as there are various ways to calculate value of profit but this method take less time
and value for money.
2

NPV={after tax cash flow/(1+r)^t}-
initial investment
investment £900000 PV
Year 10.00%
0 £ -900000 1 £ -900000
1 £ 200000 0.909 £ 181818.182
2 £ 500000 0.826 £ 413223.140
3 £ 600000 0.751 £ 450788.881
4 £ 100000 0.683 £ 68301.346
NPV £ 214131.55
From above it is stated that present value is taken at 10% per annum and sum of present value is
calculated £1114130 approx and Initial investment is £9lkh. NPV is calculated by subtracting the
value of investment from the sum of present value that is £214131.54(approx).
Internal rate of return
It is the interest rate at which the net present value of all the cash flows (both positive and
negative) from a investments equal to zero. It is basically used to find the affectivity of a
investment for an organisation. Internal rate of return is discount percentage rate used in capital
investment appraisals which brings the equality between the actual cost of a project and its future
cash inflows. IRR may be considered as the rate of growth a project is expected to generate in
future. In generally a project with a higher percentage of IRR is considered more desirable that
one with a lower percentage IRR (Lagoarde-Segot, 2015). This method brings simplicity in
operations by interpreting values. It is easy to visualise for managers as the preferred situations
are mutually exclusive. Along with benefits, there are few limitations too of this method. This
method ignores economies of scale due to which a pitfall in actual rate can be occurred. Another
limitation of this method is that it is a impractical implicit assumption of reinvestment rate.
IRR 20.54%
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From above calculation IRR of the project is 20.54% that means NPV will be zero or equal to
when present value percentage is 10% and IRR is 20.54%.
Financial Theory and its impact of an expansion on the company and stakeholders.
Finance and business are two interlink because a business has to make financial decision,
investments decision, purchase of raw material and stock, and other transaction like buying
assets, profit and loss calculation etc therefore organisation needs to have a very strong financial
management theories. There are number of theories in practice relating to financial management
that have been developed like agency theory, expectation theory, liquidity preference theory, net
income approach, capital assets pricing model and so on. Financial management theory help to
assist a company and will be a useful tool in achieving financial goals of the organisation. In
some cases financial theory are not always easy to follow,because these are based on a number
of different aspects like, outsourcing, risk management , investments, rate of return and return on
investments. The theory will allow an organisation to gain profit from some unexpected sources
which is the biggest benefits of using it (Lusardi and Mitchell, 2014).
Impact of financial theory on expansion of company
It influence the interest rate of the company and take control over the interest, it creates
various conflicts and New Delhi gold company have to be prepare for those conflicts and this can
harm the decision making ability of the managers and it also influence the strategy making
power of the management. These theories also affect the economic condition of the company that
can harm the market image of the company and it can create various problems for the
organisation. If financial theories are not well implemented then it can also harm the
shareholders and investors that will affect their interest and investment in the organisation. Net
income approach refers to the net income which have been earned by the organisation. This
approach affect the business and operational risk and can leave a negative impact on monetary
resources. It also create issues while preparing cash flow statement and at the time of payment of
debts by creating various types of rules and also influence the interest rate (Ziegler, 2012).
There are not only negative impacts but also positive impacts of financial policies such as
it provide the actual idea of debt and equity of the organisation, it also help to create well
established capital structure that will lead to the company towards goals and if the theories are
well implemented then it will help New Delhi gold company to grow. Financial theories such as
4

expectation and capital asset model are the few theories or models that help the organisation to
deal with the problems within and outside of the organisation. Agency theory and net income
theory of Financial theories impact on company's Stakeholders by giving them benefits from
increased profits which expansion brings. In agency theory it explains the relationship between
principles and agents of New Delhi gold company. Problems are resolved which between
shareholders and company's executives. In net income theory company determine its value which
can be increased by decreasing overall cost of capital with the help of higher portion of debts.
Part 2
TRUE/FALSE
Answer 1- false,as the primary function of the capital budget is to forecast funds required for
future investment that may be raised through external funding.
2 - true , Sole proprietorship is is the simplest business from under which one can operate its
only business.
3 - true ,capital budget is use to fund needed for future investments.
4 - true, as a project may have a more than one irr.
5 - true,because a higher IRR with same initial cost is more desirable than the other .
6 -d), insiders should be able to trade whenever they want.
7 -E) ,because payback and discounted payback method of capital budgeting methods might not
consider the salvage value of a machine being considered for purchase.
8- d), as low discount rate means that NPV is affected more by the cash flows that occurs further
is the future. So when the value of the outflows is greater than the inflows, the NPV is negative.
9 -d), Amex Oil Index is the smallest broad market average index.
10 -b), 18.75%
Expected rate of return
Year Return Probability
Expected
return
1 0.1 0.25 0.025
2 0.2 0.5 0.1
3 0.25 0.25 0.0625
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Asset's expected return 0.1875
11 -a), both projects should be purchased, because the IRR for both projects exceed the firm's
required rate of return.
12- b), If the multiple IRR problem does not exist, any independent project acceptable by the
NPV
method will also be acceptable by the IRR method.
13- d), Project A because of higher IRR
project A project B
investment PV investment PV
Year 10.00% Year 10.00%
0 -50000 1 -50000 0 -50000 1 -50000
1 15625 0.909 14204.545 1 0 0.909 0.000
2 15625 0.826 12913.223 2 0 0.826 0.000
3 15625 0.751 11739.294 3 0 0.751 0.000
4 15625 0.683 10672.085 4 0 0.683 0.000
5 15625 0.621 9701.896 5 99500 0.621 61781.672
NPV
9231.04327
2007 NPV
11781.6716
443859
IRR 16.99% IRR 14.75%
14 – c), make a decision based on the project’s NPV while computing the NPV of a budgeting
project.
15 – e) Answers b and c are both correct because it help to Overcomes the problem of multiple
rates of return and Compounds cash flows at the required rate of return throughout the project.
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16 – d) All of thesebecause in pay back period ,time value is not recognised ,it gives high
emphasis on liquidity and ignore profitability and it considered only cash flow before the pay
back period.
17- b) The IRR is a discounted cash flow method is not a
18- d) None of these statement is correct.
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Q.19
Year Cash flows
0 -150000
1 35000
2 35000
3 35000
4 35000
5 40000
Payback period 4.35 year
Q.20
a) The transparency that results from this compliance can be costly for some firms.
Transparency is a concept which intended to prevent conflicts and make viable the financial
reporting structure.
CONCLUSION
The above project concluded the concept of financial theories that is used with in an
organization to analyse financial position of business. for this purpose various investment
appraisal techniques as NPV, IRR and Payback period are undertaken. On the basis of these tools
appropriate decision are taken and justified.