Assessing the Limitations of NPV in Long-Term Decision-Making

This assignment discusses the net present value (NPV) analysis of two projects, A and B, with different investment amounts and discount rates. The NPV calculation indicates that project A has a higher positive NPV (£110,991) compared to project B (£44,158), suggesting that the company should invest in project A. However, the assignment also highlights several limitations of using NPV analysis for long-term decision-making, including sensitivity to discounting rate, exclusion of real options, and reliance on assumptions about future cash flows.

Managerial Finance

Table of Contents
Introduction......................................................................................................................................2
Ratio Analysis..................................................................................................................................2
Profitability ratios........................................................................................................................2
The Return on Capital Employed (ROCE)..............................................................................3
Net Profit Margin.....................................................................................................................4
Gross Profit Margin.................................................................................................................4
Liquidity Ratio.............................................................................................................................5
Current Ratio...........................................................................................................................5
Acid Test Ratio........................................................................................................................6
Efficiency Ratio...........................................................................................................................6
Inventories turnover.................................................................................................................7
Assets Turnover.......................................................................................................................7
Gearing Ratio...............................................................................................................................8
Interest Cover...........................................................................................................................8
Earnings per share....................................................................................................................9

Recommendations of how the financial performance of the poorly performing business can be
improved..........................................................................................................................................9
Liquidity ratios...........................................................................................................................10
Efficiency ratios.........................................................................................................................10
Profitability ratios......................................................................................................................10
Leverage ratios...........................................................................................................................11
The limitations of relying on financial ratios to interpret firm performance.................................11
Portfolio 2; Capital Investment Appraisal.....................................................................................13
The limitations of using investment appraisal techniques to aid long term decision-making.......14
Bibliography..................................................................................................................................16

Portfolio 1
Comparative analysis between Tesco limited and Sainsbury limited
Introduction
The report focus on examine the financial performance for two famous company (Sainsbury and
Tesco) in the retail market in UK. The report permits the comparison of the ratio analysis, in
which the profitability, liquidity, efficiency and gearing ratio is examined and recommendation
provided for the best companies from the examination of the ratio analysis for the financial
period 2014/15. Tesco is the global third largest retail company after Wal-Mart and Carrefour as
evaluated in term of income (2015). The company is the UK leading home supermarket chain.
The company has 2306 stores with more than 31% shareholding in UK market. Sainsbury is the
3rd biggest retail firm in the UK supermarket industry with it holding of more than 17% of UK
market shares.
Ratio Analysis
Profitability ratios
Profitability ratio indicates the profitability of the firm. The ratio covers the return on capital
employed, the net profit margin, and the gross profit margin as depicted in the table below.
TESCO Sainsbury's
PROFITABILTY RATIOS 2014 2015 2014 2015
Return on Capital Employed
(%) 4.65 -23.54 9.3 -1
Net Profit Margin (%) 1.53 -9.22 2.99 -0.7

Gross Profit Margin (%) 6.3 -3.9 5.79 5.08
The Return on Capital Employed (ROCE)
This ratio is important in understanding the wellness of the business. The ratio employs the long-
term venture in generating income. The ROCE ratio is importing in helping the business
succeeds its prospect profitability, so this might evaluate the success or failure of the business
(Jain, 2007).
Return on Capital Employed= {(PBIT/ Capital Employed) *100
As result of great market share, Tesco depicts week return on capital employed unlike Sainsbury
For the financial period m2014/15. Tesco was not able to of stabilizing it ROCE whilst
Sainsbury had its ROCE declining but not as alarming as those of Tesco. It can be comprehended
that, Sainsbury was on a position of using its long-term venture efficiently in generating more
income unlike Tesco.

Net Profit Margin
The net profit margin appraises the amount of every pounds of income for the business keeps
earning which implies that a 5% net margin signifies that the business depict a net income of
0.05 pounds.
Net profit Margin= {Net income/sales)*100}
Specifically, the table above depict that Tesco’s profit margin was low unlike those of Sainsbury
for the financial period 2014/15, there was substantial plunge of Tesco’s profit margin from
1.53% to -9.22%. Sainsbury depict a decline in profit margin from 2.99% to -0.70%. In this
regards, it might be concluded that Sainsbury depict an ideal performance in terms of creating
income unlike Tesco for the financial period 2014/15.
Gross Profit Margin
The gross profit margin depicts the earning of the company after taking into consideration the
expense incurred by the business in producing the goods/service (Shi, 2001).
Gross Profit Margin = {Gross profit/ Sale Revenue}*100
From the table above, it can be observed that the gross profit margin for Sainsbury is much better
unlike for Tesco. Although Tesco depict a high portion of gross profit margin, there is a big
declining trend. Nevertheless, Sainsbury’s portion of gross profit margin is not as good as those
of Tesco limited.

Concerning the gross profit margin, it can be appraised from the table above that Sainsbury
depict better performance. Although Tesco depict a high portion of gross profit margin, this
shows that the profit margin is decline very fast unlike those of Sainsbury. Nevertheless,
Sainsbury portion of gross profit is not as good as those of Tesco but it might be depicted that
Sainsbury had slight decline in gross profit for the financial period 2014/15. In this regards, as
much as Sainsbury depicted a slight decline in gross profit, the company overall, depicted an
improvement.
Liquidity Ratio
The liquidity ratio provides the capability of the business to meet it short-term commitment. The
ratio describes the fastness of the business in converting asset to cash to meet their obligations.
TESCO Sainsbury's
LIQUIDITY RATIOS 2014 2015 2014 2015
Current Ratio 0.73 0.6 0.64 0.65
Acid/Quick Ratio 0.43 0.42 0.49 0.48

Current Ratio
The current ratio points out the capacity of the business to transform its asset to cash
Current Ratio = {Current Assets/ Current liabilities}
From the table above, it can be observed that Tesco is having a high current ratio unlike those of
Sainsbury. The implication is that Tesco is experiencing a decline in its current ratio while Tesco
depict an increase in its current ratio. The sharp growth in current for Sainsbury implies that the
ability of the business to convert asset to cash is very fast. It can thus be comprehended that the
Tesco and Sainsbury are both performing well in terms of current ratio with Tesco depicting an
outstanding performance (William Petty, 2015).
Acid Test Ratio
Acid test ratio is a sign that shows the whether the business is having enough short-term asset
that will cover its short-term debt devoid of selling inventory.

Acid test ratio = {Current assets – Inventories} / Current liabilities
From the table above, it is evident that Sainsbury was better unlike Tesco limited implying that
Sainsbury depict sufficient short-term asset and the company does not need to sell its inventory
to meet its short-term debt (Peter, 2015).
Efficiency Ratio
This ratio aids in understanding the effectiveness of the company in utilizing its asset and aids in
explaining how good the business is controlled with the asset.
TESCO Sainsbury's
EFFICIENCY RATIOS 2014 2015 2014 2015
Inventory Turnover 16.27 19.71 22.65 22.63
Asset Turnover 2.58 2.77 2.43 2.46
Inventories turnover

The inventory turnover is evaluated by days implying that the duration that is required to change
inventory to sales. As a result, the less the number of days, the better the performance of the
company.
Inventory Turnover (days) = {Inventory / Cost of sales} * 365
In specific, the table above depicts that the inventory turnover for Tesco will be able to transform
its inventories to cash within 16 to 19 days. On the other Hand, the inventory turnover for
Sainsbury is 22.65 to 22.63 for the financial period ending 2014/15 respectively. In this regards,
Tesco performed well in term of inventory turnover as compared to Sainsbury.
Assets Turnover
The Asset turnover ratio employed to define the wellness of the business in using its assets. The
amount of revenue generated per unit of assets. The higher the ratio, the better it is because it
implies that the business is making more income per unit of asset. The asset turnover for
Sainsbury is low as compared those of Tesco, which implies that the ability of Tesco to utilize its
assets is very effective unlike Sainsbury. Both firms depict an asset turnover that is steady for the
last two years which is good for Tesco and Sainsbury.
Asset Turnover = {Sale revenue / Total assets}
Gearing Ratio
The gearing ratio is a financial ratio that appraises the financial advantage, which signifies the
extent that the firm activities will be financed by owner’s funds versus the creditor’s funds. In
this regards, the higher the firms leverage level, the more the firm is deem to be risk since the
firm should keep on servicing its debt devoid of how bad the income is.

TESCO Sainsbury's
2014 2015 2014 2015
Interest Coverage 6.05 -11.78 0.41
Earnings per share 0.36 -2.12 0.36 -0.08
Interest Cover
The interest cover evaluates the amount of operating profit existing to cover interest payables.
Where there is low operating profit, the risk of investors and shareholders will be high.
Interest Cover = Operating profit / Interest Expense
From the table above. It is evident that the Sainsbury is having a low rate of interest cover as
compared to Tesco. For the Tesco, it had low rate almost twice the amount for the 2014. Because
Tesco might rarely upheld interest cover rate, while Sainsbury could, Sainsbury considers to in
an ideal situation for the last two years (Gibson, 2008).

Earnings per share
Earnings per share depict the amount shareholder will receive as derived at the end of financial
period. Where the company provides improved earning per share each financial period, depict
that the business is improving in terms of profitability and expansion.
EPS= {Earning attributable to ordinary shareholders/ Number of shareholders}
From the table above, it is evident that both Tesco and Sainsbury depict a decline in EPS with
Tesco depict the worst decline EPS. The general implication is that Sainsbury is having better
business performance unlike Tesco about profit creations and business growth.
Recommendations of how the financial performance of the poorly performing business can
be improved
The best option to examine the financial health of the business and identification of areas for
improvement is observing closely the financial ratios. The ratios employed in making
comparison between diverse aspects of a firm’s performance or how the business is performing
poorly. Ratios must be evaluated monthly in order to ensure that top changing tends in the
business are maintained (Damodaran, 2010). Even though there are diverse terms for diverse
ratios, the ratio falls into four basic classes as explained below.
Liquidity ratios
The ratio evaluates the liquidity of the business that will be available in covering the debts and
providing wide overview of the financial, health of the business. The current ratio evaluates the
ability of the business to create cash to meet its short-term debt while the quick ratio evaluates
the ability of the business to have cash to support its debt requirement. High quick ratio is a sign

of underutilized capital and might prompt the company to venture moiré of its capital on projects
that will provide positive returns
Efficiency ratios
This ratio provides extra awareness of the business like the debtor’s collections, effectiveness of
cash flow and operational outcomes. Inventory turnover provide an overview of the business in
terms of time it takes it sold and replace inventory. Where it takes long for the inventory to be
sold, the more it will be costly for the business. It is important to evaluate inventory since gross
profit is realized when inventory is sold. The ratio ensures that there business improves in areas
that need corrections (Jain, 2007). The average collection period provide an overview of the
average number of days it takes for the debtors to pay for the goods provided. To ensure that
there is improved debtors collection period, the company provides credit polices and set
collection processes.
Profitability ratios
Profitability ratio is important in evaluating the financial viability of the business but is
significantly vital in comparing the business with other in the same industry. The net profit
margin evaluates the amount that the business will realize relative to revenue. Where the
business depict a high profits unlike their competitors, the company is deem to be efficient,
supple and in a position of exploring new opportunities. The return on asset singles the how well
the business is in using its asset to create income (Shi, 2001). The return on equity evaluates the
wellness of the business in relation to invested capital. It provides investors an overview of how
much the business is making in terms of profits for every dollar invested in the business.

Leverage ratios
Advantage ratio provides signs of the long terms solvency of the business and the extent of
business the long-term debt in supporting the business. The debt to equity and debt to asset is
important in the daily operation and it used by lenders to evaluate how the asset of the business is
funded. Whether the finance is from creditors or the company’s venture.
The limitations of relying on financial ratios to interpret firm performance
Historical
Every information used in the ratio analyzed is from the past outcome, this does not imply that
similar outcome will be evident in the future. Nevertheless, ratio analysis may be used on
profoma information and contrast with the past outcome for consistency.
Historical versus current cost
The information on the income statement is accounted at the current cost while some constituent
of the statement of financial position might be accounted at the historical cost, which may be
different. This dissimilarity might lead to unusual ratio outcome (William Petty, 2015).
Inflation
If the rate of inflation has changed in the time under appraisal, this may imply that the numbers
are not equivalent across the period. Since, for instance, if the inflation rate is 100% this year,
revenue may double for the next financial period when in reality the revenue did not change at
all.
Aggregation

The information in the annual report that is used in working out the ratios might have been
summed differently in the past, hence the current ratio analysis on the trend lone does not
contract similar information in the while trend period.
Operational changes
A business might change its operations layout to an extend that the ratios worked out in their past
and contrasted to the similar ratio in the current period depict wrong conclusion about the
business situation.
Accounting policies
Diverse firms might depict dissimilar policy for accounting similar dealings. The implication is
that the ratio outcome of diverse firms might be like contrasting Apple and Orange (Gibson,
2008). For instance, a form might be using the accelerated depreciation whilst another firm may
be using straight-line method of depreciation.
Interpretation
It might be hard to examine the justification for the outcome of the ratios. For instance, the
current ratio of two; one may turn to be perfect, until one recognize that the firm disposed a large
amount of inventories to boost its cash situation. A more comprehensive assessment depict that
the current ratio will just temporarily be at this level and will just reduce in the future.
Company strategy
It might be risky to undertaker ratio analysis contrasting with other companies that is undertaking
diverse plans. For instance, a firm might be following low cost strategy and hence it will be

willing to accept a low gross profit margin interchange of big market control. On the other hand,
a firm in similar industry is centering on high client service plan in which its price are high and
gross margin are high bit it will never achieve the income level of the other firm.
Portfolio 2; Capital Investment Appraisal
Whether they should opt for project A or project B
Net present Value of the project of project A
Machine 1 2 Incremental Initial Outlay
Net profit P.V.I.F
20%
Cash flows' Cost of new machine £ 125,000
2016 £ 60,000.00 0.83333 £ 50,000 less; depreciation £ 100,000
2017 £ 60,000.00 0.69444 £ 41,667 Cost of Old Machine £ 25,000
2018 £ 60,000.00 0.57870 £ 34,722 less; cost of New Machine £ 60,000
2019 £ 50,000.00 0.48225 £ 24,113 less; depreciation £ 48,000
2020 £ 50,000.00 0.40188 £ 20,094 Incremental Initial Outlay £ 73,000
2021 £ 40,000.00 0.33490 £ 13,396
£ 183,991
NPV=net cash flow-Incremental outlay
NPV= (183,991 -73,000) = £110,991
Net present Value of the project of project B
Net profit P.V.I.F 20% 2 Incremental Initial
Outlay

2016 £ 20,000.00 0.83333 £ 16,667 Cost of new machine £ 125,000
2017 £ 30,000.00 0.69444 £ 20,833 less; depreciation £ 20,833
2018 £ 40,000.00 0.57870 £ 23,148 Incremental Initial
Outlay
£ 104,167
2019 £ 70,000.00 0.48225 £ 33,758
2020 £ 80,000.00 0.40188 £ 32,150
2021 £ 65,000.00 0.33490 £ 21,768
£ 148,324
NPV=net cash flow-Incremental outlay
NPV= (148324-104167) = £44,158
From the above net present value analysis, company should accept project with highest positive
NPV in which, the company should consider investing in project A since, the company will
realize a positive NPV of £110,991 which is very unlike investing in project B which generate a
positive NPV of £44,158
The limitations of using investment appraisal techniques to aid long term decision-making
The main limitation of using the NPV is the sensitivity to discounting rate. The working of NPV
is the sum of the multiple discounting rates both negative and positive and transform to present
value in terms of the similar point in time (Damodaran, 2010). In this regards, the discounting
rate employed in the denominator of every present value workings is important in establisbing
the NPV. A small change in discounting rate will depict substantial effect on the final output.

NPV also is a venture criterion that entirely excludes real options that may be available within
the venture. NPV does not take into consideration a wide overview of the gain or loss in
undertaking the project. To have wide overview of the gain relative it the venture for the project,
internal rate of returns, or marginal internal rate of return will be important.
NPV requires some guessing about the company cost of capital. Assuming that the cost of capital
is low, will lead to sub-optimal venture while too high cost of capital will lead to forgoing too
many bets venture. Furthermore, NPV is not important in making a contrast with two projects of
different sizes. Since the NPV method provide outcome in values, the size of the net present
value output is established manly by the size of the input (William Petty, 2015). The assumption
made concerning the dollar amount and timing of the future cash linked with the project is
another disadvantage. The business need approximates of its interest rates for the project
duration. Theses assumption might or might not be realized. Incorrect assumption will be a result
of misleading workings of the NPV. It is intricate in working for the NPV. The business requires
an approximates of every cash dealings that will exist with the project. The business employs the
numerical table the provide multipliers for many timeframes and interest rates. The business
should locate correct multipliers for every cash dealings and multiply the cash by the multipliers.
Once the business undertakes every workings, it sums up tit total to establish the NPV of the
project.

Bibliography
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