Capital Budgeting Techniques for Victoria Babies Ltd

This assignment analyzes a business case for Victoria Babies Ltd, a company considering expanding its operations in the UK. The objective is to evaluate two potential investment options (A and B) using various capital budgeting techniques, including Net Present Value (NPV) and Internal Rate of Return (IRR). The analysis aims to determine which project yields the most favorable financial returns and aligns with the company's strategic goals.

MFR

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Appraisal techniques..............................................................................................................1
Application.............................................................................................................................4
Findings..................................................................................................................................7
CONCLUSION................................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
Investment appraisal techniques are quite useful for assessing effectiveness and
attractiveness of new project of company in effectual way. The present report deals with Victoria
Babies Ltd which is planning for expansion. It has various investment options which is required
to be evaluated and best one is to be chosen. Four techniques are discussed such as payback
period, NPV, ARR, IRR listing out shortcomings and advantages of each of them. Moreover,
calculations of various appraisal techniques are also made to chose the best option among
various options available to company. The computations of all the appraisal techniques are made
and findings are imparted for selecting the best option to investment in by the company to yield
adequate returns.
Appraisal techniques
Investment appraisal techniques play vital role in the company to make better decisions
related to investment. Victoria Babies Ltd is planning for expansion in varied aspects. It is
essential for taking decision with the help of appraisal techniques. These include IRR (Internal
Rate of Return), NPV (Net Present Value), Payback period and ARR (Accounting Rate of
Return). These all techniques are discussed below-
Payback period
It shows recovery period of invested project. It is quite essential technique which
provides clarity about risk associated with project. This paves the way for company to opt in for
investment or not. Generally, shorter payback period is considered to be the best. This is because
investors get the returns within short span of time (Li and Trutnevyte, 2017).
Advantages
1. The main advantage of payback period is that it evaluates risk associated with the project.
2. Moreover, it provides clarity about when investment will yield desired returns.
3. Another advantage of this method is that it is simple to calculate and provide better results by
utilising time factor.
4. It is focused on risk factor of the project so that adequate returns can be generated with much
ease.
Disadvantages
1. There are shortcomings as well of this method.
1

2. It ignores cash flows which occurs after computation of payback period. Furthermore, another
drawback of such method is that it ignores time value of money.
3. This is required to assess project and generate good results. Moreover, it leads to poor
investment decisions. Another disadvantage is that it does not consider profitability of the project
which leads to wrong results.
4. It does not take into account subsequent investments which is considered the biggest limitation
of the method (Laird and Venables, 2017.).
NPV
NPV is useful as it evaluates project on the basis of profitability aspect. NPV help to
assess project on the basis of difference of present value of cash inflows and outflows of project.
Victoria Babies Ltd can easily assess profitability of project whether to opt for expansion in
abroad or any other options. There are positive as well as negative cash flows. It is recommended
by market analysts that Higher the NPV, better for the company to invest in the project.
Advantages
1. The advantage of NPV is that it takes into account time value of money.
2. It aids in making effective decision as it rejects project having less NPV.
3. NPV aids in maximising organisation's value as higher NPV of project maximises
organisation's worth.
4. It takes into account all the cash flows over a life of the project.
Disadvantages
1. It is not suitable for the company as it is purely based on discounting rate.
2. This inculcates complexity which is the biggest limitation of using NPV.
3. NPV is merely based on forecasting and this leads to incomplete information and as such,
wrong decisions are made.
4. Another disadvantage of this method is that relying on discounting rate may result into forego
of better investment projects.
ARR
ARR is a capital investment technique which provides clarity about return on investment
made by the company (Mayer, Breun and Schultmann, 2017). It highlights effectiveness of
project on the basis of profitability. Basic evaluation can be made with reference to profitability
of the project. Moreover, it is useful for extracting results in the best possible way.
2

Advantages
1. It is simple to calculate and interpret outcome drawn while assessing project.
2. Project's viability can be easily attained in quick manner and with less time.
3. It provides clarity about effectiveness of project in less time which saves valuable time for
management.
4. Accounting profit is taken with reference to IRR.
5. This eases evaluating profitability aspect of new project and aids in making viable decisions.
6. It is useful for investing in short-term projects which lapses within short time frame
(Pivorienė, 2017).
Disadvantages
1. Major drawback of this method is that it does not consider time value of money which is
required while determining usefulness of project.
2. Cash flows from investment is required to evaluate properly effectiveness of project but is
ignored in this method.
3. It is not suitable to implement ARR method as it does not consider terminal value while
investing in the project.
4. It is not useful method for long-term projects and as such, viable decision cannot be made in
this aspect.
IRR
IRR is another effective method which provides rate of return on project over its useful
life. It is termed as discounting rate which assumes that present value of cash inflows will be
equal to cash outflows. In simple words, net present value of investment will become zero for the
project. Management can set minimum required investment rate by which project can be easily
assessed. If rate is more than minimum one, investment is accepted else rejected (Internal Rate
of Return (IRR), 2018).
Advantages
1. The main essence of this method is that it consider time value of money while assessing
project and as such, correct interpretation can be made.
2. It is easier to compute and derive outcome in effective manner.
3. Hurdle rate is ignored while calculating IRR of the project and as such, wrong determination
of investment decision is not possible.
3

4. It does not take cost of capital in account and as such, it provides better results.
5. This method gives priority to increase or maximising in shareholder's wealth.
6. IRR is used for ranking project options as it provides rate of return on various projects.
Disadvantages
1. Reinvestment rate is estimated for life of project which leads to inaccurate results regarding
profitability of new project.
2. Another disadvantage of IRR method is that computation is not easy and incorporates complex
calculations difficult for assessing usefulness of project (Ababneh, Shrafat and Zeglat, 2017).
3. IRR gives due importance only to profitability aspect but ignores recovery of investment in
near future.
4. IRR is not helpful for when there are two mutually projects and as such, interpretation cannot
be done.
5. It is unsuitable when size and term of two projects differ from each other which is the biggest
drawback of this method.
Application
Investment Option A
Calculation of NPV
Formula- Total cash flows / Initial investment
Year
Net cash
inflow
PV factor @
10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 100000 0.909 90909.09 100000
2 100000 0.826 82644.63 200000
3 100000 0.751 75131.48 300000
4 100000 0.683 68301.35 400000
5 100000 0.621 62092.13 500000
379078.68
4

Initial
investment 500000
NPV -120921.32
Calculation of Payback period
Formula- Initial Investment / Average Payback
= 5 years
Calculation of ARR
Formula – Average Profit / Average Investment
Average Investment is taken as initial investment
= 70000 / 500000
= 14 %
Calculation of IRR
Formula- PV (Present Value) of cash flows – Initial Investment
= 0 %
Investment Option B
Calculation of NPV
Year
Net cash
inflow
PV factor @
10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 220000 0.909 200000 220000
2 240000 0.826 198347.11 460000
3 50000 0.751 37565.74 510000
4 70000 0.683 47810.94 580000
5 50000 0.621 31046.07 630000
514769.86
5

Initial
investment 500000
NPV 14769.86
Calculation of Payback period
= 2 + (40000 / 50000)
= 2 + 0.8
= 2.8 years
Calculation of ARR
= 50000 / 500000
= 10 %
Calculation of IRR
= 11.58 %
Investment Option C
Year
Net cash
inflow
PV factor @
10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 150000 0.909 136363.64 150000
2 130000 0.826 107438.02 280000
3 100000 0.751 75131.48 380000
4 150000 0.683 102452.02 530000
5 130000 0.621 80719.77 660000
502104.92
Initial
investment 500000
6

NPV 2104.92
Calculation of Payback period
= 3 + 120000 / 150000
= 3 + 0.8
= 3.8 years
Calculation of ARR
= 25000 / 500000
= 5 %
Calculation of IRR
= 10.17 %
Findings
The investment appraisal techniques are calculated which shows various options to be
selected by Victoria Babies Ltd so that it may expand its operations. There are three options
which are available to company to choose the best among them. Starting from option A which is
expanding existing plant with implementing bigger machines. It can be found out that this option
is not good one to chose as it has lower NPV which is considered for evaluating effective
outcome of the project. It can be interpreted that NPV is -120921 which implies that there is
negative aspect in case of this technique (Kolawale and Grace, 2017). It is not suitable for
company as NPV should in be positive value. On the other hand, payback period is 5 years
which means that company cannot recover initial investment amount before 5 years. This is not
recommended as shorter payback period is suggested for the betterment of the organisation.
Apart from this, IRR is 0 % which implies that there will be no adequate rate of return that will
be yield by investing in this project of implementing bigger machines. However, ARR is 14 %
which is good. But it is recommended that investment should not be done in this project by the
company as desired results will not be accomplished.
Investment option B is related to building new production plant in UK itself. By
analysing investment appraisal techniques, it can be said that company should invest in the same
as good profitability will be generated by it. This is evident from calculation of NPV which is
14729.86 and it implies that NPV is positive and will provide good profits to Victoria Babies
7

Ltd. It has more NPV and it should be adopted as per this method. On the other hand, payback
period is 2.8 years which is less than compared to other options. It implies that initial investment
amount will be yield in shorter period which is better for investors to get results within short time
span. Apart from this, IRR is 11.58 % which is higher. This means that company should opt for
this investment option as better results are provided in it. Next comes ARR which is 10 %
implies that accounting profit will be generated in effective manner by investing in this project.
Investment option C is related to international expansion to existing plant in China. It can
be interpreted that investment in the project should not be made (Atari and Prause, 2017). This is
because NPV is less in this project which is just 2104.92. It implies that NPV is less than
compared to other options. It is recommended that Higher NPV should be selected and in this
aspect, option B is suitable. Besides this, payback period is 3.8 years which means that it will
take longer time to yield adequate results. While, IRR ARR are 10.17 % and 5 % which is low
than other options. Thus, it can found out that Victoria Babies Ltd should invest in the
investment option B which is related to expansion of plant in UK as all the investment appraisal
techniques are in favour of the same. It will be beneficial for the firm to achieve goals.
CONCLUSION
Hereby it can be concluded that capital budgeting techniques plays important role in the
company while selecting and evaluating good project out of available projects. Victoria Babies
Ltd should select investment option B which yields adequate results to it in the best possible
way. It will garner good quantum of profits in the long run with much ease.
8

REFERENCES
Books and Journals
Ababneh, H., Shrafat, F. and Zeglat, D., 2017. Approaching information system evaluation
methodology and techniques: a comprehensive review. International Journal of
Business Information Systems. 24(1). pp.1-30.
Atari, S. and Prause, G., 2017, October. Risk assessment of emission abatement technologies for
clean shipping. InInternational Conference on Reliability and Statistics in
Transportation and Communication (pp. 93-101). Springer, Cham.
9