Financial Management: Investment Appraisal Techniques and KADLex PLC

This report provides a detailed analysis of investment appraisal techniques, including the payback period, accounting rate of return, net present value, and internal rate of return, to evaluate the economic feasibility of acquiring a machine. It also explores valuation methods such as the price/earnings ratio, discounted cash flow method, and dividend valuation method, recommending their use for KADLex PLC's acquisition. The report discusses the benefits and limitations of each technique, offering a comprehensive overview of financial management principles and their application in investment decisions and mergers. Desklib provides students access to a wealth of solved assignments and past papers for further study.

Financial
Management

Table of Contents
INTRODUCTION ..........................................................................................................................3
TASK 1............................................................................................................................................3
a) Calculate using the following investment appraisal techniques, and provide brief
recommendations as to the economic feasibility of acquiring the machine................................3
b) Evaluate the benefits and limitations of each of the differing investment appraisal
techniques....................................................................................................................................6
Task 2...............................................................................................................................................8
a) Price/ earnings ratio................................................................................................................8
b) Discounted cash flow method.................................................................................................8
c) Dividend Valuation Method....................................................................................................9
d) Discuss the problems associated with using the above valuation techniques and recommend
with economic justifications to the board of KADLex PLC to use in this acquisition.............10
CONCLUSION .............................................................................................................................11
REFERENCES..............................................................................................................................12

INTRODUCTION
Financial management is an essential aspect for the organisation that facilitates planning,
controlling, organising, evaluating and managing its financial resources. These are the activities
performed by the financial manager for achieving the goals and objectives of the firm. It helps in
making financial decisions and managing the scares financial resources of the firm and their
optimum utilisation. The main objective of financial management is to maximise organisation's
value. The three major decision making involved in are the investment decision, financing
decision and dividend decision. This report includes Investment Appraisal techniques which
aims in evaluating the economic feasibility of an investment plan. Investment Appraisal is an
investigation and examination done by the company for assessing the profitability of an
investment plan across the useful life of the asset in consideration with its affordability and
strategic fit (Bleoca, 2016). It helps the businesses in estimating the attractiveness of the
investments or the projects based on the results of various techniques of capital budgeting and
financing. It also includes different valuation methods which are used by the firms in case of
mergers and takeovers. These valuation techniques are used for valuing the organisation's net
worth at the time of mergers and acquisition.
TASK 1
a) Calculate using the following investment appraisal techniques, and provide brief
recommendations as to the economic feasibility of acquiring the machine.
i. The Payback Period
Payback period refers to the amount of time which is expected to recover the cost of
investment. It is like a break even point of investment (Buckle and Thompson, 2020). Therefore,
shorter the payback period is, better it is considered and the investment with shorter payback
would be more attractive and considered better in economic feasibility.
Payback Period Method
Cash outflow for the value of the machine = 2,75,000 320000
Year Cash Inflow Net Cash Flow

1 10500 - 15500 89500
2 10500 - 15500 89500
3 10500 - 15500 89500
4 10500 - 15500 89500
5 10500 - 15500 89500
6 10500 - 15500 89500
Total 537000
Pay Back Period = Original Investment / Cash Inflows
= 320000 / 89500 = 3.58
NOTE: Hence, the organisation will cover the cost of machinery in nearly 3.58 Years.
ii. The Accounting Rate of Return.
It is that rate which reflects the expected percentage of return on investment or project
which is being considered. It considers profitability of a project and mostly businesses uses it to
compare multiple projects or compare returns expected on different rate of accounting rate of
returns (Clark, 2018). However, since it ignores time value of money, it is not considered best
approach to decide on the feasibility of a project.
Average Rate of Return
Year Cash Inflow Depreciation @ 15% Net Cash Inflow
1 89500 48000 41500
2 89500 48000 41500
3 89500 48000 41500
4 89500 48000 41500
5 89500 48000 41500
6 89500 48000 41500
Total Returns 249000
Average Returns 41500
ARR = Average Annual Profit / Initial Investment

= 41500 / 320000 = 12.96 %
Note: Therefore, The average rate of return earned on investing in the machine is 12.96 %
iii. The Net Present Value
It is another investment appraisal technique which analyse the profitability of a project. It
is considered favoured approach for assessing feasibility of the projects as it considers time value
of money as well (Fedoryshyna and Todosiychuk, 2019). It includes determining difference
between present value of cash inflows and outflows over the estimated project time.
Net Present Value
Year Cash Inflow Discounting Factor @ 12% Net Cash Inflow
1 89500 0.892 79910.71
2 89500 0.797 71348.85
3 89500 0.711 63704.33
4 89500 0.635 56878.86
5 89500 0.567 50784.70
6 89500 0.506 45343.48
Total 367970.95
Net Present Value = Net Cash Inflow – Net Cash Outflow
= 367970.95 - 320000 47970.95
Note: Hence, the net present value is positive with the amount of 47970.95, so it is
suggested that the proposal should be accepted.
iv. The Internal Rate of Return.
It is that financial metric or rate at which net present value is expected to be equal to zero.
It is also set up in discounted cash flow analysis and estimates the profitability of the potential
investment (García and García, 2017). Higher IRR is preferred when comparing projects as it
makes project more feasible and desirable.
Internal Rate of Return

Cash outflow for the value of the machine purchased is 320000
Lets assume, Lower Discount Rate 10 %
Higher Discount Rate 15 %
NPV FOR 10 %
Year Cash Inflow Discounting Factor NPV
1 89500 0.909 81363.64
2 89500 0.826 73966.94
3 89500 0.751 67242.67
4 89500 0.683 61129.70
5 89500 0.621 55572.46
6 89500 0.564 50520.42
Total 389795.83
NPV FOR 15 %
year Cash Inflow Discounting Factor NPV
1 89500 0.869 77826.09
2 89500 0.756 67674.86
3 89500 0.658 58847.70
4 89500 0.572 51171.92
5 89500 0.497 44497.32
6 89500 0.432 38693.32
Total 338711.20
IRR= Lower Rate + NPV at Lower Rate * (Higher Rate - Lower Rate) / NPV at Lower
Rate -NPV at Higher Rate
= 10+(389796 * (15 - 10)) / (389796 - 338711) = 48.15
IRR 48.15 %
Note: Thus, the IRR computed in the given case is 48.15 %

b) Evaluate the benefits and limitations of each of the differing investment appraisal techniques.
Payback Period
 Payback period is relatively easier to understand and calculate as compared to the other
investment appraisal techniques. It requires very less inputs for calculation and requires
less assumptions to be made. It helps the organisation for making quick decisions for
utilisation of its limited resources (Lucas and Noordewier, 2016). It prefers for the
liquidity, as for small businesses it is important to quickly realise the cost of investment
for reinvesting it in other opportunities. It is beneficial for the industries having uncertain
and rapid technological changes as it reduces the chance of losses due to obsolescence.
 The major disadvantage of it is that it does not consider the time value of money factor
which have a crucial importance in business concepts. It sometimes give unrealistic
results, as it does not consider normal business scenarios. Short term projects doesn't
guarantee profitability and ignores the rate of return earned on the project as it is suitable
only for the small businesses and does not provides a complete analysis in terms of
project attractiveness. In some cases cash flows are earned even after the completion of
payback period but this tool forsakes such cash flows.
Average Rate of Return
 It is a simple and widely used tool of investment appraisal techniques that can be easily
understood by everyone. It facilitates in true evaluation of the profitability for the
investment as it considers all costs and revenues associated with the investment. It is
based on the accounting information, therefore no other reports are required for its
computation (Madura, 2020). It is based on the accounting profits thus measures
profitability of the investment. It helps in quick decision making as the project with
higher ARR is selected over the project with lower ARR.
 It ignores the cash flows of the project, which are most important factor for a business
organisation. Also it does not take into account the terminal of the projects. It considers
all the costs and revenues associated with the investment over a period of time as the
equal value but ignores the reduction in the value of such cash flows. This technique does
not consider the impact of time value of money. This concept tells the worth of money
today, but is uncertain with the same amount of money that it would worth in future.
Net Present Value

 The primary benefit of NPV is that it considers the impact of time value of money. The
computation of NPV by taking into consideration the discounted cash flows earned on an
investment for determining its viability (Mahpour and Mortaheb, 2018). It also helps the
management of the organisation in taking better decisions because it not only facilitates
evaluation of the size of the project but also helps in analysing the profit or loss making
capability of the project. Another major benefit of NPV is that it maximises the
organisation's earnings by investing in the ventures that ensures maximum returns.
 The disadvantage of using NPV is that it is challenging for identifying the accurate
discount rate for representing the true risk premium of the investment. Another
disadvantage is that company may select the cost as per its convenience either too high or
too low, which results in misleading information that increases chances of loosing a
profitable opportunity or invest in the venture which is not worthwhile. The NPV
calculation is done on the basis of the discounting factor but there is no sat criteria for
calculating this rate. Also the NPV can only be used for the comparison of similar sized
projects, it can not be used of comparing projects of different sizes.
Internal Rate of Return
 The most important benefit of IRR is that it considers the impact of time value of money
while evaluation of a project or investment. It is very simple to understand, compute and
interpret. There is no requirement of hurdle rate/ required rate for calculating IRR so the
risk of wrong and misleading results are minimised (Melnychenko, 2020). There is no
base or criteria for selection of any particular rate for IRR so there is a uniform ranking
system. Also in this method all the cash flows are given equal importance whether they
are earned earlier or later.
 In this method economies of scale are being ignored as it does not consider the money
value of the benefits. There is no comparison as to which project is more worth. There are
unrealistic assumptions made like reinvestment of the profits earned on the investments at
the similar internal rate of return. It is not a better tool for comparing two or more
projects (Morris and Daley, 2017). Also it does not consider the size of the project, and
simply compares the amount of cash generated. In addition to this, it is only concerned
with projected cash flows and totally ignores the potential cost which can impact the
organisation's profitability.

Task 2
a) Price/ earnings ratio
Price earning ratio is the tool used for valuation of the current market price of the
company's shares in relation to the earning per share. Sometimes it is also known as price
multiple or earning multiple ratio. It is used by investors and analysts for evaluating the shares as
they are overvalued or undervalued. It is the mostly used tool for determination of the firms
value and revels how the stocks are valued in comparison with that of the industry trends
(Prentice, 2016). Higher P/E means stocks are overvalued in comparison to the earnings and in
vice versa case the stocks are valued relatively low with respect to its earnings.
Valuation of company using price/ earning ratio
P/E ratio = MPS/ EPS
Market Price per Share 2.05
Distributable earnings 40.4
Outstanding shares 147
Earning Per Share 0.275
P/E Ratio 7.459
Company's Valuation 301.35 Millions
b) Discounted cash flow method
Discounted Cash flow method is designed for establishing the present value of number of
future cash flows. Present value helps the investors for evaluation of asset worth at the present
and a later date and facilitates in decision making for investing in the particular asset or not. It is
a form of Intrinsic Valuation and is a detailed and in-depth approach used in investment
valuation. The present value of a projected future cash flow is computed using a discount rate for
finding discounted cash flows (Sweeting, 2017). If the discounted cash flows are above the cost

made on investment then it is suggested to take up the project as the opportunity may results in
positive returns. And vice versa in case of discounted factors being low.
Discounted cash flow method
Distributable earnings 4.35
Distributable earnings growth rate 2.50 %
Corporate tax rate 20.00 %
WACC 10.14 %
Year Cash flow Discounting factor @ 10.14% Discounted cash flow
1 4.35 0.908 3.950
2 4.45 0.824 3.676
3 4.57 0.748 3.421
4 4.68 0.680 3.183
5 4.80 0.617 2.963
17.191
Working Notes
1) Calculation of cost of capital
Ke = Rf + B (Rm - Rf)
Ke 11.6
Kd = (interest* (1 - T )) 4.032
Interest 5.04
2) Calculation of Weighted Average Cost of Capital
WACC = (E / V * Re)+((D / V * Rd) * (1- T))
E = Market value = MPS* Outstanding shares 301.35
D = Market value of firm's debt 72
V = Value of firm = E + D 373.35
Cost of Equity (Ke) 11.60 %
Cost of Debt (Kd) 4.03 %

Tax Rate (T) 20.00 %
Weighted Average Cost of Capital (WACC) 10.14 %
c) Dividend Valuation Method
Dividend discount method is used for ascertaining the value of the company's stock. It is
a Quantitative valuation tool for valuing company's worth. It works on the assumption that
current fair price of equity is equal to the sum of all future dividends discounted at their present
value of the company. It attempts at fair valuation of stock disregarding of the existing market
conditions and considers the dividend payout factors and expected rates of market (Van Raaij,
2016). It the value of dividend discounted method is more then the current trading price of the
stock, that means the shares are undervalued and qualifies to buy the shares and Vice verse in
another case.
Dividend Valuation Method
P0 = D1 / (Re – g)
Growth Rate (g) 6.80% 6.8
Previous Year Dividend (D0) 13p
Current Year Dividend = D1 = (D0 + g) 13.884
Market premium (Rm) 11.00%
Risk free rate of return (Rf) 5.00%
Beta 1.10%
Re = Rf + (Rm- Rf) * Beta 11.6 11.60%
P0 = Base Price = D1/ (Re – g) 2.8925 2.89%
Outstanding shares 147
Company Valuation 4.251975 millions
Working Note
G= Dx/ (Dx -1) - 1
d 10, 10.5, 11, 12, 1
Year 1 NA

Year 2 5
Year 3 4.762
Year 4 9.091
Year 5 8.333
g 6.796
d) Discuss the problems associated with using the above valuation techniques and recommend
with economic justifications to the board of KADLex PLC to use in this acquisition.
Limitations of valuation methods:
Price / earnings method – This model uses price-earnings ratio of the company which is based
on current market price and earnings relevant to it. One of the major issues is that it is based
on market price which is subject to fluctuations on daily basis and to zero in the date of
which price shall be taken so that valuation of the company in the face of mergers and
takeover is not incorrect and shareholders of neither party to merger suffers. P/E Ratio is a
lagging matrix and sometimes misleading as the data used for computation are past/
historical, so it is important to pay attention while using this matrix (Weetman, 2018). Many
of the assumptions are made in this method like growth rate, required rate of return and tax
rate. It ignores the impact of buyback of stock that makes a vast difference in estimation of
the values of the stock.
Discounted cash flow method – This model is based on discounting future expected cash flows
and the biggest issue of this stems out from this fact only. To apply this model while merger
and takeover, company need to forecast future cash flows, certainty of which and its growth
rate cannot be ensured. Also, it uses weighted cost of capital at present which is based on
few factors which are market oriented and can change during the process of merger. (Ross,
2016). In that case, cost of capital arrived will not show correct rate with which future cash
flows should be discounted, resulting in incorrect valuation of the company. This method is
extremely sensitive in context with the assumptions made and uncertain with the
calculations of terminal value of the firm.

Dividend Discount valuation model – This model is based on the dividends announced by the
company and its growth rate. Biggest issue that arises while using this model for calculating
valuation of the company for mergers and takeover is that many a times companies do not
announce dividend in a year for any reason. In that case, this model cannot be applied at all
regardless of the profitability and efficiency of cash flows of the company. The key
limitation of the method is that down sides it is that it lack accuracy and can only be used for
the organisations paying dividends at a higher rate. It also considers too conservative for not
taking in account the stock buyback.
CONCLUSION
From the above report it can be concluded that every investment appraisal technique has
its own prows and corns and the organisation is suggested to adopt the technique which best suits
its project on the basis of nature of project, amount to be invested, and the returns the company
expect from the investment plan. Also the valuation methods plays an important role in valuing
the stock of the organisation and helps company identifying whether their stocks are over valued
or under valued and take corrective measures for overcoming such issues.

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