Investment appraisal helps in figuring out the opportunities that can be derived from a certain investment. The main step of investment appraisal is a determination of possible outcomes that can derive from the investment by the company. A careful appraisal of investment helps in figuring out the rewards and risks that are available in the investments of the company. In this report, investment feasibility of the investment done by the company Stevenage Technologies limited is shown with the detailed findings. Further, the report focuses on the sources of income that can be opted by the company for proposing bank loan.
In the report, mainly the investment appraisal methods like net present value method, accounting return method, payback method, profitability index method are to be used for analysing the methods of investment appraisal. Recommendation based on the suitability of the investment methods are provided in this report.
Investment methods that are used for measuring the feasibility of the investment are divided into following categories:
Net present value:
In this method of investment appraisal, the difference between the present values of cash inflows over the present value of cash outflows is termed as the net present value related to investment. According to Vernimmen et al. (2018, p. 267), higher the net present value more feasible is the investment for the company. The investment with higher NPV is profitable for the company. In the report, the cost of capital is taken to be 12%. Therefore, a discount factor of 12% is to be taken for the analysis of the proposed investment. NPV investment methods take into consideration cost of capital and other risk inherent factors that help in making proper projections of the future. Net present value is to be calculated for 6 years with discounting factor of 12%. Total cash inflow for the project is £ 798190. The investment for the asset replacement requires an investment of £ 780000. The cost of asset replacement is assumed to be of £ 780000. The net present value of the asset replacement project is £ 18190. Net present value has generated the positive value of £ 18190. As positive value is generated from the project, therefore, the project can be accepted easily.
Cash out a flow of the project needs to be calculated after adjusting the initial investment with the increasing working capital of £ 200000. Total initial investment is taken to be £ 580000 and further add to the increased working capital of £ 200000 net outflow of the project is estimated to be of £ 780000.
The acceptance and rejection of the project depend on the Net present value generated from the project. The condition for selection of the project by the help of NPV depends on the three conditions.
Stevenage Techno Ltd is opting for replacement for expanding production. The cash inflow results have reported total cash inflow of £ 798190. Therefore, in order to opt for replacement option positive NPV generation is essential. Moreover, while calculating Payback period total cumulative cash flows of the business is matched with total cash inflows, which shows that within the range of £ 730000 to £ 975000 the cash outflow is to be calculated. Therefore, for matching with the total cash inflow it is assumed that the help of financing 4-year bank loan at 11.5% interest does initial investment of £ 580000. Initial investment is done for £ 580000, as total cost of machine is £ 1.8 million, which is not the immediate cost. Therefore, assumption of cost for initial investment is taken as £ 580000. For generating positive NPV initial investment is taken at £ 580000.
Therefore, based on the analysis of the project, as a net present value of the asset replacement is positive, therefore, the project of asset replacement is profitable for Stevenage Techno Ltd.
Accounting return method
According to Arrow and Kruz (2013, p. 24), in accounting rate of return method, the average accounting profit is divided by the average investment to estimate the return that could be generated from the investment. In the average accounting return method, then the project is mainly accepted when the ARR is greater than or equal to accounting rate of return. Accounting rate of return targeted by the directors as 14%.The calculation based on the average accounting return shows that on adding the cash flows of the organisation and divided by 6 years has generated an annual profit of £ 205000. The average investment for the project is (780000/2) = £ 390000. The ARR of the project is 52.5641. Decision criteria of the project acceptance depend on the rate of ARR generated by the company. As the ARR of the project that is calculated actually is more than the minimum targeted return (14%) therefore, the project of asset replacement is highly profitable for the company.
Cash inflow of the project is taken as the annual profit that is presented in the case study. In the last year (6th) year the value of scrap value of £150000 is added to the annual profit as a sale of the old asset is added to the last year's annual profit.
In cash outflow, calculation includes only cost of new assets, which is added with the net proceeds from sale of scrap, working capital requirements and tax shield. Therefore, interest rate of 11.5% is not considered, as this is not included in the estimation of cash outflow.
In this method of investment appraisal, the payback period is calculated by dividing investment required by the net cash inflow from the project. The rejection or the acceptance of the project depends on the payback period. Higher the payback period more acceptable is the project (Abor, 2017, p. 293). Payback method is easy to calculate and shorter payback helps in improving the liquidity position of the company. Payback method of investment appraisal is used for understanding the years needed for generating profit from asset replacement. As per the analysis report, it can be seen that payback of 4.26 years is being generated from the project. Decision criteria based on the profitability shows that as payback period (4.26) is less than the minimum-targeted payback (5 years) therefore, a project could be accepted easily. CIAT refers to cumulative cash flow of business. As taxation is ignored therefore, CIAT here refers to as the cumulative cash flows for the business.
Calculation of payback period
PB- 4/ 5-4 = (780000-730000)/ (975000-780000)
PB -4/1 = (50000 /195000)
PB -4 = 0.2564
PB= 4+0.2564 = 4.2564 or 4.26 years.
In this investment appraisal method present value of future cash flow derived from the project are divided with the initial investment required for the project. It is mainly the modified form of net present value method of investment appraisal. Present value is generally the absolute measure of investment whereas profitability index is mainly the relative measure of investment appraisal (Zhang et al. 2015, p. 761). As per the rule of acceptance the project with profitability index more than 1 is accepted as the feasible project for the company. The index below one is generally rejected. Profitability index sometimes refers to as the benefit-cost ratio used for capital rationing. Analysis of profitability index shows that PV of cash flow from the project is £ 798190 and a present value of cash outflow is £ 780000. On the calculation of profitability index, the value of the project is 1.02. Therefore, as the profitability index is 1.02 project remains indifferent and acceptance depends on the trends of acceptance seen in other investment techniques. Therefore, based on the other methods of investment appraisal techniques project acceptance can be done. Moreover, as the value is not less than 1 then project of asset replacement is profitable.
(Refer to appendix 1)
In the theory of investment appraisal, mainly the time value of money is taken into consideration for understanding the feasibility of the investment. Mainly, the investment project is compared with return rate over the minimum return reported by the organisation. Based on the analysis, when the return is higher than the minimum rate of return then project is acceptable otherwise, the project is rejected. Therefore, the company accepts mainly the higher return generating investment. Approximate rate of return is calculated so that based on the accepted return the project feasibility could be determined easily. The practice and theory-based investment appraisal state that the objective of the financial manager is maximisation of wealth. Evaluation of opportunities based on the various investment appraisal techniques helps in understanding the best investment plan. The theory of investment plan further helps to add value to Stevenage Techno Ltd. The theory further focuses on the costs and benefits that are associated with the financing decisions (Baum and Crosby, 2014, p. 22). The future cash flows that are calculated from the project further help in understanding the risk factors that are seen in the project. Cash flow evaluation and different techniques of investment appraisal helps in reflecting the risk-adjusted rate of discount, which, helps in understanding project feasibility more easily.
Evaluation of the asset replacement is profitable for the company because as per the decision criteria the project can generate more profitability and efficiency.
Based on the analysis of the above method the feasibility of the project is determined.
The sources of finance are classified into different subdivisions:
The main sources of finance are based on equity capital sources and debt sources.
Based on the suitability of the financial sources venture funding, equity financing, debentures and preference share capital can be used for raising the finance for purchasing the asset. It can be assumed that the new asset to be purchased by the company can be used for more than 5 years. Therefore, the asset can be financed by raising loans with the help of equity share capital. According to Robb and Robinson (2014, p.153), equity capital helps in increasing the creditworthiness of the organisation. Moreover, equity capital is permanent and used for financing long-term projects.
Venture funding refers to as the form of private equity capital where funds deemed for higher growth potential uses this type of financial sources (Hsu et al. 2014, p.2). For long-term durable projects and for risky projects this type of capital is used. This type of financing sources is used for financing risky projects and in this case, as the new project of asset replacement is a part of risk so the venture capital can be used as the suitable alternative source of financing other than the bank loan financing.
Debenture capital financing can be used as the source of finance alternative other than the bank loan. In this case, of financing decision making power is not vested on the financer, therefore, decision making regarding the profitability and efficiency due to asset replacement can be taken by the company itself. Moreover, the amount that is to be paid in the form of interest can be claimed for a tax deduction. An advantage that the company can get further ensures the effectiveness of the financing source.
Preference share capital can also be used as the alternative source of finance for the project. This type of capital is used for raising finance for long-term projects. The benefits of special rights that are provided to the financer help in appealing the finance to the cautious investors (Burchardt et al. 2016, p. 25).The safety of the capital and the fixed return that can be generated ensures the affectability of the source of finance. The most important benefit of this source of finance is that there is no obligation for the payment of a dividend from the project.
Therefore, all the four resources that are discussed in the above part can be taken as the alternative for the bank loan source of financing. Equity capital, venture capital, preference capital and debentures can be used as the appropriate source of capital that can be used for financing the asset replacement project.
The main aim of the finance department who are focusing on the project feasibility is wealth maximisation. The project of asset replacement helps in determining the suitability of the asset replacement for the betterment of the project. The NPV that is generated from the project is positive, therefore, positive NPV generating project can be accepted easily. The investment appraisal techniques that are used for the appraisal techniques show the positivity of project acceptance. Further, the alternative sources that are used for the project financing ensure the effectiveness of the project. The new asset that can be used for replacement at the end of a 6th year can be done with the help of other sources. Positive NPV and the achievement of tax advantage benefit from the project can be used for selecting the suitable source of finance. Therefore, debentures and equity financing can be selected as the source of finance as this type of source reduces the burden of risk from the company.
The report is based on the robust analysis of certain project appraisal techniques that are used for understanding the feasibility of the asset replacement project. The report focuses on the future cash flow and the discounting factor that is used for understanding the risk of the project. Sources of finance that are used as the alternative of bank loan are being provided in the report. The report clearly analysis the target set by the directors and based on the target set project acceptance is analysed. Overall analysis of the alternative sources of financing done by Stevenage Techno Ltd is shown by detailing their efficiency as an alternative source.
Arrow, K.J. and Kruz, M., (2013). Public investment, the rate of return, and optimal fiscal policy (Vol. 1). Routledge: Abingdon
Baum, A.E. and Crosby, N., (2014). Property investment appraisal. John Wiley & Sons: UK
Burchardt, J., Hommel, U., Kamuriwo, D.S. and Billitteri, C., (2016). Venture capital contracting in theory and practice: implications for entrepreneurship research. Entrepreneurship Theory and Practice, 40(1), pp.25-48.
Hsu, D.K., Haynie, J.M., Simmons, S.A. and McKelvie, A., (2014). What matters, matters differently: a conjoint analysis of the decision policies of angel and venture capital investors. Venture Capital, 16(1), pp.1-25.
Robb, A.M. and Robinson, D.T., (2014). The capital structure decisions of new firms. The Review of Financial Studies, 27(1), pp.153-179.
Vernimmen, P., Le Fur, Y., Dallochio, M., Salvi, A. and Quiry, P., (2018). The Time Value of Money and Net Present Value. Corporate Finance: Theory and Practice, Fifth Edition, Fifth Edition, pp.267-283.
Zhang, Q., Huang, X. and Zhang, C.,( 2015). A mean-risk index model for uncertain capital budgeting. Journal of the Operational Research Society, 66(5), pp.761-770.
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