Investment Appraisal for BL

Introduction and Case Background

BL is planning to undertake a project that will replace the existing cranes or repair the existing ones. After analyzing the two options the company should decide on the decision to make that is either maintain or repair the existing cranes or replace them.

Capital Expenditure Manual

New crane

The initial cost of the new crane = 345,000, Annual running cost 60,000, Scrap value = 30,000, Cost of capital 26% and required payback period 5 years

60% probability of two new contracts of 40,000 annually and 20% chance of doubling the jobs

Sell off old crane = 20000

Old crane

Cost of bringing it to standard = 40,000, Annual cost 40,000, 50% probability of breaking down and 50% breaking down twice and Cost of fixing and job loses 25,000

Table 1. DEPRECIATION TAX SHIELD CALCULATION

Table 2. Cash flows of replacing the old machine for the new machine

The present value of cash flows is £ -117,603

The payback period will be = 5 + 18405 = 5.36 years

51362

Expected value of getting first two contracts

Doubling

0.2x 0.6×80,000) + 0.8×0.4×40, 000= 22400

0.8x 0.6×80, 000) + 0.2×0.4×40, 000= 41600

64000

0.6×80,000) + 0.4×40, 000= 64000

128000

Table 3. The old machine cash flows

The present value of cash flows is – 115919

Expected extra cost

(0.5 x65000)+0.5 x40, 000x 0.5= 52500

0.25×40000

From the working above it should be undertaken because it gives a higher present value of cash outflows as compared to maintaining the old machine. The machine should be purchased.

Nominal Vs Real Rates of Return

The effects of inflation on investment appraisal are usually reflected by considering the purchasing power of money today as compared to money tomorrow. Inflation affects the rate of returns that is used in calculating the present value of money. This is because it affects the cost of the loan that Is taken in financing the project. If one has 10 dollars today and decides to spend it one year from now, the purchasing power of the 10 dollars because the price of the product could have changed. This means the real costs of capital are subsidiary less than the cost of money. The nominal rate is the rate which is inclusive of the inflation rate and has not been adjusted for inflation. The real cost of capital is the adjusted cost for inflation. (Pandey I M., 2008).

In analyzing the project one must change the rate used to be consistent. If cash flows are used at nominal values then the nominal rate of return should be used. However, investment consultants should consider inflation because without inflation the project may look profitable while It is not profitable. In the case at hand 26% is the nominal rate of return while 21% is considered to be the real rate of return. In calculating the net present value of the project the nominal cash flow will be subjected to the nominal rate of return. It is normally calculated as follows (Pandey I. M., 2008):

Nominal discount rate = (1 + Real discount rate) x (1 1+ inflation rate) – 1

K = (1 + k) (1 + r) – 1

K = (1+ 0.21) (1+4) – 1

= 26%.

The re-calculated net present value for the project indicates that the machine should be purchased because it is a positive net present value. According to the net present value decision criteria, a positive net present value means the project is viable and should be undertaken (Pandey I M.,2008). This is a similar incidence in this case.

Table 4.Cash flows of replacing the old machine for the new machine

The present value of cash flows is £ -84,494

The payback period will be = 5 + 18405 = 5.36 years

51362

Expected value of getting first two contracts

Table 5. The old machine cash flows

The present value of cash flows is – 125,850

Using a discount rate of 21%, the first decision should be maintained.

The calculation of the internal rate of return for a project depends on the management and the type of project to be undertaken. The net present value is considered by many as a solution to many investment decisions however others use internal rate of return in assessing the viability of the projects. Both the net present value and internal rate of return consider the time rate of money.

Net present value

This method considers time value for money. It is calculated as shown below.

Net present value = present value of cash inflows – net investments

The criteria for accepting rejecting the project are if NPV ≥ 0 accept the project otherwise rejecting the project. The project is accepted when the NPV ≥ 0 because it will increase the shareholders’ wealth.

Internal Rate of Return (IRR)

This method also relies on the concept of calculation of present values. The IRR determines the interest yield of the capital project at which the net present value becomes zero. Returning to the NPV calculation, we note that a discount rate, based on the needed rate of return of the business, determines the present value of future cash flows. In the case of IRR calculations, the reverse is true, the rate is calculated using the net future cash flows and the IRR is the rate at which the discount will bring the net cash flow to zero, i.e. the present value of the net cash flows and the investment required are the same. Where the IRR is greater than the expected return or the cost of funds the project is financially viable and projects with higher IRR are more viable (Westerfield R., Jaffe, and Jordan , 2007). Therefore, the internal rate of return is the rate of discount that causes the present value of cash inflows to be equal to the net investment value of the project that is the rate that produces 0 net present values (McLaney E., (2003). The criteria for accepting and checking the project is that internal rate of return ≥ cost of capital the project is accepted otherwise the project is subject to rejection. Calculation of the IRR requires two steps. The first step is to calculate the internal rate of return factor using the formula (Westerfield R., Jaffe, and Jordan ,2007):- This can be summarized as follows:

• Annuity: – calculate the payback period of the project and Use the present value annuity factor table to find the factor closest to the payback period. This could produce an internal rate of return.
• For a mixed stream of cash flows:- Calculate the average annual cash flow to get a fake annuity and divide by average annual cash flow into initial net investment to get a fake payback period.

In this case the internal rate of return will be

Payback period is = initial investment

331500

Average cash inflows (279972/2)= 2.3681

The internal rate of return is 48%.

The cash flows of 21%

Payback period is = initial investment331,500

Average cash inflows (279972/2)= 2.3681

The internal rate of return is 48%.

• The simpler method is to use spreadsheet software such as Microsoft Excel that allows direct calculation of the IRR from a table of projected cash flows.

Measuring project risk

The measurement of project risk is quite important in the overall evaluation of capital budgeting projects. Being able to measure the risk of capital budgeting projects lets one somehow differentiate between those projects having similar returns. One’s ability to compare projects with different returns is also greatly enhanced since one can get some feel for the type or risk-return trades –offs offered by the projects. In order to measure project risk, a decision-maker must be able to differentiate between the variability of project returns (Arnold, G. 2008).

The standard deviation:-The standard deviation of a distribution of project returns represents the square root of the average squared deviations of the individual observation from the expected value.

The coefficient variation:-The coefficient of variation, V, is calculated simply by dividing the standard deviation, σ, for a project by the expected value, E, for the project. The following equation presents the equation for the coefficient of variation. V = σ/E

Sensitivity analysis:- One of the difficulties of estimating future returns in a risky situation is the complexity of the influences which may work on them. Returns are not a simple uncomplicated quantity. They are the result of various factors, i.e. the revenues less all the relevant costs, and each of these may be subject to its own special risk unrelated to that affecting the others. To simplify the situation somewhat, use may be made of what is known as sensitivity analysis to isolate the more important factors from the less important ones. One of the most common sensitivity approaches is to estimate the worst, the expected and the best outcomes associated with a project (McLaney E., 2003).

Some various factors or variables affect the investment decision to be made. These variables are always analyzed using sensitivity analysis in case they are seen to affect the viability of the project. In this specific project, various variables have been identified as the key variables and affect the viability of the project. One of the key variables is the cost of capital in this case is assumed to be 26% with a nominal value of 21%. However in my opinion it forms a basis that will affect the long-term viability of the project (Arnold, G., 2008).

The other factor that will affect the project is the cash outflow. In this project, there are various cash outflows apart from the initial investment and this cash outflow can vary from time to time. The best example is the maintenance fee for the old machine, this cash outflow of the old machine depends on the ability of the old machine to continue performing without breaking down. According to the information provided they stated that there is a 50% chance of the machine breaking down again. This creates a chance that there will be variable cash outflows. Another variable in this case that will affect the performance or the analysis of the investment is the cash inflows. The company projects that the old machine will break down at least with a chance of 50%, this means that there will be effect on the cash inflows, therefore it is an important variable that will affect the viability of the project. In such a situation the project or the variables are subjected to sensitivity analysis where certain scenarios are taken in relation to each variable and they are analyzed to see how sensitive they are to change McLaney E., 2003).

As mentioned, cash outflows and inflows have a great influence on the project’s net present value or internal rate of return therefore they should be analyzed using sensitivity analysis.

Extra information required

The discussions above specifically rely on the ability of the firm to estimate parameters that inform calculations. These include a) a project’s future cash flow; b) the risk-adjusted discount rate; c) the project’s impact on cash flows; and d) the project’s impact on future investment opportunities (Myers, 1984). This makes financial projections alone in determination of capital investment only a part of capital budgeting, albeit an essential part (Myers, 1984; Haka, 1987).

The use of non-financial measures then becomes the other supporting approach to capital budgeting. For example, Myers (1984) describes the shortcomings of the DCF analysis as an inability to capture the benefits of future growth and flexibility and concludes that for rational decision-making it is essential that these considerations find due importance in project evaluation. In a similar vein, Klammer (1993) and Shank and Govindarajan (1992) recommend integration of strategic cost management into capital budgeting using methods that consist of value-chain analysis, cost-driver analysis, and competitive-advantage analysis.

In the analysis, one must also consider the cash flows associated with the delayed investment. Therefore the management should be candid enough to provide information relating to delayed investment i.e. if the management delays investing today what will be the returns for the company?

Conclusion

BL should invest in the machine as it will increase the shareholders’ value in both the capital expenditure manual criteria and recalculated NPV. The company stands to gain main from the investment rather than repairing the existing machine.

References

1. Arnold, G. (2008); Corporate financial management; 4th ed.. – Harlow: Financial Times Prentice Hall.
2. Brealey R. Myres, S. and Marcus, J.(2001); Fundamentals of corporate Finance, Irwin series in finance, Boston, MA: Irwin/ McGraw – Hill.
3. Fama, E. & French, K. (1992): ‘The cross-section of expected stock returns’, Journal of Finance, vol. 47, pp. 427-65
4. Graham, J. & Harvey, C. (2001): ‘The theory and practice of corporate finance: Evidence from the field’. Journal of Financial Economics, vol. 60, pp. 187-243
5. Haka, S. F. (1987): Capital budgeting techniques and firm specific contingencies: A correlational analysis, Accounting, Organizations and Society 12: pp: 31–48
6. Klammer, T. (1993): Improving investment decisions. Management Accounting: 35–43.
7. Mukherjee, T. K. (1987): Capital budgeting surveys: The past and the future. Review of Business and Economics Research 22: pp:37–56.
8. Myers, S. C. (1984): Finance theory and financial strategy. The Institute of Management Sciences 14: pp: 126–137.
9. McLaney E., (2003); Business finance theory and practice; Prentice Hall ISBN 0-273-67356-4
10. Pandey I M (2008); Financial management; Vikas Publishing House PVT ltd.
11. Pike, R. (1996): A longitudinal survey on capital budgeting practices. Journal of Business Finance & Accounting 23: pp: 79–92.
12. Ryan, P. A., and G. P. Ryan. (2002): Capital budgeting practices of the Fortune 1000: How have things changed? Journal of Business and Economics 8: 355–364.
13. Shank, J. K., and V. Govindarajan. (1992): Strategic cost analysis of technological investments. Sloan Management Review: 39–51.
14. Sharpe, W. (1964): ‘Capital asset prices: A theory of market equilibrium under conditions of risk’, Journal of Finance, vol. 19, pp. 425-42.
15. Turong, G.; Partington, G.; and Peat, M. (2008): Cost-of-Capital Estimation and Capital- Budgeting Practice in Australia, Australian Journal of Management, Vol. 33(I), pp: 95-121
16. Ulrich, D. (1998): ‘A new Mandate for Human Resources’, Harvard Business Review
17. Werhane, PH and RE Freeman (1999), ‘Business ethics: the state of the art’, International Journal of Management Reviews, vol 1, no 1, pp 1–16.
18. Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. ISBN-13: 978-0-07-353059-8/ISBN-10:0-07-353059-X