Capital investment decision
Investment appraisal using Accounting Rate of Return (ARR)
Smooth Software Limited has three projects (Project Beta, Project Gamma, and Project Delta), from which the board of directors has to select one. Accepting one of the projects will lead to the rejection of two projects. A project should be accepted if its accounting rate of return is more than the firm’s acceptable cut-off point (Abeysinghe, 2010). In the case of a mutually exclusive project, the project with the highest accounting rate of return should be accepted. Assume that Smooth Software Limited’s target accounting rate of return is 80%. The board of directors should go for project Beta which has an accounting rate of return of 133% since it has the highest ARR compared to project Gamma and Project Delta. This decision conforms to the accounting rate of return accept-reject rule, that the project with the highest ARR should be accepted in case of mutually exclusive projects (Abeysinghe, 2010).
The accounting rate of return can easily be calculated as it uses readily available accounting information as such managers and board of directors can easily understand it. However, it disregards the time value of money, it is based on accounting information, not cash flow and it does not match the company’s objective of maximising the market value of shares.
Investment appraisal using the non-discounted payback period
The payback period is the number of years necessary to regain back the money invested in a project i.e., initial investment outlay (Abeysinghe, 2010). A project should be rejected if the payback period is more than the cut off point. In the case of a mutually exclusive project, the project with the shortest payback period should be accepted. Assuming the firm’s target payback period is 4 years, the board of directors should go for project Delta which has a payback period of 2.75years. This is because it has the least payback period when compared to project Beta and project Gamma.
On the other hand, a non-discounted payback period is very easy to calculate as it uses cash flow instead of profit or loss figures. However, it may reject a project that generates cash flows for a long period this is because it disregards cash flows after the payback period and also the time value of money.
Investment appraisal using Net present value (NPV)
A project should be rejected only when the net present value is negative; in case of mutually exclusive projects accept the one with the highest but positive net present value (Deloitte.com. 2010). The board of directors should accept project Beta which has the highest net present value of £24,937,000.
The net present value method considers all cash flows and also the time value of money; therefore, it maximizes the owner’s wealth. Nevertheless, many managers or board of directors do not understand it because it is informed of figures and related costs that are involved in assembling information and making calculations may not provide expected returns. Its weakness is that it presumes that the discounting rate is recognized, and its recommendations can conflict with an internal rate of return recommendations.
Investment appraisal using internal rate of return
This method equates the initial cost of investment with the net present value; therefore, it results in a zero net present value. A project should be rejected if the internal rate of return is lower than the cost of capital; in the case of mutually exclusive projects, the one with the lowest internal rate of return should be rejected (Deloitte.com. 2010). Therefore, project Delta should be accepted, since it has the highest internal rate of return of 41.1%.
The internal rate of return method factors in the time value of money and is easy to comprehend given that it is a percentage value and not a quantity.
In addition, it often leads to similar results like the net present value and it matches the firm’s objectives of owners’ wealth maximization. However, it may result in various conclusions and may lead to inaccurate judgment when comparing mutually exclusive projects.
Conclusion
In conclusion, the key goal of a business is to maximise the owners’ wealth. Therefore, a company needs to invest in a project that has value. A high-quality investment evaluation should consider the time value of money and that cash is the king. These two important tip rules out the accounting rate of return and non-discounted payback period as investment appraisal method. Owing to the reality that money should have been reinvested and the company would have received capital gains and the purchasing power of money is lost every time due to inflation. We are then left with the NPV and IRR.
The net present value is the disparity between the cost and the value of the project. To make the owners contented a company should invest in a project that has an affirmative NPV. The IRR equates NPV to zero as it is the disparity between the current value of cash inflows and cash outflows. IRR is easy to use when used properly; though it disregards the size of the projects i.e., two projects may have identical IRR nevertheless one can make more cash flow than cash flow produced by the other project. When making decisions between mutually exclusive projects, IRR should not be used.
This is because it proves to be unreliable when it comes to ranking investment projects of different scales. This leaves us with the NPV which proves to be more reliable and easier to use than IRR. Thus, the board of directors should go for Project Beta that has the highest NPV.
References
Abeysinghe, R. 2010. Investment Evaluation Criteria, Web.
Deloitte.com. 2010. Classification of Leases, Web.