INVESTMENT APPRAISAL

Investment Appraisal



Investment appraisal

Introduction

When starting or acquiring a business, it is essential to evaluate investments as it involve substantial resources and company need to see whether these resources will provide future benefit or not. Furthermore, companies also look for risks that are always associated with the investment. Hence, entire business decision whether for expansion, new development etc requires strong feasibility analysis in order to avoid risk and to avail opportunities for future benefits. The focus of this paper would be on Investment Appraisal covering basic capital investment appraisal techniques.

Discussion

Overview of the Case

Wholefooods Ltd has been considering tendering their local authority contract to supply school meals. If they decide to tender and are successful, this will be their first contract in the public sector. The contract is for a period of five years with the initial investment of £60,000.

Capital Investment Appraisal Techniques

In order to appraise this investment, the techniques that will be used are Payback period, Accounting Rate of Return, Discounted Payback period, Net present value and Internal Rate of Return (Röhrich, 2010, p. 55). For this, net cash flow has to be calculated which is as followed:

Calculate the Payback and Accounting Rate of Return for the project using Excel to make all your calculations.

Payback Period

For calculating Payback, we will need net Cash Flow which are as followed:

(See excel for detail calculation)

Cash flow Calculation

 

Year 1

Year 2

Year 3

Year 4

Year 5

Sales Units

60,000 64,000 64,000 66,000 66,000

Sales price

£1

£1

£1

£1.2

£1.2

Total Revenue

£60,000

£64,000

£64,000

£79,200

£79,200

 

 

Outflows

 

Material Cost

£36,000

£38,400

£38,400

£46,200

£46,200

Rental Cost

£4,000

£4,000

£4,000

£4,000

£4,000

Transp. cost

£4,000

£4,000

£4,000

£4,000

£4,000

Dep Exp

£12,000

£12,000

£12,000

£12,000

£12,000

Total Outflows

£56,000

£58,400

£58,400

£66,200

£66,200

 

 

Total Revenue

£60,000

£64,000

£64,000

£79,200

£79,200

Total Outflows

£56,000

£58,400

£58,400

£66,200

£66,200

Operating Profit

£4,000

£5,600

£5,600

£13,000

£13,000

Add: Depreciation

£12,000

£12,000

£12,000

£12,000

£12,000

Cash flows

£16,000

£17,600

£17,600

£25,000

£25,000

Payback Period

Years

Cash flows

Cumulative Net Cash Inflow

Outlay

£60,000

-£60,000

Year 1

£16,000

-£44,000

Year 2

£17,600

-£26,400

Year 3

£17,600

-£8,800

Year 4

£25,000

£16,200

Year 5

£25,000

£41,200

 

 

Payback Period

3 + (|-£8,800| ÷ £25,000)

 

 

3+(8800/25000)

 

 

3+0.352

 

 

3.352

Years

Pay Back Period refers to the time needed to recover investment cost. Investment of Wholefoods will take 3.352 years to covers their initial cost. As company expects that they will recover within 4 years, this investment from Pay Back Period techniques is favouring this investment. According to Payback period theories, it is preferable to choose a project that covers investment cost in short duration and considering this; Wholefoods investment will be covering their initial investment cost in less than 4 years and it is advisable to go for this project (Ross, Westerfield, Jordan, 2011, pp. 121).

Accounting Rate of Return

In order to calculate Accounting Rate of Return we will be using accounting income as this will include deprecation expenses (Peterson, Fabozzi, 2011, p. 76).

Accounting Rate of Return

Year

Accounting Income

Year 1

£4,000

Formula:

Year 2

£5,600

Average Accounting Profit / Average Investment

Year 3

£5,600

 

Year 4

£13,000

 

Year 5

£13,000

 

Average Accounting Income

£8,240

 

Accounting Rate of Return

13.73%

8240/60000

The accounting rate of return for this project is 13.73 while company expects accounting rate of return to be 25%. As it is not higher than what was expected by the company, this technique is not favouring project acceptance (Needles, Powers, Crosson, 2010, p. 1184).

Design a spreadsheet that calculates the discount Factors for each of the relevant years and calculate the Discounted Payback and the Net Present Value.

Discount Rate Factor

Calculation for discount rate factor

Discount rate is 14%

 

 

Discount Rate - 14%

 

1/1.14^0

1

Formula:

1/1.14^1

0.8771930

1/(1+cost of capital)^ ...