INVESTMENT APPRAISAL

Investment Appraisal



Investment Appraisal

Introduction

Investment policies have given a new perspective to the role of financial management. Investment decisions are one of the big financial decisions, all decisions about business investments ranging from the analysis of investments in working capital, including cash, banks, accounts receivable, inventories and investments represented in capital assets such as buildings, land, machinery, technology and so on. To make the right decisions, the Drumbeat Holdings should consider evaluation and analysis of elements that define the criteria for analysis, flow of funds associated with investment, investment risk and required rate of return. 

Objective

Main objective of this report is to assess whether the board of Drumbeat Holdings should consider proposed €600,000 capital investment to upgrade its existing electronic equipment or not.

Four methods that provide respective information for Drumbeat Holdings investment in its upgrade its existing electronic equipment will be evaluated on the basis of multiple project appraisal techniques. These include the accounting rate of return, payback period, net present value and internal rate of return of a project (Brown, 2008).  The method of accounting rate of return is used only to provide a benchmark fast and approximate cost of a project and it is little used (Shapiro, 2005). The payback period is the time required to recover the initial investment and is considered as an estimate of project risk (Lasher, 2010). The method of net present value is the most frequently used. It indicates whether the proposed project meets the minimum required rate of return (Helfert, 2001). Finally, the method of internal rate of return is an estimate of the profitability of a project (Shapiro, 2005).

Accounting Rate of Return Calculation

The rates of return play an important role in determining the value. In many cases, these rates are measures of value (Osborne, 2010). The accounting rate of return of a project is defined as the average annual income after taxes associated with the project, divided by the annual investment associated with the project (Lasher, 2010). For the proposed investment decision of Drumbeat Holdings in its existing electronic equipment,

Calculation of ARR

Following formula has been used to calculate the accounting rate of return for the Drumbeat Holdings for capital investment to upgrade its existing electronic equipment. This formula has used as it will help in determining the annual accounting rate of return that Drumbeat Holdings can get after investment in the existing electronic equipments.

ARR =

Average Cash Flow - Depreciation

x 100

Investment

Prior to calculating the ARR, depreciation for the project has been calculated using straight line depreciation method of 20% per annum. Using the straight line method, annual depreciation of the project has appeared at has been calculated as €120,000 per year. Calculation of annual depreciation is presented below.

Depreciation

20%

Equipment cost

600,000

Annual Depreciation =

Equipment Cost - Salvage value

Useful Life

Annual Depreciation =

600,000 - 0

5

Annual Depreciation =

€120,000

ARR is calculated below.

Accounting Rate of Return (ARR)

ARR =

Average Cash Flow - Depreciation

x 100

Investment

ARR = 160,000 - 120,000

x 100

300,000

ARR =

13%

ARR of 135 shows that Drumbeat Holdings on average will get an accounting return of 13% for €600,000 capital ...