Investment Appraisal Report

[Name of Student]

[Name of Professor]

[Date of Submission]

Introduction

This report aims to conduct analysis of investment in the production plant and machinery. For this purpose, different techniques of the capital budgeting have been used which includes; the payback period, accounting rate of return (ARR), Net present value (NPV) and Internal rate of return (IRR). These techniques allow to analyse if the investment generates value for the firm or not and in how much time the initial investment could be recovered and what does it provides an average return. Furthermore, the potential impact of foreign exchange rate on the investment project has also been examined and alternate sources of finance are also discussed through which firm could finance the investment project. Meanwhile, other non-financial matters are also analysed that should be considered in the investment project.

Background

Herts Gadgets International plc is considering an investment into the new production plant and machinery for the product, and this investment requires an investment of £13,000,000 as an initial investment and also requires another £2,000,000 for the working capital. So, the total initial investment required is £15,000,000 and life of the project would be 5 years only. The expected contribution from the new sales would be 2,865,000 annually for the next 5 years and it will also reduce the direct labour cost and direct material cost by 20%, thus an expected cost saving tend to be £1,680,000 annually. This is case information that will be used to analyse the investment proposal of the company through using the different capital budgeting techniques.

Techniques Applied

In order to analyse the proposed investment project, different types of capital budgeting techniques have been used and discussion on these techniques is conducted in this section. The techniques applied are (1) Payback period (2) Discounted payback period (3) Accounting rate of return (ARR), (3) Net Present value (NPV), (4) Internal rate of return (IRR).

(1) Payback period 

The first technique applied in this report is the payback period which explains total expected time the initial investment would be recovered from the project. In this technique, the expected future cash flows are used to calculate in how much time the investment initial would be recovered so in other words it provides break-even point in terms of time (Oktaviani, 2018). For instances, if a project has 5.5 years then it means that initial investment would be recovered in 5 years and months.

(2) Discounted payback period 

The second technique applied in this report is the discounted payback period which also explains the total expected time in which initial investment would be recovered but in this technique discounted cash flows are used rather than cash flows only. This technique helps to overcome the limitation of payback which ignores the time value of money concept (Kuznetsov, 2016). However, discounted payback period considers the time value of money concept which makes it more effective and appropriate as compared to payback period alone.

(3) Accounting rate of return (ARR)

Accounting rate of return (ARR) is third technique applied in this report which tells an average rate of return that company could earn from the project annually over its life time (Magni, 2019). The application of this technique is used when multiple projects are compared with each other but it also has limitation that it does not consider the time value of money concept which may led to either acceptance of project which may not be attractive.

(4) Net Present value (NPV) 

Net present value (NPV) is the fourth technique applied in this report, this technique is used to calculate how much value investment or project can provide after deduction of the initial investment and considering the concept of the time value of money. It enables to analyse overall profitability of the project over its life time (Baker and English, 2011). Hence, this technique is also used in the following report to determine how profitability of the investment that company has planned to undertake.

(5) Internal rate of return (IRR)

Internal rate of return (IRR) is fifth technique of the capital budgeting applied in this report. This technique allows to analyse the profitability potential of the investment and provides a discount rate at which NPV is zero, it is used to determine how much a return project tend to provide over its life cycle (Baker and English, 2011). Hence, it is mainly used for the purpose of the analysing multiple projects.

(6) Weighted average cost of capital (WACC)

Weighted average cost of capital (WACC) is last technique which was used in the project to calculate the discount rate for the firm considering its capital structure. Basically, WACC is the rate of return which investors expect from the firm and it is used to discount the cash flows of the project to calculate NPV of the project (Bierman and Smidt, 2012). One of strength of the WACC and also the core reason behind using WACC is that it provides average cost of capital after considering all types of sources of finance including debt, equity and also preferred shares. Hence, it was used as discount rate since the company had two types of sources of finance debt and equity based on which WACC was calculated.

Discussion of Findings

(1) Payback period

Table 1 Payback period of the Investment

The payback period of the investment is calculated through a typical formula as a year at which cash flow is negative but will turn positive next year. So, that year is considered to be year and remaining months are calculated by dividing the remaining amount to be recovered by cash flow of the next year and this provides approximate remaining time. So, the calculate payback period for the project is 4.8 years or it can be said that project will recover the initial investment approximately in 4.8 years fully.

(2) Discounted payback period 

Table 2 Discounted Payback period

The discounted payback period for the project is found to be 4.6 years approximately which shows that if discounted cash flows are used for the calculation of payback period, then approximately it will take 4.6 years to recover the initial investment. The discounted payback period is less than payback period which shows that project tend to be recover in lesser time when discounted cash flows are used and it also favourable.

(3) Accounting rate of return (ARR)

Table 3 Accounting Rate of Return (ARR) of the Investment

The accounting rate of return of the investment is calculated by dividing the average return from the investment divided initial investment. The calculated accounting rate of return is 31.7% indicating that on average the investment will provide a return of 31.7% annually. However, it does not consider discounted cash flows which makes it a less effective technique (Baker and English, 2011). Meanwhile, decision of the investment cannot be alone made over the using ARR.

(4) Net Present value (NPV) 

The incremental cash flows were calculated through multiple steps, where in first step the yearly contribution of sales was determined by adding a growth of 5% and total savings were also added which provided total new contribution and savings due to the investment. Meanwhile, the net present value (NPV) of the investment is calculated by discounting each year’s incremental cash flow and sum of all cash flows including negative initial investment. The NPV of the investment is calculated to be £2,165,012.057 which shows that since NPV is positive, hence it can be analysed that project produces profitability for the company. Because, a positive NPV is signal that investment will generate a positive value for the company and its shareholders (Baker and English, 2011). Hence, it is valuable, favourable and preferable in terms of investment. Thus, based on the calculations of NPV, it can be suggested that investment should be made by the company since it would generate a positive value.

(5) Internal rate of return (IRR)

The internal rate of return (IRR) of the investment is also calculated through excel function and calculated IRR is 16.265% which suggests that project has positive IRR, hence it will generate value. Meanwhile, another rule of thumb is that if the IRR is greater than expected rate of return then project should be accepted (Bierman and Smidt, 2012). Meanwhile, in this investment the expected rate of return or WACC is less than IRR which makes the investment project more attractive, favourable and profitable. Hence, based on this rule of the thumb the investment project should be accepted.

Potential Impact of Foreign Exchange

The company is operating in the United Kingdom but it’s all sales is made into the three different countries; South Korea, Spain and Canada. Since, this makes company’s sales value sensitive to the exchange rates of these countries, hence, if the exchange rate of any of these countries strengthen against the sterling pound then company’s profitability will be affected negatively since it will receive less amount of same products due to weaker sterling pound against these currencies. Similarly, if the pound strengthens against these countries’ currencies then products of the company will become expensive for the customers which tend to affect overall sales volume of the company. Thus, in this condition the sales amount would be affected. Therefore, the impact of foreign exchange on the investment project tend to be negative in every aspect but under the condition weaker sterling pound, the sales volume may increase and benefit company at some extent but also not necessarily.

Alternate Sources of Finance

There are three different types of source of the finance a company can typically use. The first source of finance is the internal financing through retained earnings. The second source of financing is the external finances that could be used by the firm, and in this source of financing company has to issue new shares into the market in order to invest in the new project. Meanwhile, the last source of the financing is the debt, where the company can apply for the long-term loan with a bank or financial institution. However, considering the current capital structure of the company, the equity consists of 70.6% and debt consists of 29.4%; and company still has potential to get external debt from the bank or financial institution (Niu, 2008). As it has also been suggested by traditional theory of capital structure that there is an optimal mix of the capital structure through which a firm could reduce the WACC and increase the overall value as result of tax bracket on the debt. Therefore, it is suggested to the firm that should finance the investment project through debt financing because it is a cheaper way of financing and can also benefit company due to tax bracket.

Non-Financial Matters

The non-financial matter that could affect investment can include; capability of the management, required skills and professional employees to support the investment project and include the organisational culture. These aspects should be considered when investing since these could affect the investment as whole or at some extent. For instances, if the management does not have sufficient capacity to deal with the expansion then it could lead to burnout, inefficiency and ineffectiveness (Lopes and Flavell, 1998). Similarly, it is also essential that company must have professional and experts to assist in expansion of the production capacity otherwise it could turn into a disaster. Meanwhile, due to the expansion of production capacity, it is more likely that company might introduce some new technology or new processes, which must be accepted by the employees (Bakhshani, 2017). Thus, overall an organisational culture is important in accepting the change. Therefore, these are the non-financial matters that must be considered while making an investment so that benefits could be achieved as expected.

Recommendation and Conclusions

The techniques applied reveals that initial investment will be recovered in 4.8 years approximately and accounting rate of return (ARR) is 31.7% indicating that investment will provide an average return of 31.7% annually throughout project life. Meanwhile, the NPV of the project is £2,165,012.057, since it is positive, thus, it can be determined that project is profitable and would create value for the company. In addition to, the internal rate of return is found to be 16.26% and since IRR is greater than WACC, hence as per the rule of thumb the project should be accepted. Because, it will create value for the company. Therefore, it is recommended for the company that investment should be made since it would create value for the company.

References

• Baker, H.K. and English, P. eds., 2011. Capital budgeting valuation: financial analysis for today's investment projects (Vol. 13). John Wiley & Sons.

• Bakhshani, S., 2017. The Relationship between Non-financial Factors, Capital Structure and the Performance of the Listed Companies on the Stock Exchange. International Journal of Economics and Financial Issues, 7(3), p.542.

• Bierman, J.R. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

• Kuznetsov, N.E., 2016. SPECIFICS OF CALCULATIONS OF CAPITAL INVESTMENTS PAYBACK. In Совершенствование учетно-информационного обеспечения управленческих решений хозяйствующих субъектов на основе парадигмы устойчивого развития (pp. 147-150).

• Lopes, M.D.S. and Flavell, R., 1998. Project appraisal—a framework to assess non-financial aspects of projects during the project life cycle. International journal of project management, 16(4), pp.223-233.

• Magni, C.A., 2019. Accounting Measures and Economic Measures: An Integrated Theory of Capital Budgeting. Journal of Accounting and Finance, 19(9), pp.166-208.

• Niu, X., 2008. Theoretical and practical review of capital structure and its determinants. International Journal of Business and Management, 3(3), pp.133-139.

• Oktaviani, R.F., 2018. Capital Budgeting For the Feasibility of SMEs Food And Beverage. International Journal of Pure and Applied Mathematics, 119(15), pp.377-388.