Type: Definition Essays
Sample donated: Freddie Freeman
Last updated: March 26, 2019
INVESTMENT DECISIONS TABLE OF CONTENTS 1. Introduction. 3 2.
Investment Appraisal 3 3. Break Even Analysis. 5 4. NPV & IRR Calculations.
6 5. Conclusion. 7 6. References. 8 1. Introduction Thisreport will discuss the choice of investment decision for Alex. He wants toopen up a restaurant and this report will help him out to evaluate thefinancial performance of both options based upon NPV, Break even and othermodels.
2. InvestmentAppraisalThe application of amethod to measure the financial viability of a project requires the necessaryclassification knowledge. In general, these methods can be divided into staticmethods and dynamic methods. The result of this division is the standard overwhich the value of money (capital) changes over time, since the value of moneychanges over time. This is mainly due to economic inflation. Therefore, thebank’s interest rate is the nominal interest rate.
Therefore, the future returnon investment projects must be discounted over time. The discount rate is aparameter that “captures” changes in the value of money in a timelyfashion. The discount allows us to bring all of these future values ??(amounts)into account at the same time. The main contribution of this paper is to usethe dynamic method (NPV, IRR) as a discount method because the generalstructure of the formula contains the so-called discount coefficient.
All investment projectsare considered mutually exclusive or independent. An independent project meansthat the decision to accept or reject the project has no effect on otherprojects the company is considering. The cash flow of a separate project has noeffect on the cash flows of other projects or business units.
For example, thedecision to replace a company’s computer system would be seen as beingindependent of the decision to create a new factory.A mutually exclusiveproject is to accept such a project will affect the acceptance of anotherproject. In mutually exclusive projects, one project’s cash flow will have animpact on the other project’s cash flow.
Most business investment decisionsfall into this category. Starbucks’ decision to buy Teavana will surely have aprofound impact on the future cash flows of the coffee business and affect thedecision-making process for other Starbucks projects in the future.NPV is the most commonmethod with a variety of applications. Many authors consider this method tohave no drawbacks. Its special advantage is that the net present value of aproject to assess, given an absolute value, and provide investors with ananswer to the rate of return on investment. The financial analysis of theproject also frequently uses the profitability index (PI). “The profitindex is closely linked to the NPV because it is equally sensitive to thechosen discount rate.
” There is no major problem with the explanation ofthis indicator, that is, when the investment needs to be profitable, it mustsatisfy the condition of PI?1, where 1 represents the unit value of the projectinvestment expenditure. According to the formula given above, it is easy todetermine the definition of internal rate of return (IRR) that is, it is adiscount rate that equalizes the left and right sides of the equation, then NPVequals zero.According to the NPVrule, we choose item A, and we prefer internal rate of return rule B. If wehave to choose one, how can we resolve the conflict? When the two methods areinconsistent, the convention is to use the NPV rules because it better reflectsour primary goal: to increase the company’s financial wealth. 3. BreakEven AnalysisThe break even periodfor project A is 1.
71 years and project B has break even period of 2.10 years. Discounted Payback Period Analysis Project A Year 1 Year 2 Year 3 Year 4 Year 5 Undiscounted Net Cash Flow (100,000) 50,000 70,000 150,000 150,000 150,000 Cumulative Net Cash Flow (50,000) 20,000 170,000 320,000 470,000 Positive Cash Flow? FALSE TRUE TRUE TRUE TRUE Undiscounted Payback Period 2 First Year Positive Partial Year Payback Period 1.71 Actual Number of Years Partial Year Payback Period 1.71 Using arrays and index Discounted Payback Period Analysis Project B Year 1 Year 2 Year 3 Year 4 Year 5 Undiscounted Net Cash Flow (175,000) 50,000 100,000 250,000 250,000 250,000 Cumulative Net Cash Flow (125,000) (25,000) 225,000 475,000 725,000 Positive Cash Flow? FALSE FALSE TRUE TRUE TRUE Undiscounted Payback Period 3 First Year Positive Partial Year Payback Period 2.10 Actual Number of Years Partial Year Payback Period (One Cell) 2.10 Using arrays and index Year 0 1 2 3 4 5 Project A Cash flow (100,000) 50,000 70,000 150,000 150,000 150,000 PV factor 100% 93% 86% 79% 74% 68% PV of cash flow (100,000) 46,500 60,200 118,500 111,000 102,000 NPV 338,200 IRR 78% Project B Year 0 1 2 3 4 5 Cash flow (175,000) 50,000 100,000 250,000 250,000 250,000 PV factor 100% 93% 86% 79% 74% 68% PV of cash flow (175,000) 46,500 86,000 197,500 185,000 170,000 NPV 510,000 IRR 66% 4.
NPV & IRR Calculations ProjectB has a higher net present value but has a validity of five years compared tothe same term in Project A. Since this project will be used to produce theoutput of the manufacturing enterprise, it can be assumed that Project A willbe replaced at the end of the third year, so that the NPV above isunderestimated. In other words, suppose the project will be used indefinitely.Theinternal rate of return for both projects is 50%, but apparently Project takesprecedence over Project B. Note that NPV rules correctly identifycost-effective alternatives. The IRR rule fails in this case because it ignoresthe order in which it is flowing. Project A is a case where we are nowinvesting 1000, accumulating up to 1500 in a single period.
It’s a very goodreturn on our investment. In project B, we borrowed 1000, but also pay 1500 in1 period. It’s a very high interest rate, we have to pay. However, IRR does notconsider whether we borrow or not, and reports that exchange rates for bothprojects are the same.Theinternal rate of return for projects A and B was 78% and 66% respectively.Therefore, you should choose point B. However,NPVA = 338 and NPVB = 510From the point of view of maximizing shareholder wealth,Project A is therefore better than Project B. The inconsistency comes from thesize of the investment question.
The internal rate of return method only givesthe profitability of a project invested in each investment and does not measureabsolute profitability.One attraction of the payback period is that it provides”risk currency” measures. At the beginning of the project, we have agreat deal of uncertainty about future cash flows, the economic environment andcash flow may be more or less than expected, and there is more and moreuncertainty about the future. However, the performance standard is the wrongway to solve this problem. There are two tools for analyzing the risksassociated with long-term cash flows.
The first is the setting of the discountrate. As we will see below (Conferences 9 and 10), the discount rate can becalculated according to the risk of the investor by breaking it down into arisk-free rate, a time value offset and a risk premium. 5. ConclusionIn addition, we know much less about the near and distantfuture, and if things change in the future, we usually change the design of theproject. Therefore, we have to take into account that one project took a lot oftime in our analysis and the other project took a lot of time because thelonger projects gave us less flexibility. As we will see later, this argumentalso has some merit because flexibility has economic value.
However, the righttool for analytical flexibility is the analysis of the decision tree or theanalysis of options (so-called “real options”). 6. References · Gotze,U.
, Northcott, D. and Schuster, P., 2016.
INVESTMENT APPRAISAL.SPRINGER-VERLAG BERLIN AN.· Pasqual,J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitabilitycriteria with the net present value.
International Journal ofProduction Economics, 142(1), pp.205-210.· Weber,T.
A., 2014. On the (non-) equivalence of IRR and NPV.
Journal ofMathematical Economics, 52, pp.25-39.· Bas,E.
, 2013. A robust approach to the decision rules of NPV and IRR for simpleprojects. Applied Mathematics and Computation, 219(11),pp.5901-5908.