Appraisal Techniquesss

Appraisal Techniques

Managing Financial Principles and Techniques

Author:Trivikram Nath Pandey4/19/2010

Jones Plc.Appraisal Techniques

Appraisal Techniques

Prepared for

Dr. Shaik Moulali, Phd. Finance

Faculty of Bentham Institute of Management & Languages

Bentham House, Ring Road, Rethibowli

Hyderabad – 500028

Prepared by

Trivikram Nath Pandey

Enrolment Number: BAP – 0210 – 10002

Level 7 BTEC Advanced Professional Diploma In Management Studies

19 April 2010

Bentham Institute of Management & LanguagesPage 2 of 35


ACKNOWLEDGMENT

This project has been made in the guiding of the respected faculties. The project report is about “The objective it to apply financial techniques, select appropriate information and make recommendations in the process of investment decision making.” Given case company’s name is Jones Plc. which deals in public sector business.

This have prepared a detailed report after a survey in the market, conducting in depth research using both primary & secondary data, studying about Appraisal Techniques, factors infusing investment decision and business financial environmental factors. On conclusion part suggestions for investment in the TransportExpress Plc. and Semicon Pvt. is given. All this had been possible because of the guidance of the faculties of Bentham Institute of Management & Languages.

Highly obligation is made to the best faculty. Dr. Shaik Maulali who guide for completing this project report. Thanks to the academic head Mrs. Firdaou Khan who provide moral and subjective support to complete this project. At last acknowledge to all team of Bentham Institute of Management & Languages and class mates for helping in completion of this project.

Yours Truly

Trivikram Nath Pandey PGDMS Student Enrolment: BAP-0210-10002



Table of ContentsAppraisal Techniques..................................................................................................................2

ACKNOWLEDGMENT.............................................................................................................3

Introduction:................................................................................................................................6

TransportExpress Plc.:.............................................................................................................6

Semicon Pvt.:...........................................................................................................................6

Report to the CEO of Jones Plc.:.................................................................................................7

Pass Criteria P2.1:........................................................................................................................8

Current Appraisal Methods:....................................................................................................8

Applications of Appraisal techniques:.....................................................................................8

Steps of Appraisal Techniques:...............................................................................................9

Cash Inflow and Outflows in Appraisal technique:.................................................................9

1. Payback Period (PBP):.......................................................................................................11

2. Average Rate of Return (ARR):.........................................................................................11

3. Profitability Index (PI):.......................................................................................................12

4. Net Present Value (NPV):..................................................................................................13

5. Internal Rate of Return (IRR):............................................................................................14

Comparison of NPV and IRR:...............................................................................................16

Problem solving:....................................................................................................................17

Using NPV method for TransportExpress Plc.:.....................................................................18

Using IRR method for TransportExpress Plc.:......................................................................18

Using NPV method for Semicon Pvt.:...................................................................................19

Using IRR method for Semicon Pvt.:....................................................................................20

Conclusion:................................................................................................................................21

Pass Criteria P2.2:......................................................................................................................21

Appraisal Techniques:...........................................................................................................21



Risk and Managerial (Real) Options in Capital Budgeting:..................................................24

Pass Criteria P2.3:......................................................................................................................27

Expected cash flow calculaton:............................................................................................27

Results for Semicon Pvt.:......................................................................................................27

Conclusion as per expected cash flow:..................................................................................28

Actual cash flow calculaton:..................................................................................................28

Using NPV method for TransportExpress Plc.:.....................................................................29

Using IRR method for TransportExpress Plc.:......................................................................30

Using NPV method for Semicon Pvt.:...................................................................................31

Using IRR method for Semicon Pvt.:....................................................................................31

Conclusion:............................................................................................................................32

Recommendations:....................................................................................................................33

Abbreviations:............................................................................................................................33

Bibliography:.............................................................................................................................33



Aim: The objective it to apply financial techniques, select appropriate information and make recommendations in the process of investment decision making.

Introduction:

Jones Plc is considering two mutually exclusive investment projects one each in public sector and private sector on year 2005.

Jones Plc has 100 million pounds to invest in two different companies. The investment is as part of its business expansion strategy. Jones Plc has two options to invest:

1. TransportExpress Plc.2. Semicon Pvt.

TransportExpress Plc.:

TransportExpress Plc. works in road transport services in the city of Workshire. TransportExpress Plc. has business expansion strategy, the company plans to enter into new markets and purchase a fleet of new buses, purchase land and necessary equipment needed for its new venture. For business expansion TransportExpress Plc has to invest 100 million pounds.

Semicon Pvt.:

Semicon Pvt. has business in manufacturing semi-conductor parts which can be used in other equipments. As part of its business expansion strategy, the company has to plan on launching new products. The company has to purchase new equipment for the production of new product, employing/hiring man power for its new product, and above all else for pursuing R&D. The company has an investment around 100 million pounds.



Report to the CEO of Jones Plc.:Date: 19th April, 2010

To

The CEO Jones Plc India

Sub: Business report for recommending the project.

Sir,

As the work is given, all appraisal methods, tools and techniques are used to understand which company (TransportExpress and Semicon.) is best for investment. According to findings and analyses the result is in helpfulness of Semicon.

In all compressions of TransportExpress and Semicon the recommendation is in favour of Semicon. Hope that this recommendation will be accepted.

Thanks for your kindness and valuable time.

Yours Truly

Trivikram Nath Pandey Executive



Pass Criteria P2.1:

Current Appraisal Methods:Appraisal techniques are also called Capital Budgeting. Appraisal technique is the process of making long term investment decisions. It is decision-making process that enables a company to evaluate the viability of a long-term project and whether it is worth undertaking or not.

In other words Appraisal techniques or Capital budget is also a plan of proposed outlines for adopting long-term assets and includes the means for financing the purchase of company or acquisition.

Basically there are two type of investment, first is current investments and second is capital investments. These are:

Current investments: Current investment is also called current expenditure. These investments are short term investments. This investment takes all expenses in same financial year. This investment includes many administrative expenses like: wages, salaries, rent, bills, expenditure of row materials etc. In other words operating budget is a plan for the operating expenses and revenues associated with activities for the current period.

Capital investments: Capital investment is also called capital expenditure. Capital investment in long-term investment. A capital investment results in current cash outlay with the expectation of future benefits.A company’s constancy and potential achievement often depends on its capital investment. It is extremely difficult for a company to a company to recover money tied up in bad capital investments.

Applications of Appraisal techniques:Appraisal techniques proposals can come from a diversity of sources. For the process of result analysis of appraisal techniques are often grouped in one of the following categories:

New technology and gadgets Substitution of existing equipment A number of allocations for do research and development for new products and the

expansion of existing products. Compulsory projects etc.



Steps of Appraisal Techniques:An Appraisal technique consists of a logical progression of activities. These activities are as follows:

Step 1. Detection: The first stage in Appraisal technique is to identify which type of capital expenditure are necessary and are in line with organisational strategies, objectives and missions.

Step 2. Search: Appraisal investment proposal to be thoroughly invested and alternative investments explored.

Step 3. Estimation: Non-financial benefits, revenues, financial, cost, and cash flows for each option must be predictable and compared for the projects whole time series.

Step 4. Selection: Naturally projects selections for implementation are those in which the predicted financial benefits go beyond expenses by the highest margin.

Step 5. Funding: Project funding must be secured through internal cash, externally in the capital market or through some combination.

Step 6. Implementation and control: An appraisal technique must be monitored and evaluated. Predictions at the time the project was selected need to be compared with actual results.

Cash Inflow and Outflows in Appraisal technique: Category Description Cash flow activitiesInitiation Initial cash

investment Outflows to fund the investment and initiate the

project. Communication for working capital. Inflows or outflows if there is an asset being

replaced.Operation Interim incremental

net cash flows Outflows for operating expenditures. Outflows for additional capital investments. Commitment for additional working capital for

operations. Inflows generated by the investment and cash

released from working capital no longer needed for operations.

Disposal Incremental net cash flow for the final year

Inflows or outflows related to the investments disposal.

Cash inflows from the release of working capital no longer committed to the investment.


Techniques of Investment Appraisal

Traditional Methods

Average Rate of Return

Payback Period

Discounted Cash Flow

Net Present Value

Iternal Rate of Return

Profitibility Index


Basically there are two types of Appraisal techniques. Under these two techniques there is two and three type of methods. These can be easily understood by diagram given below:



As per above table this is understood that there are total five methods of Appraisal techniques. Details of these methods are as follows:

1. Payback Period (PBP) : The target payback period represents what the company

considers to be acceptable length of time for a project. Project with a payback shorter than the target payback period are accepted. Those with a payback longer than the target payback period are rejected.Payback period = Investment required / Net annual cash inflow

Acceptance/Rejection Criteria: In case of single project; if PBP is less than life of the project then accept the

project.If PBP is greater than life of project then reject the project.If PBP is equal to life of the project then result is neutral. Here project may accept or not.

In case of two or more project; the project with less PBP should be accept.

Advantages and Disadvantages of payback period method:

Advantages DisadvantagesUses a simple calculation. Ignores the time value of money with cash

flows with no regard to timing.Results are easy to understand. Ignores cash flows happening after the

payback period expiration.Gives an uneven measure of liquidity. Provides no measure of profitability.Gives an uneven measure of project risk. May incorrectly promote short-term projects

if the objective payback period is too short.

2. Average Rate of Return (ARR): The rate of return on an investment that is

calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. The average rate of return does not guarantee that the cash inflows are the same in a given year; it simply guarantees that the return averages out to the average rate of return.

Acceptance/Rejection Criteria: In case of single project;

If ARR > COC then, accept the project.



If ARR < COC then, reject the project.If ARR = COC then, neutral project may accept or not.

In case of two or more projects; a project with higher ARR will be selected with ARR > COC.

3. Profitability Index (PI): The PI is the ratio of the present value of a project’s

future net cash flows to the project’s initial cash outflow.

PI = ( CF1/(1+K)1 + CF2/(1+K)2 + ... + CFn/(1+K)n) / ICO

OR

PI = 1 + (NPV / ICO)

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of investment to payoff of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

The ratio is calculated as follows:

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. If value is less than one then it would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project: If PI > 1 then accept the project

If PI < 1 then reject the project

If PI = 0 then neutral project may be accepted or not.



4. Net Present Value (NPV): The present value of an investment's prospect net

cash flows minus the first investment. If positive, the investment should be made or else it should not.

NPV (Net Present Value) is the differentiation between the present value of cash inflows and the present value of cash outflows. NPV is used in appraisal techniques to analyze the productivity of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. The net present value brings into consideration all the cash flows over the life of a project. The weights applied are based on the time value of money, means the sum of money received in the future are insignificant then the sum received today. Before getting into the NPV analysis, company has needed to recognise the market and with strength, weakness, opportunity and threat. In performance domination in the market is the definitive way out for fetching revenue and sustainability of the company.

Acceptance/Rejection Criteria: In case of single project.

If It means ThenNPV > 0 The investment would add

value to the company.The project may be accepted.

NPV < 0 The investment would subtract value from the company.

The project should be rejected.

NPV = 0

The investment would neither profit nor lose value for the company.

Company should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Conclusion should be based on other criteria.

In case of two or more project; a project with higher NPV may be accepted.

Steps in NPV:

1. Calculate present value of cash inflows.2. Calculate present value of cash outflows.3. Find out NPV by deducting total PV of cash inflows form total PV of cash outflows.

NPV = Total cash inflow – cash outflow



In other words NPV is the present value of an investment project’s net cash flows lesser amount the project’s original cash outflow.

NPV= CF1/(1+K)1 + CF2/(1=k)2 + …+ CFn/(1=k)n – ICO

Strengths and Weaknesses of NPV:

Strengths WeaknessesCash flows unspecified to be reinvested at the obstacle rate. May not include decision-making options

entrenched in the project.Financial records for TVM.It considers all cash flows.

5. Internal Rate of Return (IRR): The IRR estimates the discount rate that

makes the present value of net cash inflows equal to the initial investment. In other words IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow.

IRR interpretation: The IRR method evaluates a capital investment by comparing the estimated IRR to a prearranged principle. This criterion is based on whatever rate the company uses to evaluate investments, such as its minimum rate of return, the rate from another desirable alternate investment or an industry average.

ICO = CF1/(1+IRR)1 + CF2/(1+IRR)2 + …+ CFn/(1+IRR)n

IRR calculation: The IRR method has two basic steps:

1. Establish the rate of return that makes the present value of net cash inflows equal the investments initial amount.

2. Measure up to the estimated rate of return with the company’s desired rate or return to assess the investments appeal.



Uniform net cash flows: The steps in decisive IRR for an appraisal project with uniform net cash flows are:

1. Decide the total initial investment for the project.2. Recognize the predetermined criterion cut-off rate of return.3. Establish net cash inflows for each year.4. Divide the initial investment (step 1) by the annual cash flow (step 3) to obtain a value

for IRR.5. Pass on to a present value annuity table to locate a discount rate at the specified number

of years that matches the IRR value.6. Evaluate the IRR rate (step 5) to the chosen criterion cut-off rate (step 2).

If the intended IRR exceeds the decisive factor cut-off rate, the project is an advantageous investment.

Uneven cash flows: for a project with irregular cash flow projections, the IRR calculation becomes audition and fault and interruption.

Acceptance/Rejection Criteria: In case of single project;

If IRR > COC, then accept the project.If IRR < COC, then reject the project.If IRR = COC, then neutral, project may be accepted or not.

In case of two or more project; a project with higher IRR is accepted, with IRR > COC.

Strengths and Weaknesses of IRR:

Strengths WeaknessesFinancial statement for TVM. Expected all cash flows reinvested at the IRR.Takes all cash flows. Problems with project rankings and numerous

IRRs.Smaller amount subjectivity.



Comparison of NPV and IRR: The basic assumption underlies both the NPV and IRR methods: risk or uncertainty, is not a major problem. In addition both NPV and IRR consider:

The time value of money. The initial cash investment.

A major difference is that the end result of NPV is a pounds figure whereas the final computation for IRR is a percentage. Therein is an advantage for NPV, as the NPV values of individual projects can be added to estimate the effect of accepting some possible combination of project. Because IRR yields a percentage, multiple projects cannot be added or averaged to evaluate any combination of capital investment projects.

Another advantage of the NPV method is its usefulness in evaluating a project in which the required rate of return varies over the life of the project. The total present value of the cash inflows can be determined and compared with the total initial investment to evaluate the attractiveness of a project. Again, it is not possible using the IRR method to infer if the project is unattractive. Different required returns for each of the year’s means that there is no single rate of return or a single IRR value.

Both methods have some reliability coutions:

NPV is only as reliabe as the discount rate that is selected. An unrealistiv discount rate can result in an erroneous decision to accept/reject a project.

A capital investment project should not be accepted solely on the basis of a high IRR value. A high IRR result must be looked ar further to assess if and opportunity to invest cash flows at such a high IRR is realistic.

But among all the various methods to analyze capital investment, the DCF methods are theoretically some of the most reliable. The NPV and IRR methods will typically yield similar results as long as there are no differences in:

The amount of the initial investment. The net cash flow pattern. The life of the project. The cost of capital over the life of the project.



Single-Point Estimate and Sensitivity Analysis:Sensitivity Analysis: A type of “what-if” uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a project’s measured results (such as NPV or IRR).

Allows us to change from “single-point” (i.e., revenue, installation cost, salvage, etc.) estimates to a “what if” analysis.

Utilize a “base-case” to compare the impact of individual variable changes. If result of NPV and IRR is opposite to each other, than result of NPV is selected.

Therefore problem is arising between NPV and IRR in that case organisation follow NPV results. Otherwise both methods are good and mostly these two NPV and IRR are used.

Problem solving:As the problem given by Jones Plc. company there is a requirement of using current methods to analyse competing investment project in the public and private and make justifiable decisions. Company is in year of 2005 & use the data give in case.

The data’s of TransportExpress Plc. and Semicon Pvt. are given below:

Year Expected Cash FlowsTransportExpress Plc. Semicon Pvt.

2005 -100 (Out Flow) -100 (Out Flow)2006 50 102007 40 302008 30 402009 10 65

Note: 1. Amount in millions of pounds.2. Cash flows are discounted at cost of capital of 10%.

As per above discussion company has to use NPV and IRR method because these two methods are more acceptable in current scenario.



Using NPV method for TransportExpress Plc.: Year CFAT PV factor at 10 % PV of cash inflows2005 -100 (Out Flow)2006 50 .909 45.452007 40 .826 33.042008 30 .751 22.532009 10 .683 6.83

Total = 130 Total = 107.85NPV = PV of cash inflows – Outflows

NPV = 107.85 – 100 = 7.85

As per project acceptance/rejection criteria is concern, if NPV is positive than project will be accepted.

Therefore NPV = 7.85 which is positive so, this project will be accepted as per NPV method.

Using IRR method for TransportExpress Plc.: Fake PBP = Total cash outflow/Average CFAT

Average CFAT = 130/4 = 32.5

So, FPBP = 100/32.5 = 3.077

The PV factor closes to 3.077 against 4 years as per annuity table A-4 are 3.1024 (11%) and 3.0373 (12%). It is better to take between 10% - 13% so, that result will be perfect.

Let calculate PV of CFAT at 10% and 13%.

Year CFAT PV factor at 10 %

PV of cash inflows

PV factor at 13 %

PV of cash inflows

2005 -100 (Out Flow)2006 50 0.909 45.45 0.885 44.252007 40 0.826 33.04 0.783 31.322008 30 0.751 22.53 0.693 20.792009 10 0.683 6.83 0.613 6.13

Total = 130 Total = 107.85 Total = 102.49



Since, IRR = Lower PV factor + (difference between PV of cash inflow with lower rate and outflow/difference between PV of inflows) * Difference between PV factor rate.

IRR = 10% + (107.85-100/107.85-102.49) *

IRR = 10% + (7.85/5.56) * 3 = 10% + (1.412) * 3

IRR = = 10% + 4.236 = 14.236%

As per project acceptance/rejection criteria is concern, if IRR is greater than COC then, project will be accepted.

Therefore IRR = 14.236 % which is greater than COC.

Here, IRR > COC so, this project will be accepted.

Conclusion for TransportExpress Plc.:

For TransportExpress both NPV and IRR gives positive result. Therefore it is better to invest in TransportExpress.

Using NPV method for Semicon Pvt.:Year CFAT PV factor at 10 % PV of cash inflows

2005 -100 (Out Flow)2006 10 .909 9.092007 30 .826 24.782008 40 .751 30.042009 65 .683 44.395


NPV = 108.305 – 100 = 8.305





Using IRR method for Semicon Pvt.:Fake PBP = Total cash outflow/Average CFAT

Average CFAT = 145/4 = 36.25

So, FPBP = 100/36.25 = 2.759




PV of cash inflows PV factor at 18 %

PV of cash inflows

2005 -100 (Out Flow)2006 10 0.877 8.77 0.847 8.472007 30 0.769 23.07 0.718 21.542008 40 0.675 27 0.609 24.362009 65 0.592 38.48 0.516 33.54

Total = 145 Total = 97.32 Total = 87.91Since, IRR = Lower PV factor + (difference between PV of cash inflow with lower rate and outflow/difference between PV of inflows) * Difference between PV factor rate.

IRR = 14% + (100-97.32/97.32-87.91) * 4 = 14% + (2.68/9.41) * 4

IRR = 14% + (0.285 * 4) = 14% + 1.139 = 15.139%

Therefore IRR = 15.139 %


Therefore IRR = 15.139% which is greater than COC.


Conclusion for Semicon Pvt.: For Semicon Pvt. both NPV and IRR gives positive result. Therefore it is better to invest in Semicon Pvt.



Conclusion: As expected cash flows are concern, here NPV and IRR both give positive

results for both TransportExpress Plc. and Semicon Pvt. Companies. But Jones Plc. has to choose only one company to invest 100 million pounds. As per comparison of TransportExpress Plc. and Semicon Pvt. and according to selection/rejection criteria, Semicon Pvt. has higher NPV and IRR.

Therefore Jones Plc. has to invest 100 million pounds in Semicon Pvt.

Pass Criteria P2.2:It is understood that Jones Plc. has to invest 100 million pounds in one of the companies named TransportExpress Plc. and Semicon Pvt. Company has to select appropriate and relevant financial information for use in the process of making strategic decisions on investment.

Let discuses all topics related with appropriate financial information. Started with Appraisal Techniques or Capital Budgeting.

Appraisal Techniques:Appraisal technique is the process of making long term investment decisions. It is decision-making process that enables a company to evaluate the viability of a long-term project and whether it is worth undertaking or not.

In other words Appraisal techniques or Capital budget is also a plan of proposed outlines for adopting long-term assets and includes the means for financing the purchase of company or acquisition.

Basically there are two type of appraisal techniques these are given below:

1. Traditional methoda) Payback Period (PBP) methodb) Average Rate of Return (ARR) method

2. Discounted cash method or non traditional methoda) Net Present Value (NPV) methodb) Internal Rate of Return method (IRR) andc) Profitability Index (PI). Method

Total there are five methods. Details about these five methods are given in page no. 8 to 16.



Rest of the important things have discussed here.

Capital Budgeting and Estimating Cash Flows:There are few points which are:

The Capital Budgeting Process Generating Investment Project Proposals Estimating Project “After-Tax Incremental Operating Cash Flows

The Capital Budgeting Process:

Generate investment proposals consistent with the firm’s strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform postaudits for

completed projects.

Classification of Investment Project Proposals:

New products or expansion of existing products Replacement of existing equipment or buildings Research and development Exploration Other (e.g., safety or pollution related)

Screening Proposals and Decision Making:

Section Chiefs Plant Managers VP for Operations Capital Expenditures Committee President Board of Directors



Estimating After-Tax Incremental Cash Flows: Basic characteristics of relevant project flows:

Cash (not accounting income) flows Operating (not financing) flows After-tax flows Incremental flows

Principles that must be adhered to in the estimation are:

Ignore sunk costs Include opportunity costs Include project-driven changes in working capital net of spontaneous changes in current

liabilities Include effects of inflation

Tax Considerations and Depreciation: Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.

Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS).

Depreciable Basis: In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over time for tax purposes.

Depreciable Basis = Cost of Asset + Capitalized Expenditures

Capitalized Expenditures: Capitalized Expenditures are expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred.

Sale or Disposal of a Depreciable Asset:

Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells for more than book value) or capital loss (asset sells for less than book value). Often historically, capital gains income has received more favorable U.S. tax treatment than operating income.



Corporate Capital Gains / Losses:

Currently, capital gains are taxed at ordinary income tax rates for corporations. Capital losses are deductible only against capital gains

Calculating the Incremental Cash Flows:

Initial cash outflow -- the initial net cash investment. Interim incremental net cash flows -- those net cash flows occurring after the initial cash

investment but not including the final period’s cash flow. Terminal-year incremental net cash flows -- the final period’s net cash flow.

Risk and Managerial (Real) Options in Capital Budgeting:There are various options to in appraisal techniques these highly effected with:

The Problem of Project Risk Total Project Risk Contribution to Total Firm Risk: Firm-Portfolio Approach Managerial (Real) Options

Total Project Risk: Projects have risk that may change from period to period. Projects are more likely to have continuous, rather than discrete distributions.

Probability Approach: A graphic or tabular approach for organizing the possible cash-flow streams generated by an investment. The presentation resembles the branches of a tree. Each complete branch represents one possible cash-flow sequence.

Basket Wonders is examining a project that will have an initial cost today of 100 million pounds. Uncertainty surrounding the first year cash flows creates three possible cash-flow scenarios in Year 1.

Project NPV Based on Probability Tree Usage: The probability tree accounts for the distribution of cash flows. Therefore, discount all cash flows at only the risk-free rate of return.

NPV = total no. of years (NPVi) (Pi)

The NPV for branch i of the probability tree for two years of cash flows is

NPVi = CF1/ (1+Ri)1 + CF2/(1+Ri)2 - ICO



Simulation Approach: An approach that allows us to test the possible results of an investment proposal before it is accepted. Testing is based on a model coupled with probabilistic information.

Factors we might consider in a model:

Market analysis: Market size, selling price, market growth rate, and market share

Investment cost analysis: Investment required, useful life of facilities, and residual value

Operating and fixed costs: Operating costs and fixed costs

Each proposal will generate an internal rate of return. The process of generating many, many simulations results in a large set of internal rates of return. The distribution might look like the given graph.



Contribution to Total Firm Risk: Firm-Portfolio Approach Combining projects in this manner reduces the firm risk due to diversification.


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Managerial (Real) Options: Management flexibility to make future decisions that affect a project’s expected cash flows, life, or future acceptance.

Project Worth = NPV + Option(s) Value

Expand (or contract) : Allows the firm to expand (contract) production if conditions become favorable (unfavorable).

Abandon : Allows the project to be terminated early. Postpone: Allows the firm to delay undertaking a project (reduces uncertainty via new

information).

As discussed Jones Plc or any other company has many type of option to select appropriate and relevant financial information for using in the process of making strategic decisions on investments. At last company has to collect all available data regarding investment and forecast the future of the investment by using given techniques in above discussion. After these calculations and analysis Jones Plc. or any company is able to make easy effective strategic decisions.



Pass Criteria P2.3:As per appraisal techniques, NPV and IRR are most common techniques which is used by many companies and it is proved above that these two methods are the best current appraisal methods. Here expected cash flow and actual cash flow both are required.

Expected cash flow calculaton: Expected cash flow is already calculated in Pass Criteria P2.1 so, that result of expected cash flow can be taken from above calculation. Therefore as expected cash flow is concern the results are as follows:

Results for TransportExpress Plc.:

NPV method for TransportExpress Plc.:As per project acceptance/rejection criteria is concern, if NPV is positive than project will be accepted.

Here, NPV = 7.85


IRR method for TransportExpress Plc.:Here, IRR = 14.236 %





For TransportExpress both NPV and IRR gives positive result. Therefore it is better to invest in TransportExpress.

Results for Semicon Pvt.:

NPV method for Semicon Pvt.:As per project acceptance/rejection criteria is concern, if NPV is positive than project will be accepted.



Here, NPV = 8.305


IRR method for Semicon Pvt.:Here, IRR = 17.204 %




Conclusion for Semicon Pvt.:

For Semicon Pvt. both NPV and IRR gives positive result. Therefore it is better to invest in Semicon Pvt.

Conclusion as per expected cash flow: As expected cash flows are concern, here NPV and IRR both give positive results. But Jones Plc. has to choose only one company to invest 100 million pounds. As per comparison of TransportExpress Plc. and Semicon Pvt. according to selection/rejection criteria, Semicon Pvt. has higher NPV and IRR.


Now, for final conclusion calculations as per actual cash flow must be calculated. Let calculate the results from actual cash flows. Calculations are given in next page.

Actual cash flow calculaton:As the problem given by Jones Plc. that, company there is a requirement of using current methods to analyse competing investment project in the public and private and make justifiable decisions. Company is in year of 2010 & use the data give in case.



The data’s of actual cash flow of TransportExpress Plc. and Semicon Pvt. are given below:

Year Actual Cash FlowsTransportExpress Plc. Semicon Pvt.

2005 -100 (Out Flow) -100 (Out Flow)2006 30 52007 50 302008 40 502009 10 70

Note: 1. Amount in millions of pounds.2. Cash flows are discounted at cost of capital of 10%.

As per above discussion company has to use NPV and IRR method because these two methods are more acceptable in current scenario.

Using NPV method for TransportExpress Plc.:

Year CFAT PV factor at 10 % PV of cash inflows2005 -100 (Out Flow)2006 30 .909 27.272007 50 .826 41.32008 40 .751 30.042009 10 .683 6.83

Total = 130 Total = 105.44

NPV = PV of cash inflows – Outflows

NPV = 105.44 – 100 = 5.44





Using IRR method for TransportExpress Plc.:Fake PBP = Total cash outflow/Average CFAT

Average CFAT = 130/4 = 32.5

So, FPBP = 100/32.5 = 3.077




PV of cash inflows

PV factor at 15 %

PV of cash inflows

2005 -100 (Out Flow)2006 30 0.926 27.78 0.870 26.12007 50 0.857 42.85 0.756 37.82008 40 0.794 31.76 0.658 26.322009 10 0.735 7.35 0.572 5.72

Total = 130 Total = 109.74 Total = 95.94

Since, IRR = Lower PV factor + (difference between PV of cash inflow with lower rate and outflow/difference between PV of inflows) * Difference between PV factor rate.

IRR = 8% + (100-109.74/109.74-95.94) * 7

IRR = 8% + (9.74/13.8) * 7 = 8% + (0.706) * 7

IRR = 8% + 4.941 = 12.941%


Therefore IRR = 12.941 % which is less than COC.

Here, IRR < COC so, this project will be rejected.




For TransportExpress both NPV gives positive result and IRR gives negative result. Therefore here problem will arias. But as per above discussion about best method between NPV and IRR, NPV is more acceptable. For comparison between NPV and IRR please refer page no. 16 of this report. Hence NPV gives positive results the project will be selected and is better to invest in TransportExpress.

Using NPV method for Semicon Pvt.:Year CFAT PV factor at 10 % PV of cash inflows

2005 -100 (Out Flow)2006 5 .909 4.5452007 30 .826 24.782008 50 .751 37.552009 70 .683 47.81


NPV = 114.685 – 100 = 14.685



Using IRR method for Semicon Pvt.:Fake PBP = Total cash outflow/Average CFAT

Average CFAT = 155/4 = 38.75

So, FPBP = 100/38.75 = 2.581

The PV factor closes to 2.581 against 4 years as per annuity table A-4 are 2.589 (20%) and 2.540 (21%).



Now calculate PV of CFAT at 13% and 20%.


PV of cash inflows

PV factor at 21 %

PV of cash inflows

2005 -100 (Out Flow)2006 5 0.833 4.165 0.826 4.132007 30 0.694 20.82 0.683 20.492008 50 0.579 28.95 0.564 28.22009 70 0.482 33.74 0.467 32.69

Total = 145 Total = 87.675 Total = 85.51Since, IRR = Lower PV factor + (difference between PV of cash inflow with lower rate and outflow/difference between PV of inflows) * Difference between PV factor rate.

IRR = 19% + (100-89.96/89.96-83.38) * 3 = 19% + (10.04/6.58) * 3

IRR = 19% + (1.526) * 3 = 19% + 4.578 = 23.578%

Therefore IRR = 23.578 %




Conclusion for Semicon Pvt.:

For Semicon Pvt. both NPV and IRR gives positive result as per acceptance/rejection criteria. Therefore it is better to invest in Semicon Pvt.

Conclusion: As actual cash flows are concern, here NPV and IRR both give positive results. But Transport Express Plc. has contradiction between NPV and IRR as that situation NPV result is accepted. Also in Semicon Pvt. both NPV and IRR gives higher positive results. So, Semicon Pvt. is the best company to invest 100 million pounds. As per comparison of TransportExpress Plc. and Semicon Pvt. according to selection/rejection criteria, Semicon Pvt. has higher NPV and IRR.




Recommendations:Recommendations based on a post – audit appraisal on the appropriateness of selected project decisions. Here calculation is done by both expected cash flow and actual cash flow. In expected cash flow the result shows the Jones Plc. has to invest in Semicon Plc. and actual cash flow also give same result. It is common to take result on actual bases. Here actual data is available so company has to believe in actual cash flow results. However in all phases the result in favour of Semicon Plc.

Hence all criteria are cleared by Semicon Plc. Therefore Jones Plc. has to invest their 100 million pounds in Semicon Plc.

Abbreviations:R&D Research and Development ICO Initial Cash OutflowARR Average Rate of Return TVM Time Value of MoneyNPV Net Present Value IRR Internal Rate of ReturnPV Present Value COC Cost of CapitalCF Cash flow DCF Discounted Cash FlowCFAT Cash Flow after Tax FPBP Fake Payback PeriodPlc. Public Company Pvt. Private Company

Bibliography:

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Journal, pp.C1-C19, May 18, 2001

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186152904X3. Harris R — Applied Time Series Modelling and Forecasting (Wiley, 2003) ISBN: 04708444344. Lumby S and Jones C — The Fundamentals of Investment Appraisal (Thomson Learning, 2000)

ISBN: 18615260755. Makridakis S et al — Forecasting, Third Edition (Wiley, 1998) ISBN: 04715323396. Pettinger R — Investment Appraisal: A Managerial Approach (Palgrave Macmillan, 2000) ISBN:

03338005917. White G I — The Analysis and Use of Financial Statements (Wiley, 2003) ISBN: 074142918X

Website visited:

1. http://www.venturechoice.com/articles/average_rate_of_return.htm accessed on 12th April, 2010.

2. http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_decisions.htm accessed on 12th April, 2010.

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