As the financial manager of your company, you have a total investment budget of 80,000 pounds to

work with, and you are responsible for evaluating the following five investment projects:
Life of Annual Fixed
project Initial Annual costs cash
Project
in Investment Revenue outflows
years
Project 1 3 20,000 40,000 10,000
Project 2 5 60,000 60,000 20,000
Project 3 4 30,000 36,000 12,000
Project 4 10 24,000 34,000 16,000
Project 5 15 36,000 16,000 4,000

The variable costs, as cash outflows, are 40% of the annual revenues and the cash flows are
confined to within the lifetime of each project. Assume that there is no inflation or tax. It is
also given that Project 4 and Project 5 are mutually exclusive and the cost of capital 10%.

Required:

1) What is the optimal allocation of the £80,000 available for investment to these projects and
what is the maximum net present value that will be achieved?

2. Discuss the advantages and disadvantages of the main investment appraisal methods and
explain which method a company should use and why.

In this report should demonstrate your knowledge and understanding and your own personal
critical reflection, using your skill at reasoning. You are also expected to use some academic
literature to support your discussion.

ANSWER

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 Annual
Life of Initial Annual
Fixed costs
Project project
in years Investment Revenue cash
outflows VC TC PROFIT
Project
3 20,000 40,000 10,000
1 16000 26,000 14,000
Project
5 60,000 60,000 20,000
2 24000 44,000 16,000
Project
4 30,000 36,000 12,000
3 14400 26,400 9,600
Project
10 24,000 34,000 16,000
4 13600 29,600 4,400
Project
15 36,000 16,000 4,000
5 6400 10,400 5,600

PROJECTS PRESENT VLAUES AND CASH FLOWS

1 2 3 4 5
YEAR FACTO
S R 10% CF PV CF PV CF PV CF PV CF PV
- - - - - - - - - -
2000 2000 60,00 6000 3000 3000 2400 2400 3600 3600
0 1 0 0 0 0 0 0 0 0 0 0
1400 1272 16,00 1454
1 0.9091 0 7 0 5 9600 8727 4400 4000 5600 5091
1400 1157 16,00 1322
2 0.8264 0 0 0 3 9600 7934 4400 3636 5600 4628
1400 1051 16,00 1202
3 0.7513 0 8 0 1 9600 7213 4400 3306 5600 4207
16,00 1092
4 0.683 0 8 9600 6557 4400 3005 5600 3825
16,00 9934.
5 0.6209 0 7 4400 2732 5600 3477

6 0.5645 4400 2484 5600 3161

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 7 0.5132 4400 2258 5600 2874

8 0.4665 4400 2053 5600 2612

9 0.4241 4400 1866 5600 2375

10 0.3855 4400 1696 5600 2159

11 0.3505 5600 1963

12 0.3186 5600 1784

13 0.2897 5600 1622

14 0.2633 5600 1475

15 0.2394 5600 1341

INVESTMENT APPRAISAL

1 2 3 4 5
1481 652.5
NPV 6 9 430.708285 3036 6594.045235

IRR 49% 10% 11% 13% 13%

ARR 70% 27% 32% 18% 16%

RANK 1 4 5 3 2

CHOOSE 1 3 2
-
INVESTMEN 2000
T 0 -24000 -36000

SUM OF NPV = 14816 + 6594 + 430 = 21840

NET PRESENT VALUE

Using a concept known as net present value, or NPV, one can compute the total value of a future
stream of payments that is still in the future. This can be done by calculating the overall value of the
payments. If a project or investment has a positive net present value (NPV), it indicates that the
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discounted present value of all future cash flows related to that project or investment will also be
positive, and this is desirable because it shows that the project or investment will be profitable in the
future. This is due to the fact that a positive NPV indicates that a venture or investment will generate
a profit in the foreseeable future.
The difference between these two values can be arrived at by performing the calculation of
subtracting the present value of cash inflows from the present value of cash outflows over a
predetermined amount of time. Because its name implies, net present value is simply the difference
between the present value of cash inflows and outflows after those flows have been discounted at a
predetermined rate. This difference is calculated by subtracting the present value of cash inflows
from the present value of cash outflows.
If the return on investment (NPV) of a project is positive (greater than zero), then the company can
expect producing a profit from the project and should consider whether or not to move forward with
the investment. If the net present value of a project is equal to zero, then it is not anticipated that the
project will result in any significant gain or loss for the company.

The element referred to as "net present value" is the difference between the present value of cash
inflows and outflows over a specific period of time (NPV). The internal rate of return (IRR), often
known as the rate of return, is a metric that is used to determine the prospective profitability of
investments.
The fact that the net present value takes into account the time value of money and assists the
management of the company in making better decisions are two of its primary benefits. On the other
hand, the net present value has a number of drawbacks, including the fact that it does not take into
account any hidden costs and cannot be utilised by the company for any other purposes.

NPV provides an unambiguous measure. It does this by estimating the amount of wealth that would
be created in today's dollars as a result of the potential investment, taking into account the discount
rate. The amount of an investment is taken into account by NPV. It is applicable when contrasting
marginal forestry investments with acquisitions or projects worth multiple billions of dollars.
The majority of the time, this method arrives at the same conclusion as the NPV method.
2) The market discount rate is needed for NPV, but the cash flows from the project are what are used
for IRR.

Having said that, you will still need an estimate of the required rate of return before you can make a
final decision.
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When using NPV, one of the drawbacks is that it can be difficult to accurately arrive at a discount
rate that represents the investment's real risk premium. This is one of the challenges that comes with
using this method.

The biggest problem with the net present value method is that it requires a certain amount of
guesswork in relation to the business's cost of capital. You will make less-than-optimal investments if
you believe that the cost of capital is too cheap. You will pass up numerous excellent investment
chances if you believe that the cost of money will be too high.
RATIO INTERNAL DE RENSEIGNEMENT

The prospective profitability of different investments is calculated using a statistic known as the
internal rate of return (IRR) in the field of financial analysis. The internal rate of return (IRR) is a
discount rate that guarantees that the net present value (NPV) of all cash flows in a discounted cash
flow analysis is equal to zero. The same formula is used to determine IRR as it used to determine
NPV.
When everything is totalled up, the cash flow after taxes for each period is discounted by a certain
rate at time t. After that, the total of all of these cash flow projections is subtracted from the initial
investment, which results in an amount that is equal to the current NPV. In order to calculate the IRR,
you will first need to "reverse engineer" the problem and determine what value of r is necessary to
ensure that the NPV remains unchanged.

The rate of interest at which the net present value of all cash flows resulting from a project or
investment is the same as getting nothing. is known as the internal rate of return, abbreviated as IRR.
Cash flows, both positive and negative, are factored into IRR. It is utilised in the assessment of the
desirability of a particular investment or undertaking at any given time.
The IRR's Potential Drawbacks

It disregards the actual monetary value of investments of a comparable nature. It does not make any
comparisons between the lengths of holding periods for similar investments. It does not take into
account the possibility of eliminating negative cash flows. It gives no consideration whatsoever to the
reinvestment of cash flows that are positive.

ACCOUNTING RATE OF RETURN

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The Accounting Rate of Return, abbreviated ARR, is calculated by taking the expected annual
average net income of an asset and dividing that number by the expected annual average capital cost
of that asset. The ARR is a formula that is used to determine various aspects of capital budgeting.

The formula for calculating the ARR begins by taking the asset's average yearly revenue and dividing
that number by the asset's initial cost. The percentage rate of return is calculated by first taking this
decimal figure and multiplying it by 100. A company can get a general idea of the potential earning
power of a particular investment by looking at its accounting rate of return.

The return on an investment can be easily determined by using this straightforward method, which
takes into account the profit made from the investment.

Calculating and comprehending the payback pattern over the course of the project's economic life is a
simple endeavour.

It takes into account the sum of all profits or savings made over the course of the entire economic life
of the project.

The concept of net earnings, which refers to earnings after accounting for depreciation and taxes, is
taken into consideration by this method. In the process of evaluating a potential investment, this is a
very important consideration.

The ARR is one method of valuing investments, but it differs from other approaches in that it
prioritises profits over cash flow. It is influenced by a variety of non-cash, non-objective factors, such
as the rate of depreciation that is used to compute profits. The ARR does not take into account the
timing of a company's profits either.

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