Investment Appraisal Techniques

Acceptance of a bid or start of a new project by any firm requires many critical things to be analysed first. The technique used commonly by every firm to analyse new projects are investment appraisal techniques. Investment appraisal techniques are the techniques to evaluate the project to be undertaken, its viability and profitability with respect to the investment to be made in the project. The project can be a long term or a short term project. Before starting or investing in a project, a detailed analysis of the project is necessary in order to gain from the project. While analysing the project many critical parts are required to be given importance to. The technique is advantageous as it allows the firms to estimate the long term viability of the project. The important factors that are considered here are the investment in new plant and machinery, cash flows that will be generated over years from the project, property related decisions, projects on research and development and advertising campaigns.
There are many techniques used for the purpose of Capital Investment Appraisal. Some of the techniques used are as follows:
Net Present Value
Accounting Rate of Return
Internal Rate of Return
Modified Internal Rate of Return
Adjusted Present Value
Profitability Index
Equivalent Annuity
Payback Period
Discounted Payback Period
Real Option Analysis
The most commonly used technique to evaluate the project is the Net Present Value. NPV is the technique where the cash flows of the projects are estimated and they are compared with the initial investment to be made in the project at the start of the year. Proper discounting rate is used for the purpose of evaluating the project and assumptions are also made while evaluating the project. The project or an investment plan is given assent when the NPV of the project is positive. The project with positive NPV is accepted as the cash flows or the revenues which will be generated in long term recovers the initial cost of the project and the firm ends up making profit with positive NPV. The technique of NPV is the most reliable technique among all other techniques of investment appraisal. Every technique has its own advantages as well as disadvantages. It may also happen that one technique of investment appraisal may suggest different project and other technique also suggest different project. The key determinants for the NPV technique are the duration of the project, discounting rate of the project and the estimates of costs and benefits.
The major assumptions made while using the NPV techniques are as follows.
All the cash flows that are generated every year occur at the end of the period.
Another assumption is that the cash flows occurred at the end of the year are re-invested at the project’s discounting rate of return.
Net present value is used with assumptions and available information like cash flows, discounting rate and investment to be made. NPV allows the firm to estimate the cash flow which is not 100% accurate. It does not fully take into account the opportunity cost of choosing the project. For example, it may happen that after starting with the project based on NPV technique, it may happen that there comes a more advantageous opportunity for the firm which can’t be taken used now. So, this technique doesn’t take into account the future investment opportunities. Another disadvantage of the project is that it doesn’t provide the investor with the true and correct picture of the gain or loss. There is always a kind of uncertainty involved in the project being analysed.
The bid in the given assignment is analysed using the NPV technique being the most reliable technique of investment appraisal.

Analysis of the Bid

The firm is in the running of a new ESA contract which would earn the firm at least revenue of 1.5$ million if the bid is accepted. The contract is a long term fixed contract of 5 years. It involves supply of high-tech optical component for a continuous period of 5 years. 10 units of component would be supplied to the agency every year for 5 years and the selling price of the component would be 300000$. According to the estimates made by the team, the selling price set is a very competitive price and it is less likely to make any better offer.
If the bid of B & P Limited is accepted by ESA, it would commit the firm a long term fixed price contract. The initial investment required to be made in the project would be 1.5$ million for the purpose of purchasing the machinery and for refurbishment of the plant which is not used now by the firm situated in Great Yarmouth.
The information useful for the purpose of evaluating the project is given as follows:
The plant in Great Yarmouth was depreciated fully in the books of the firm except for the value of the land which is 10,000$.
The land on which the plant stands was purchased for 10,000$ but it has now the value of 600,000$ due to its proximity to a reasonably high end shorefront development area.
Refurbishment of the plant would require an initial investment of 500,000$ which would be depreciated on a straight line method and the tax rate applicable to the firm is 35%.
The new machinery to support the refurbished plant would cost the company 10,00,000$, which would be depreciated on a straight line basis for a period of 5 years.
The studies of the market revealed that the refurbished plant and machinery being highly customised for the project would not earn the firm a second hand value after the project is completed. Hence, the salvage value estimated at the end of 5 years for the plant and machinery to be used in the project would be zero.
It is forecasted by the firm that the cost of goods sold would include fixed cost of 300,000$ every year. Moreover, variable cost of 180,000$ per unit is also forecasted which would have an inflation rate of 4% every year.
Working capital of the project would be 10% of sales at the start of production. The working capital of the project will be recovered at the end of the projct duration.

Analysis of the above information

Initial investment in the project would be 15,00,000$ which would be depreciated over a period of 5 years on a straight line basis. Working capital would also be considered while computing initial investment.
The cost of the land purchased is not useful while evaluating the project as it is sunk cost which has already been incurred. However, if the project is not undertaken the firm could have sold the land on which the plant stands for the amount of 600,000$. Therefore, this would be considered as an opportunity cost and it will be included in cost of first year.
If the firm had salvage value it could have been included in revenue of the last year, but as the firm had no salvage value, it will be ignored while estimating the cash flows of the project.
Fixed cost is the cost which is going to be incurred irrespective of the acceptance of the project. Hence, it is ignored while estimating the cash flows. Only those expenditures which will be incurred if the project is accepted are considered while estimating cash flows. Fixed cost would be incurred even if the project is not accepted.
Working capital is the basic requirement of the project to start with. Business can’t be conducted without working capital. Working capital is the capital used for day to day expenditure of the business. Hence, every year 10% of sales would be required for working capital and the working capital invested in the project would be recovered at the end of 5th year.
The discounting rate of the project is 12%. Tax rate applicable to the firm is 35% and the depreciation method used by the firm is straight line method.
Financial Analysis of the Bid

Explanation:-

It is given that the selling price of the component would be 300,000$ and every year 10 components would be supplied. Hence, the revenue every year would be 30,00,000$.
Variable of producing one unit is 180,000$. So, total variable cost of producing and supplying 10 units would be 18,00,000$ which would increase by 4 % every year as inflation rate is 4%.
Fixed cost is not considered here as it is irrelevant from the view point of the project.
Depreciation has been considered here although it is non-cash expense as firm would have the advantage of tax relief on the amount of expenditure. Later on, the depreciation has been added up to calculate cash flows as it is non-cash expense and company will not actually incur the expenditure.
To find out total cash flows, working capital which will be recovered at the end of the project life is added up. The cash flows are discounted using the discounting rate to calculate the discounted cash flows.
Total discounted cash flow for 5 years is 28,79,379.35$.
Calculation of Initial Investment
Refurbishment of the plant-500,000$
New plant & machinery-10,00,000$
Working capital-300,000$
Opportunity cost-600,000$
Total initial investment in the project would be 24,00,000$.
Working capital would only be required in the beginning as there is no increase in sale and the revenue is same throughout the project life. Opportunity cost is considered in the beginning as it is relevant for the project.
Net Present Value
NPV=PV of Cash inflows-PV of Cash Outflows
NPV=28,79,379.35-24,00,000
NPV=479,379.35$
The NPV of the project is positive. Hence, the firm should accept the project. Positive NPV as discussed above shows that the initial investment made in the project would be recovered. Moreover, the firm would make profit over and above the initial investment. Although, NPV does not accurately forecast the profit from the project, it almost gives the idea about profitability of the project.
In addition to the NPV technique, firm should use sensitivity analyses to forecast the cash flows. Sensitivity analyses involve analyses of the cash flows after considering the risk actor. Many a times it happens that the cash flows although projected with accuracy, due to certain circumstances the cash flows vary or the production cost increases or the cost of plant may go up. Therefore, after considering the possibilities of variation in cash flows, companies conduct sensitivity analyses to find out the cash flows if the possibilities thought about prove to be true.
Another technique to consider the risk factor in cash flows is the risk adjusted NPV method, wherein the cash flows are adjusted with risk factors which are co-efficient of determinants. Higher the risk, higher are the co-efficient of determinants and lower would be the discounting rate.

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References

ANON, N.D., “Capital Investment Appraisal”, Accessed on 1st December 2015,
ANON, N.D., “Capital Investment Appraisal”, Accessed on 1st December 2015,
ANON, N.D., “Disadvantages of NPV”, Accessed on 1st December 2015,
ANON, N.D., “Net Present Value Method”, Accessed on 1st December 2015,
ANON, N.D., “Assumptions of NPV Method”, Accessed on 1st December 2015,
ANON, N.D., “Advantages And Disadvantages of NPV Method”, Accessed on 1st December 2015,
ANON, N.D., “Capital Investment Appraisal Techniques”, Accessed on 1st December 2015,
ANON, N.D., “Capital Investment Appraisal Techniques”, Accessed on 1st December 2015,

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