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Key Topics
- Requirement
- Solution
- Introduction
- Importance of investment appraisal process
- Cash flow techniques
- Discounting cash flow technique
- Traditional technique
- Determining the cash flows of the project
- Criticisms of the methods used in the investment appraisal process
- Critical review of the logic behind the decision-making process
- Conclusion
- References
Requirement
Investment Proposal Assignment
Solution
Introduction
Investment proposal is generally prepared for the prospective investors or lenders who can invest in a particular project of a firm, and the sponsor of the project or the management of the company makes the investment proposal. By looking at the proposal, the investors can understand the project or the company's value and they can determine their return on investments from that project. So, it helps them to take the decision that whether they have to invest in that project or not.
Random House is one of the largest trade books of general interest in the world. In 2013, it became the part of the Penguin Random House, and a German and Britain publishing company owned it jointly. It is an International listed company within the textbook publishing industry. The aim of this report is to advise the company on how it can improve its shareholder's wealth. For this, the relevant concepts of financial management related to a new product investment proposal are considered. In the current report, an investment proposal is developed for the company for 6 years for the new product line, which is done by using one of the discounted cash flow techniques as well as one traditional technique.
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Importance of investment appraisal process
Investment appraisal is the process of planning by a company in which it determines that whether the long-term investments that the company is planning to undertake like the purchase of new machine, replacing the old machine, entering into new products, etc. are worth funding of cash through the capitalization structure of the firm or not (Arnold, 2014). When a company plans to get started, it plans to invest in a new venture or ongoing business, it basis its decision on the process of investment appraisal. There are many reasons that why the companies undertake such appraisal.
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1. One is that when the investment is made in long-term assets, the company commits its substantial resources in that. The investment appraisal process helps in revealing the general feasibility of the project like the projected cash flows, profits, etc. All this is done by analyzing the net present value that gives an idea to the potential investor that what will be the probable profitability from the particular project, both in the short run and long run.
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2. Second is that there are alternatives to the proposed investment, and when a potential investor decides to invest or not invest in a project, it evaluates the project and ranks it in relation to the available alternatives. By comparing, one can know that which is the most profitable investment and hence the most feasible and fruitful project can be sponsored.
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3. Third is that the assessment of the capital resources is very important in this process. By analyzing the capital resources, one can know that how much capital is required initially and how much capital may be needed additionally (Bierman, 2012). So, as the project will move ahead, it can be determined that whether the investment is feasible using the available capital resources or not.
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4. Specific values are required to be assigned to the rate of inflation, the regulatory costs, and other factors while projecting the discounted cash flows over a period of time because they are uncertain. The investment appraisal process considers these variables and a realistic model is provided that consists of the risk assessments.
Thus, the investment appraisal process is an important part of the investment proposal and helps the investors take the decision regarding the investment in a particular project or company.
Cash flow techniques
The cash flow statement of any company tells the way by which a company spends its money i.e. what and how the cash outflow of the company is happening and also, what is the source from which the money of a company is coming in, i.e. the source of cash inflow (Baum, 2014). By analyzing the cash flow of a company, the investors can identify the current financial state of the business of a company and the position of the company in future. This makes them decide that whether the company has present and future potential to give returns or not.
Discounting cash flow technique
Discounting means that the value of a future amount is found or determined. Generally, the investors and the companies use this technique for evaluating the project and choosing it because this is one of the most objective techniques of the cash flow. In this method, the cash flows are discounted to the present values and hence the differences in the time periods are isolated for different projects. Within the periods of the project’s life, the magnitude and the duration of the expected cash flows are considered in this technique. Thus, the decision to accept or reject the proposal is based on the ‘net present value (NPV) which is a discounting technique. When the present cash inflow is subtracted from the present cash outflow, the net present value of the project is arrived at. The following equation helps in calculating the NPV:
In the above equation, the cash flows of the project are represented as A1, A2, A3 and so on till An. The cost of capital of the company is ‘K. but, there are some assumptions of this method: the investors consider the investment horizon of the investment projects as equal. For discounting the expected cash flow, the appropriate rate is 10%. On treating the level of risk equally, the return that shareholders receive is not more than 10%.
NPV is an important discounting cash flow technique because by using it, the time value of money can be determined. It also helps in determining the cash flows of the entire life of the project. The shareholder’s wealth can be maximized if the NPV is known by the company. Basically, the extent to which a project is profitable can be analyzed using this technique of discounting. The investors have to invest in periods and the cost and benefit of each of the investment period or the project period can be known by using this discounting technique. Investors prefer to use it for taking their decisions because when they calculate it, they can know that what is the profit or loss associated with that project and accordingly they can plan their investment.
The NPV can be positive or negative. When it is positive, the project is profitable, and the negative NPV depicts loss in the project. Hence the investors look for a positive NPV in their proposals. When the investors have to appraise the time value for many in the long term projects, they use this method as this is the standard method for calculating that. When some investment is made, or the returns are obtained (Yuen, 2013), there is always a difference in the present and the future value of that amount. The concept of time value of money makes this difference, and it means that the value of money that is there today may not be same tomorrow. For example, $100 may buy you a cell phone today, but it may not even buy a cell phone cover after 10 years. This means that the value of $100 declines with time. This value changes due to the factors like rate of inflation, uncertainty, and the opportunity cost.
Traditional technique
In this technique, the Payback period is calculated that determines the time which is required for recovering the initial investment that the investors makes in a project. Break-even point is determined for the project in the traditional technique of payback period (Mousavi, 2013). The investors can find out that how long the project will take to pay them. The recovering period of the project can be measured using the payback period. This tool helps in comparing the investment to not doing anything of the project. This is calculated as:
In the above formula, the number of years after the initial investment is represented by Ny and the value of the cumulative cash flow is ‘n’. The first value of the positive cash flow is the P. Here; the payback period is calculated for the initial first year. In the starting, the negative value is dropped by the cumulative cash flow and then after some point; a positive value is obtained. After calculating the sum of all the cash outflows, the cumulative positive cash outflow is calculated. Then, the cumulative positive cash flow is deducted from total cash outflow, and thus the modified payback is calculated. Though this is a traditional technique, but it is the most popular technique when the investment proposal is to be evaluated (Whitecotton, 2013). By evaluating the proposal, the investors can know in what time the initial outlay of the company will be recovered. It helps in dealing with the risk related to the investment, and also the liquidity of the project can be known by the investors.
Determining the cash flows of the project
Here, an investment proposal is developed for the company ‘Random House’ for 6 years for the new product line, which is done by using one of the discounted cash flow techniques i.e. the NPV technique as well as one traditional technique i.e. by calculating the payback period.
In the above table, the NPV is 45,323. The project is acceptable because the NPV of the project is positive and the payback period is 3 years. Thus, the investment in this is profitable, and the new product line of the Random House is worth investing into.
For expanding or replacing the project, the net present value concept is used, and the potential investors of the project can compare the net present value of various proposals available to them and can take a decision whether they have to accept the current proposal of Random house or they have to reject it. By doing this, they can calculate the time value of their money that they will invest, and the comparison can be made between the initial outflow of cash and the present value of the cash flow. If the proposals have positive NPVs and the investors are confused, then they can choose the one which has the highest net present value. That would be the most profitable one.
Criticisms of the methods used in the investment appraisal process
The first method which is used here is the net present value method. In this method, the opportunity cost is not taken into account by the formula and the investors. They cannot know that if they are rejecting some proposal for accepting some other proposal, then what opportunity cost do they bear. Also, there are some realistic issues that are associated with the net present value method (Orsag, 2013). The calculation of taxes are not done in it, the rate if inflation is not accounted for, fluctuations in the rate of exchange is also not determined, the hedging cost and the small time buckets are not considered, etc. Thus, for these reasons, the net present value is criticized by the company and the investors.
The second method which is used here is the payback period method which is the traditional method. Here, the time value of money is not considered along with some other important factors like the financing, risk, etc. the projects cannot be compared like in the NPV. Then, unlike the NPV method, the investors cannot determine the cash inflows that they will get from the investment in the project (Driessen, 2014). Hence they cannot determine their profits that they will get from their investment. Thus, for these reasons, the payback period is criticized by the company and the investors.
Critical review of the logic behind the decision-making process
The value that the project adds to the company is shown by the net present value method. When the net present value method is positive, the project gets more inflows in cash than the outflows, and when the net present value method is negative, the project has more outflows in cash than the inflows. Thus, the investors and the companies accept the project whose net present value method is positive. This is because they obviously want to get more inflow than the outflow and earn profits. It is indicated by the net present value that the anticipated cost of the project is less than the project earnings (Götze, 2015). Sometimes, the investors face a situation in which the net present value of all the proposals is positive, and then they face difficulty in selecting the proposal. So, they take that one in which the net present value is the maximum. This is because they more net present value means more profits from the same investment.
On the other hand, the decision regarding the payback period is taken on the basis of the time in which the initial outlay of the investment gets covered. The less time is taken for repaying the investment, more profitable is the project. The investors decide to accept the proposal when the payback period is short, and they reject the proposal when the payback period is long. This is because; they don’t want to keep their investments locked up for a long time. The amount of funds that they invest is huge and thus they need to commit them for a longer time if the payback period is very long (Pinho, 2015). This is how the logic behind the decision-making process works.
Conclusion
The investment proposal is made so that the company can raise funds for its projects. There is extremely important information which is included in the investment proposal that helps the investors and the stakeholders to take decisions regarding the investments. The main reason for making this proposal is to attract the investors for investing in the company or the project so that they can also reap the benefits of the new project by earning higher returns. There are two sections in it that contain the descriptive information about the project and the financial information about the project. The history and the background information about the company is contained in the descriptive section and the return on investment, financial aspects, etc. are contained in the financial information section. The investors have to commit the huge amount of funds with the company. Hence they have to evaluate the condition of the company and the inflows and outflows of the company in a very careful manner. They just cannot let their funds go waste as there are a number of proposals that are available to the investors for investment, and they evaluate each of them before taking the final decision of investment. The decision to accept or reject the proposal is based on the ‘net present value (NPV) and payback period method. When the present cash inflow is subtracted from the present cash outflow, the net present value of the project is arrived at. NPV is an important discounting cash flow technique because by using it, the time value of money can be determined. It also helps in determining the cash flows of the entire life of the project. The Payback period is calculated that determines the time which is required for recovering the initial investment that the investors makes in a project. When the net present value method is positive, the project gets more inflows in cash than the outflows, and when the net present value method is negative, the project has more outflows in cash than the inflows. Thus, the investors and the companies accept the project whose net present value method is positive. On the other hand, the decision regarding the payback period is taken on the basis of the time in which the initial outlay of the investment gets covered. The less time is taken for repaying the investment, more profitable is the project. In the above company, the NPV is 45,323. The project is acceptable because the NPV of the project is positive and the payback period is 3 years. Thus, it can be concluded that the investment in this is profitable, and the new product line of the Random House is worth investing into.
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Arnold, G., 2014. Corporate financial management. Pearson Higher Ed.
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Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.
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Baum, A.E., and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.
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de Pinho, P.S., 2015. Investment proposal for a private equity fund: A buy-and-build of optical retailers (Doctoral dissertation, NOVA–School of Business and Economics).
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Driessen, J., Lin, T.C. and Phalippou, L., 2012. A new method to estimate risk and return of nontraded assets from cash flows: the case of private equity funds. Journal of Financial and Quantitative Analysis, 47(03), pp.511-535.
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Götze, U., Northcott, D. and Schuster, P., 2015. Discounted Cash Flow Methods. In Investment Appraisal (pp. 47-83). Springer Berlin Heidelberg.
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Mousavi, S.M., Hajipour, V., Niaki, S.T.A. and Alikar, N., 2013. Optimizing multi-item multi-period inventory control system with discounted cash flow and inflation: two calibrated meta-heuristic algorithms. Applied Mathematical Modelling, 37(4), pp.2241-2256.
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Orsag, S. and McClure, K.G., 2013. Modified net present value as a useful tool for synergy valuation in business combinations. UTMS Journal of Economics, 4(2), p.71.
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Yuen, R.W.P., 2013. Project Evaluation Methods. Hong Kong Securities and Investment Institute Knowledge Portal.
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Whitecotton, S., Libby, R. and Phillips, F., 2013. Managerial accounting. McGraw-Hill Higher Education.
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