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Investment decisions are always complex and difficult to take and execute. According to a large number of finance professionals, investment decisions are very important for the long run of the organization (Bierman, 2008). Basically the concept of finance lies on two things, one is the efficient asset allocation and second is accounting.
In Assets allocation decision firms especially the finance managers search different areas with the help of sophisticated investment appraisal techniques to allocate the funds of the company in a place from where a concrete return can be earn. There are a number of techniques are used while taking asset allocation decisions like Payback Period analysis, Net Present Value Analysis, Internal Rate of Return Analysis and Accounting Rate of Return Analysis.
The main prospective of this study is to apply these appraisal techniques on the projects and analyze which project gives higher yield than the other and which project should be undertake on that analysis.
Ski Sensation Ltd runs a dry ski slope centre in Wales. At present, snowboarders are accommodated on the main slope on particular days and times. However, the company is considering building a new slope that will be dedicated to snowboarding. The dry slope centre is built on land that has been leased from a local farmer. All of this land is currently being used to accommodate the centre, which consists of a main slope, two beginners’ slopes, a bar, a clubroom and workshop facilities. However, the farmer has agreed to lease further land to the company, which adjoins the existing land being leased, for an eight-year period Some construction work will be required, and once the construction work is complete, the hill must be covered in plastic matting for snowboarding and a water sprinkling system installed, both for lubrication purposes and to help protect the matting. The land is awkwardly situated and so a new access road and additional car parking facilities will also be required. The supplier of the matting claims that it will have to be renewed after three to five years. Ski Sensation has investigated this claim and found that two dry ski slope centers in Ireland renewed the matting at the end of four years.
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Strategic Investment Decision making practices: A Contextual approach by Chris Carr
This article which has been written by Chris Carr was an interesting one from the standpoint of a finance professional because it is the only article in which the methods like NPV and IRR have utilized and emphasized a lot as well. This article is a result of survey performed in US, UK and Japan companies.
According to Chris the companies operating in US, UK and Japan are using NPV as the superior approach to take investment appraisal decisions. IRR and Payback periods are some useful techniques used by the financial managers of the companies located in those regions. This is the only article in which the techniques applied are exactly the same which we have used in the task A. Chris had also said that the NPV approach is superior to any other technique because of its propensity to take time value of money stance in the evaluation.
In this assignment, the researcher has to restrict himself up to only four investment appraisal methods which are Payback Period, Net Present Value, Internal Rate of Return and Accounting Rate of Return. Let’s see each one under subsequent headings.
Payback Period Analysis
Before taking any investment decision, the finance manager has to calculate the cost association with that investment decision. Let say a company start to invest in a project, so the finance manager will analyze the overall cost which should be required to undertake this project. Management does not understand how much the money has spent or invest, they want only one answer which is in how many months does the cost recovers (Rachev, & Fabozi, 2008). The term recovery is called the pay back analysis. It is the analysis which apprises the management that at what time the company will cover its initial outlay from the cash inflow.
Net Present Value Analysis
A dollar earns today is more worthwhile if it is earn after a few years. Net Present Value (NPV) as define by name it is the future value in terms of present. It is the most widely used measure in investment appraisal that likes by almost all the financial managers because of its propensity to appraise the actuality of the project (Leopard & Bernstein, 1999). NPV is a vital tool in discounted coins flow (DCF) analysis, and is a model sense for with the time cherish of money to appraise long-time projects. Used for capital budgeting, and commonly throughout economics, finance, and accounting, it events the overkill or loss of notes flows, in state value terms, once financing charges are met. The discount rate used in the NPV analysis is the weighted average cost of capital (WACC) of the company which is so essential.
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Internal Rate of Return
Internal rate of return is also one of the most famous tools of Investment appraisal used by the managers. It is based on company’s WACC. The company has to undertake only that project which gives an IRR higher then the WACC of the company. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and loans the IRR is also called the effective interest rate. The interest rate or project is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR). In the context of savings and compare the profitability of investments. It is the "annualized effective compounded return rate.
Accounting Rate of Return
It is the least famous investment appraisal technique use by the managers of an organization because it does not take the provision of time value of money in consideration that is why it doesn’t like much by the finance executives. However some companies still use this for the investment appraisal purpose. This particular technique is based on the net income earned.
Let’s now apply these tools on our projects to analyze their feasibility.
Payback Period Analysis
There is a project which will be analyzed in this section. Note that this is the analysis of payback period not discounted pay back period analysis, so we have not to incorporate the discount rate in this analysis. Let see which project has the better payback period. The analysis is mentioned below,
Payback period of the project is 5 years which can be regarded as reasonable.
Net Present Value (NPV)
The same considerations have been taken into account for this analysis as well. Discount rate which would be used for the discounting purpose is 12%.
Now, see the above chart which tells a new story. The rule of NPV is that, if the Present value is above the initial outlay, then the company has to invest in it otherwise should abrogate the idea of investment. Here, the NPV comes in Zero which is a clear indication that the company should not go for the investment because the investment will actually destroy the value of the company because the amount is showing in negative.
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The ARR of the hypothetical company is -20% which shows that the project will actually destroy the value of the company and the company has to abrogate the idea of investment.
Discussion & Analysis
From the entire discussion and analysis, I as a finance director announce that the project which the company is intending to select will actually destroy the company and the company should not go for that.
As discussed earlier that this report encompasses from two different tasks, one is the calculative part which had just performed under which thorough understanding of the investment appraisal tools have been used and institutionalized. The second part of this report though not as calculative like the previous part but it needs to discuss the same investment techniques used in the first part. In this task we have been given three different articles pertains to capital budgeting and risk and we have to critically evaluate and analyze the methods utilized and incorporated in these articles. The three articles which have been taken for this part are,
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Strategic Investment Decisions: The Importance of SCM by C. Carr & C. Tomkins
Risk in the Process of Budgeting by Paul M. Collier and Strategic Investment Decision making practices: A Contextual approach by Chris Carr. Let’s critically analyze each article in terms of the methods use for the investment decision making. First we will talk about this article,
The essence of investment is quite indispensable from a company’s viewpoint because it is the main thing which amply assists it to be viable. Almost every company accentuates rigorously to enhance the dilemma of investment within their country. The deportment of investment beneficial either for the individual or for the company/country as well. Every company’s is in the queue to enhance the stance of investment within the country. Inevitably, in the current perturb scenario of the society it is quite imperative to solicit heavy investment through different mediums to give an ad hoc to the economy. Basically there is a number of investment banking products are available in the country like Treasury Bills (hereafter T-Bills), Corporate Bonds, Mutual Funds, Term Finance Certificates (TFC) and many more.
The main perspective of this assignment is to analyze a project from the standpoint of a company and analyze is the project actually enhancing or destroying the worth of the company.