PART A
Bongo Ltd solution
Missing answers are marked yellow in the table. Workings are shown below.
| Project 1 | Project 2 | |
| ARR | 33% | 24.73% |
| NPV (£’000) | £ 142.27 | 210 |
| IRR | 25% | 8.71% |
| Payback Period (yrs) | $2.87 | 3.2 |
| WORKINGS | |
| ARR PROJECT 1 | |
| Cash flow | £ 200.00 |
| less depreciation | £ 100.00 |
| Accounting profits | £ 100.00 |
| WORKINGS | |
| ARR PROJECT 2 | |
| Cost value | £ 1,616,000.00 |
| Savage value | £ 301,000.00 |
| Cash flow | £ 500,000.00 |
| useful life | 5 years |
Depreciation = (initial investment -scrap value)/useful years
Annual depreciation = £263,000.00
| cash flow | £ 500,000.00 |
| less depreciation | £ 263,000.00 |
| Accounting profits | £ 237,000.00 |
| average investment | £ 958,500.00 |
| ARR | 24.73% |
| NPV CALCULATION | |
| Discount rate | 15% |
| initial investment | £ 556,000.00 |
| numbers of years | 5 |
| Cash Flow | £ 200,000.00 |
| Scrap Value | £ 56,000.00 |
PV = cash inflow /(1+r)^n
| Year | Cash flow | Present value |
| 0 | -£ 556,000.00 | -£ 556,000.00 |
| 1 | £ 200,000.00 | £ 173,913.04 |
| 2 | £ 200,000.00 | £ 151,228.73 |
| 3 | £ 200,000.00 | £ 131,503.25 |
| 4 | £ 200,000.00 | £ 114,350.65 |
| 5 | £ 256,000.00 | £ 127,277.24 |
| NPV | £ 142,272.92 |
IRR – Project 2:
| Year | Cash flow | Present value |
| 0 | -£ 200,000.00 | -£ 556,000.00 |
| 1 | £ 200,000.00 | £ 173,913.04 |
| 2 | £ 200,000.00 | £ 151,228.73 |
| 3 | £ 200,000.00 | £ 131,503.25 |
| 4 | £ 200,000.00 | £ 114,350.65 |
| 5 | £ 256,000.00 | £ 127,277.24 |
| IRR | 8.71% | |
Payback Period-Project 1:
Payback period = initial investment / periodic cash flow.
| Year | Cash flow | Present value | Payback Period |
| 0 | -£ 556,000.00 | -£ 556,000.00 | |
| 1 | £ 200,000.00 | £ 173,913.04 | -£ 382,086.96 |
| 2 | £ 200,000.00 | £ 151,228.73 | -£ 230,858.22 |
| 3 | £ 200,000.00 | £ 131,503.25 | -£ 99,354.98 |
| 4 | £ 200,000.00 | £ 114,350.65 | £ 14,995.67 |
| 5 | £ 256,000.00 | £ 127,277.24 |
| Payback Period | 2 | + $0.87 |
| Payback Period | 2.87 | |
PART B
Do you agree or disagree?
It is the responsibility of the management to make right investment decisions in term of long-term assets to maximize the additional wealth of the shareholders as any ignorance or mistakes can cause disastrous results in the form of financial losses. As per the author of a study has suggested, sound decision making regarding long-term investments is needed because of the involvement of large financial sources. Furthermore, it is also quite difficult and nearly impossible to get out of the investment when it has already been carried out (Atrill & McLaney, 2011, p.27).
Any expansion in a business needs deployment of the funds, and for this reason, some planning for assurance of minimum risk and maximum success is required (Kengatharan, 2017, p.9). However, many businesses fail to do so. Many owners or managers make their capital investment decisions based on their intuition, wrong calculations, and incorrect factors. It is quite understandable as about 99% of the businesses of the world are SMEs, and they produce more than 50% of the global GDP and also provide employment for the 85% of the world population. It shows that the Small and Medium Enterprises tend to lack financial complexity and capability and hence commit errors of a serious nature in their investment decisions causing large financial losses (Götze et al., 2015, p.54).
Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments.
There are many factors as well, which affect our selection process of these alternatives (Wnuk-Pel, 2015, p.219). The four methods of capital budgeting are;
Accounting Rate of Return: The Accounting Rate of Return is computed by the formula;
ARR= (Average Profit in the Project Life)/ (Average Investment Made in the Project Life)
Any Accounting Rate of Return which is equivalent or higher than the rate of the expected rate of return is acceptable and the lower is considered unprofitable.
The limitation of ARR alternative is that it ignores the time value of the money (Lumby & Jones, 2003, p.112).
Payback Period: It compares the initial investment against the timely recovery from the cash flows. The lower the payback period, the higher is its profitability.
The limitation of this alternative is that it does not consider the profitability of the project (Vyuptakesh & Sharan, 2015, p.63).
Net Present Value: It considers the costs, benefits and the time value of a project. It discounts the expected future cash flows reflecting the risks, interest lost, and projected inflation rate. If the amount of the discounted expected cash flows less the initial investment is positive, then the project can be considered financially profitable.
The limitation with this alternative is that the NPV considers fixed cash flows whereas in actual cash flows are not fixed.
Internal Rate of Return: As like the NPV, the Internal Rate of Return considers the discounted expected cash flows in a project and shows the yield of the project as a percentage.
The limitation with IRR is that it assumes the reinvestment of the cash flows with the same rate of return which is not a real scenario (Osborne, 2010, p.336).
How do you think that capital budgeting decisions should ideally be made from different types of organizations?
For the suggestion on the implementation of a capital budgeting decision-making process (Kierulff, 2008, p.324), a step-by-step process is shown;
- Defining the current investment having the potential of a good rate of return
- Describing how the good rate of return can be attained
- Pre-Feasibility Study
- Feasibility Study
- Making the Investment Decision
References
Atrill, P. & McLaney, E., 2011. Finance and accounting for managers. Harlow UK: Pearson Custom Publishing.
Götze, U., Northcott, D. & Schuster, P., 2015. Investment Appraisal: Methods and Models. 1st ed. Springer.
Kengatharan, L., 2017. Capital Investment Decision Making Under Uncertainty: Perspectives Of An Emerging Economy. Asia-Pacific Management Accounting Journal, 12(2), pp.1-22.
Kierulff, H., 2008. MIRR: a better measure. Business Horizons, 51(4), pp.321-29.
Lumby, S. & Jones, C., 2003. Corporate Finance: Theory & Practice. 1st ed. Cengage Learning.
Osborne, M.J., 2010. A resolution to the NPV-IRR debate? The Quarterly Review of Economics and Finance, 50(2), pp.234-39.
Vyuptakesh & Sharan, 2015. Fundamentals of Financial Management. 1st ed. India: Pearson Education.
Wnuk-Pel, T., 2015. Factors determining the selection of capital budgeting methods in companies operating in Poland. Zeszyty Teoretyczne Rachunkowosci, 84(140), p.217.
+447462439809