CompanyInvestment appraisal techniques plays an important role in assessing investment’s viability. You are asked to addressed following three questions to understand the importance of investment evaluation:
- Explain the suitable cash flows used for the purpose of investment evaluation.
- Calculate the Net Present Value (NPV) for the investment proposal and advise the CFO whether this project should be undertaken.
- Critically evaluate the choice of funds that the CFO wishes to use against other possible options and critically discuss any other issues that are applicable in this scenario.
INTRODUCTION
Investment appraisal techniques are quite crucial for assessing investment's viability. Present report deals with Expansion Group Ltd which is planning to undertake seven year project in Turkey. For evaluating attractiveness of project, relevant cash flows are calculated. Moreover, CAPM technique is used to carry out required rate of return in effective manner. From this, NPV is calculated for making recommendation to CFO whether to invest in it or not.
A) Determining cash flows of the project for evaluation purpose
Relevant cash flows calculated for Expansion Group Ltd
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
|
Sales revenue |
800000 |
800000 |
800000 |
800000 |
800000 |
800000 |
800000 |
|
Sales of products |
500000 |
525000 |
527000 |
529000 |
531000 |
533000 |
535000 |
|
|
|
|
|
|
|
|
|
|
Total Inflows |
1300000 |
1325000 |
1327000 |
1329000 |
1331000 |
1333000 |
1335000 |
|
Outflows |
|
|
|
|
|
|
|
|
Opportunity costs |
725000 |
725000 |
727000 |
729000 |
731000 |
733000 |
735000 |
|
Turkish visits costs |
50000 |
50000 |
51000 |
52000 |
53000 |
54000 |
55000 |
|
total outflows |
775000 |
775000 |
778000 |
781000 |
784000 |
787000 |
790000 |
|
Net cash inflows |
525000 |
550000 |
549000 |
548000 |
547000 |
546000 |
545000 |
|
|
|
|
|
|
|
|
|
|
initial invest |
500000 |
|
|
|
|
|
|
|
capital |
3000000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Opening Balance |
3500000 |
3500000 |
2950000 |
2401000 |
1853000 |
1306000 |
760000 |
|
Closing Balance |
3500000 |
2950000 |
2401000 |
1853000 |
1306000 |
760000 |
215000 |
The above computation shows relevant cash flows being calculated for the company for undertaking a project for seven years in Turkey. The proposal is made whether to accept it or not in the best possible manner. It can be highlighted that project investment cost is 35,00,000 which is bifurcated into 50,000 of set up costs of project in the nation and remaining is capital amounting to 30,00,000. The after tax cash flows are even ie, they will remain same throughout seven year time spans of the project quite effectually. Furthermore, visits to nation cost is estimated to be nearly 50,000 which will increase in these years.
On the other hand, opportunity cost is identified and valued around 725,000. This figure will also increase in future course of action. This means that after taking cash flows of 8,00,000, it is required to calculate all the relevant cash flows which will be generated by the project in seven years. It can be interpreted from the above computation that sales revenue and products sales are taken and thus, total cash inflows are computed. In relation to this, outflows are taken and net cash inflow for project are arrived.
B) Calculation of NPV and advising CFO for accepting or rejecting the project
Computation of required rate of return (CAPM Model)
|
Formula |
Required rate of return = Rf + β * (Rm – Rf) |
|
Particulars |
Figures |
|
Beta |
1.2 |
|
Rm |
6.50% |
|
Rf |
2.00% |
|
Required rate of return |
2% + 1.2 * (6.50% - 2%) = 7.40% |
|
Year |
Net cash inflows |
Present value factor @ 7.4% |
Discounted Cash Flows (DCF) |
|
0 |
3500000 |
|
|
|
1 |
525000 |
0.931098696 |
488826.8156 |
|
2 |
550000 |
0.866944783 |
476819.6304 |
|
3 |
549000 |
0.807211157 |
443158.9252 |
|
4 |
548000 |
0.751593256 |
411873.1043 |
|
5 |
547000 |
0.699807501 |
382794.703 |
|
6 |
546000 |
0.651589852 |
355768.0591 |
|
7 |
545000 |
0.606694462 |
330648.4816 |
|
|
|
|
2889889.719 |
|
|
|
Initial investment |
3500000 |
|
|
|
NPV |
-610110.2807 |
The project is being assessed with the help of NPV which is commonly used investment appraisal technique for evaluating project in the best possible manner and make structured decisions. It can be interpreted that as per given information required rate of return is calculated by taking CAPM model and thus, rate comes to 7.40%. Furthermore, net cash inflows are attained and by taking present value factor, discounted cash flows are calculated for each of years (Investment appraisal. 2012). The total sum arrived is 2889889.71 while, total initial investment cost is 3500000. It clearly shows that NPV is -610110.28 which is negative and it clears that Expansion Group Ltd should not invest in Turkey project as NPV is not in positive form. Adequate returns will not be generated, hence, it is advised not to put investment in this project.
C) Critical evaluation of choices of funds and relevant issues in the project
There are sources of funds which can be used by the CFO of company are listed below-
Bank loans
It is one of the common used method by company as it helps to take money for the investment purpose and also to take for meeting out operational expenses. Principal amount is to be paid along with interest on it on instalments (Subramanian and Ramanathan, 2012).
Advantages
- Easy to take loan and simplest procedure
- Interest rate is fixed and easy to calculate instalments amount
Disadvantages
- Interest is to be paid which limits the use.
- Debt burden increases affecting liquidity
Equity financing
The shares can be issued by Expansion Group Ltd to equity holders in order to garner funds and effectively met out its operational tasks. It is useful as no liability arises to pay to shareholders only dividends are paid.
Advantages
- No debt burden prevails to pay to shareholders
- It is suitable method of raising funds in comparison to bank loans.
Disadvantages
- Control is being observed by shareholders on money provided by them.
- Certain rate of return is to be paid by company (Golden and McMahan, 2017).
These alternative options can be chosen by CFO. There certain issues within this project is that expenses are more in quantum leading to decreased revenue. It has resulted into more of cash outflows than inflows. Furthermore, it is required that external factors prevailing in Turkey must be assessed so as to minimise risks up to a high extent. However, it can be interpreted that project should not be undertaken as NPV is not good.
CONCLUSION
Hereby it can be concluded from above report that NPV is an effective method for testing viability of business. Expansion Group Ltd should not make investment in project as NPV is negative which means that adequate returns will not be generated. Furthermore, choices of funds are available which can be opt as per the requirement of firm to meet operational tasks.
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