The following information relates to three potential investment projects that are being considered by Scrappit plc. Due to capital rationing, only one of the three projects can be pursued. Project A Project B Project C £ £ £ Initial cost 175,000 195,000 190,000 Expected life 5 years 5 years 5 years Scrap value expected 5,000 8,000 4,000 Expected cash inflows: End of year 1 75,000 95,000 50,000 2 65,000 65,000 60,000 3 60,000 45,000 65,000 4 55,000 45,000 66,000 5 50,000 45,000 57,000 Additional information: Scrappit plc estimates its cost of capital to be 18%. £35,000 depreciation is charged to Project A each year. £39,000 depreciation is charged to Project B each year. £38,000 depreciation is charged to Project C each year (a) Calculate the payback period, accounting rate of return and net present value of each of the potential projects. (b) Explain which of the three potential investment projects should be undertaken. Your explanation should be based on the results of your calculations in part (a). (c) Critically discuss the approaches to investment appraisal used in part (a). As part of your critical evaluation, identify what additional information might be used to improve the approach to investment appraisal.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
The following information relates to three potential investment projects that are being considered by Scrappit plc. Due to capital rationing, only one of the three projects can be pursued.
|
|
Project A |
Project B |
Project C |
|
|
£ |
£ |
£ |
|
Initial cost |
175,000 |
195,000 |
190,000 |
|
Expected life |
5 years |
5 years |
5 years |
|
Scrap value expected |
5,000 |
8,000 |
4,000 |
|
Expected |
|
|
|
|
End of year 1 |
75,000 |
95,000 |
50,000 |
|
2 |
65,000 |
65,000 |
60,000 |
|
3 |
60,000 |
45,000 |
65,000 |
|
4 |
55,000 |
45,000 |
66,000 |
|
5 |
50,000 |
45,000 |
57,000 |
Additional information:
- Scrappit plc estimates its cost of capital to be 18%.
- £35,000
depreciation is charged to Project A each year. - £39,000 depreciation is charged to Project B each year.
- £38,000 depreciation is charged to Project C each year
(a) Calculate the payback period, accounting
potential projects.
(b) Explain which of the three potential investment projects should be undertaken. Your
explanation should be based on the results of your calculations in part (a).
(c) Critically discuss the approaches to investment appraisal used in part (a). As part of your
critical evaluation, identify what additional information might be used to improve the approach
to investment appraisal.
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