Conceptual Overview Of Investment Appraisal

There are three primary decisions which every finance manager has to make for his organisation. These comprise of financing decisions, investing decisions and dividend decisions (Martin, Keown and Titman 2020). The term investment appraisal concerns with investing decision which the finance manager has to undertake. Every organisation has to make investment decisions in order to grow and expand. There are several types of investment decisions which requires an organisation to incur significant amount of capital investments upfront. The overall long-term objective of any organisation is to create value for its shareholders. This is done by maximizing their wealth in the long term. Investment decisions are a great way to create value for shareholders (Siziba and Hall 2021). However, the finance manager must invest with prudence when it comes to investment decisions. It is imperative to ascertain the financial viability of any potential investment opportunity. As a result, the finance manager must make use of investment appraisal techniques which helps him in ascertaining the long-term financial viability of the investment. It is required from the finance manager to apply the principles of budgeting for these investments as a result of which these decisions are also referred to as capital budgeting decisions (Kengatharan 2016).

The main purpose of this report is to consider the case study of Brexylite plc and analyse the investment project which the company is contemplating. This report looks to evaluate the opportunity from a financial standpoint using different investment appraisal techniques as well as from a non-financial standpoint for recommending to the company whether or not to accept or reject the potential investment.

Brexylite plc is a medium sized listed entity from the United Kingdom that manufactures gaming consoles. The CEO of the company believes that the company has reaches its peak potential and it has become important for them to undertake a large-scale expansion program which will help in competing better with emerging and existing peers. The business intends to expand their upcoming production and distribution facilities which will allow selling its newly branded products through quality retailers around Europe, USA and Great Britain. At present the company is considering the purchase of a new machine which will help in production of a new gadget namely, ‘Pro-3’. This report concerns evaluating this investment opportunity from a financial and non-financial standpoint.

The company makes use of the weighted average cost of capital (WACC) for the purpose of discounting in its investment appraisal process. This has been calculated considering the present sources of finance in the business. The wacc is calculated as 13.98%. All relevant calculations concerning the same have been attached in Appendix 1 of this report. There are four different investment appraisal techniques which have been used for ascertaining the financial viability of ‘Pro-3’. These methods are the net present value, internal rate of return, simple payback and the return on capital employed. The excel sheet showcasing the cash flow schedule & calculation of each of these metrics have been presented in Appendix 2 of this report. The final metric results are presented as follows:

1. NPV: £7,401,263
2. IRR: 45%
3. PBP: 1.88 years
4. ROCE: 62%

1. The cost of equity has been calculated using the capital asset pricing model formula in the accompanying spreadsheet.
2. The weights for calculating the wacc are based on market values and not book values.
3. The company has already spent £300,000 for market research and £30,000 for consultancy fees last year. These are considered as sunk costs and do not classify as outflows for investment appraisal process. This is because these expenses are already incurred by the company and will not influence decision making as these are irrelevant (Vernimmen, Quiry and Fur 2022).
4. Labour costs are direct variable expenses and is assumed to be already accounted for in calculating the total contribution per unit. Hence, these are not charged as expense because this will lead to double counting.
5. The scrap value to be recovered in the terminal year (year 4) is adjusted against corporate tax.
6. As corporate taxes are required to be paid one year in arrears, the corporate tax liability of Year 1 is treated as an outflow in Year 2 and so on.
7. The return on capital employed is calculated using the formula of average annual after-tax profit divided by the average annual investment.
8. The npv is calculated using the ‘npv’ function on the spreadsheet based on the wacc calculated.
9. The irr is calculated using the ‘irr’ function on the spreadsheet.

Report Purpose and Objective

Investment appraisal techniques can be classified into two broad categories. These are traditional methods such as payback method & return on capital employed method which is a non-discounting technique and the modern methods such as net present value method and the internal rate of return method which are discounting techniques (Graham, Adam and Gunasingham 2020). The term discounting in investment appraisal refers to estimating the present worth of future cash flows associated with the investment opportunity. It is based on the time value fundamentals which illustrates that the money worth today is much more than the money worth in future (Brealey et al. 2018). The four different methods have been briefly summarised as follows:

NPV: The npv method is one of the most popular and reliable metrics in the process of investment appraisal. It is even considered more superior than the irr method as in the case if mutually exclusive projects, both methods may result in inconsistent results wherein the decisions are made on the basis of npv. The npv gauges the long-term absolute returns which the investment will generate for maximising the shareholder’s wealth. It is the difference in between the sum of all cash inflows discounted to their present values and the sum of all cash outflows discounted to their presents values which is nothing but the absolute returns to be generated from the investment in present worth (De Matos 2018).

IRR: The irr method is another reliable method which expresses the relative returns of the investment opportunity. It is the rate of return which the investment is most likely to generate expressed in relative terms. Furthermore, it is the discount rate using which the npv of any particular project is considered as zero. Therefore, if the wacc or the required rate of return of the investment is in excess of the irr of the investment, consequently, the npv of the investment will be calculated negative and vice versa (Ross et al. 2019).

PBP: The payback is a traditional technique in the process of investment appraisal which does not discount the cash flows to its present value or worth. The metric is interpreted as the total time it takes for the organisation in recovering the total initial outlays of an investment. This method is best suited for small scale projects and for organisations that are exposed to liquidity issues who would prefer recovering funds at the earliest to invest elsewhere. This method is not considered reliable also because it ignores any cash flows which are generated beyond the calculated payback of the investment.

ROCE: This method is also referred to as the simple rate of return or the accounting rate of return method. Again, this is a traditional method which is not considered reliable for decision making. Although the metric will help to interpret the net profit which the business is likely to generate from an investment, the accounting net income is not a reliable indicator when it comes to investment decisions. Cash flows associated with an investment are better and more reliable a means to gauge the financial viability of the investment. Also, the method does not discount future values to their present worth.

• The npv of the investment is worth £7,401,263. This is most likely the long-term value which the investment opportunity under review will provide to the shareholders if the investment is undertaken. The calculated figure is positive and above zero which makes this investment worth recommending.
• The irr of the investment opportunity is calculated at 45%. This is the relative returns of the investment. The wacc of the company is 13.98% which can also be regarded as the minimum required rate of return. Since the calculated irr is significantly in excess of the minimum rate of return, the investment opportunity is profitable.
• The payback of the investment is calculated at 1.88 years. This means that the business will most likely recover the initial cash outlays (purchase price and initial working capital investment) worth £9,500,000 within 1.88 years. The management desires a payback of 4 years as per the case study. Hence, the investment prospect is favourable.
• The calculated roce of the investment is worth 62%. This indicates the book profits the investment is expected to generate over the life of the investment. The management of the company desires a minimum boon profit rate of 20% calculated using the average investment method. The roce calculated is with the help of the average investment technique and significantly surpasses the expectations of the management making this project favourable from an accounting profitability perspective.

The present capital structure of the company comprises of ordinary share capital, preference share capital, redeemable debts and irredeemable debts. For financing the new venture of the business, the board is considering either opting for increasing debts or for issuing of new shares. From calculating the wacc for the company based on market values, it can be found that the cost of equity of the company is quite high at 16.80%. However, the cost of redeemable debts and irredeemable debts are cheaper at 6.08% and 6.60% respectively. Therefore, raising finances from debt makes more sense as the cost of debt is significantly cheaper than the cost of equity. Also, considering the current capital structure of the company, the proportion of debt capital is quite less relative to the proportion of equity. As a result, the company is geared low and can afford to assume risk for financing the venture. As a result, if the company is able to issue debt on favourable terms, it is recommended for this investment prospect. However, the best way to finance the venture would be in a way that the capital structure if the company remains optimum (Banerjee 2015).

Brexylite Plc’s new investment ‘Pro-3’ will not just be restricted to the Great Britain as it has plans to export its offerings in the United States and Eurozone market as well. As a result, the business will export internationally putting itself at a risk of exposure to foreign currencies. Foreign currency risks are best explained as any risk of losses which may accrue to the business due to fluctuations in the foreign currency that engage in international transactions (Madura 2020). It is worth mentioning that the cash flow schedule that have been created for calculating investment appraisal metrics has the total contribution per unit figure have certain cash flows in Euro (€) and USD ($) expressed as an equivalent to Pound Sterling (£) at the present exchange rates. These are based on present assumptions but the business may have to sustain losses as a result of volatility in exchange rates. This will translate to reducing the operating cash flows of the investment opportunity which in turn will affect the outcome of investment appraisal. As a result, it is best advised that the business acknowledges the impact of such risks and undertake a scenario or sensitivity analysis to better judge the financial feasibility. The company may rely upon hedging strategies to mitigate exposure to such risk (Shapiro and Hanouna 2019).

Overview of the Investment Opportunity

 It is also important to evaluate the impact of non-financial factors that are also referred to as qualitative factors in investment decisions (Brigham and Ehrhardt 2019). This is because the favourability of non-financial factors may have an impact upon the financial outcome and feasibility of the investment. The most important non-financial factor pertaining to the case study are the political climate in the UK. This is because the Government of UK, at present are renegotiating new trade arrangements with the European Union and other countries. It is worth mentioning that the company has plans of exporting to Eurozone and if these renegotiations end up favourable, this would translate to higher cash flows for the business than what is projected. However, there is always a small possibility that these renegotiations may not end up favourable which can hurt the projected sales and cash flows.

Conclusion and Recommendation

Based on the above discussions in this report, the investment opportunity is recommended to the company considering the favourability of investment appraisal results. The project makes sense from a financial standpoint and is capable in creating long term value for the shareholders of the company. However, it is recommended that the finance manager also undertakes a risk analysis as the investment is exposed to risk based on foreign currency fluctuations and non-financial factors. It can therefore be concluded from this report that the main objective of investment decisions is to maximise the wealth of shareholders and a finance manager should evaluate the feasibility of an investment from a financial as well as a non-financial standpoint. 

References

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De Matos, J.A., 2018. Theoretical foundations of corporate finance. Princeton University Press.

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Kengatharan, L., 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), pp.15-38.

Madura, J., 2020. International financial management. Cengage Learning.

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Ross, S.A., Westerfield, R., Jaffe, J.F., Jordan, B.D., Jaffe, J. and Jordan, B., 2019. Corporate finance (pp. 880-86). McGraw-Hill Education.

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Siziba, S. and Hall, J.H., 2021. The evolution of the application of capital budgeting techniques in enterprises. Global Finance Journal, 47, p.100504.

Vernimmen, P., Quiry, P. and Le Fur, Y., 2022. Corporate finance: theory and practice. John Wiley & Sons.