INVESTMENT DECISIONS

TABLE OF CONTENTS

1. Introduction. 3

2. Investment

Appraisal 3

3. Break Even

Analysis. 5

4. NPV & IRR

Calculations. 6

5. Conclusion. 7

6. References. 8

1.

Introduction

This

report will discuss the choice of investment decision for Alex. He wants to

open up a restaurant and this report will help him out to evaluate the

financial performance of both options based upon NPV, Break even and other

models.

2.

Investment

Appraisal

The application of a

method to measure the financial viability of a project requires the necessary

classification knowledge. In general, these methods can be divided into static

methods and dynamic methods. The result of this division is the standard over

which the value of money (capital) changes over time, since the value of money

changes over time. This is mainly due to economic inflation. Therefore, the

bank’s interest rate is the nominal interest rate. Therefore, the future return

on investment projects must be discounted over time. The discount rate is a

parameter that “captures” changes in the value of money in a timely

fashion. The discount allows us to bring all of these future values ??(amounts)

into account at the same time. The main contribution of this paper is to use

the dynamic method (NPV, IRR) as a discount method because the general

structure of the formula contains the so-called discount coefficient.

All investment projects

are considered mutually exclusive or independent. An independent project means

that the decision to accept or reject the project has no effect on other

projects the company is considering. The cash flow of a separate project has no

effect on the cash flows of other projects or business units. For example, the

decision to replace a company’s computer system would be seen as being

independent of the decision to create a new factory.

A mutually exclusive

project is to accept such a project will affect the acceptance of another

project. In mutually exclusive projects, one project’s cash flow will have an

impact on the other project’s cash flow. Most business investment decisions

fall into this category. Starbucks’ decision to buy Teavana will surely have a

profound impact on the future cash flows of the coffee business and affect the

decision-making process for other Starbucks projects in the future.

NPV is the most common

method with a variety of applications. Many authors consider this method to

have no drawbacks. Its special advantage is that the net present value of a

project to assess, given an absolute value, and provide investors with an

answer to the rate of return on investment. The financial analysis of the

project also frequently uses the profitability index (PI). “The profit

index is closely linked to the NPV because it is equally sensitive to the

chosen discount rate.” There is no major problem with the explanation of

this indicator, that is, when the investment needs to be profitable, it must

satisfy the condition of PI?1, where 1 represents the unit value of the project

investment expenditure. According to the formula given above, it is easy to

determine the definition of internal rate of return (IRR) that is, it is a

discount rate that equalizes the left and right sides of the equation, then NPV

equals zero.

According to the NPV

rule, we choose item A, and we prefer internal rate of return rule B. If we

have to choose one, how can we resolve the conflict? When the two methods are

inconsistent, the convention is to use the NPV rules because it better reflects

our primary goal: to increase the company’s financial wealth.

3.

Break

Even Analysis

The break even period

for project A is 1.71 years and project B has break even period of 2.10 years.

Discounted Payback Period

Analysis

Project A

Year 1

Year 2

Year 3

Year 4

Year 5

Undiscounted Net Cash Flow

(100,000)

50,000

70,000

150,000

150,000

150,000

Cumulative Net Cash Flow

(50,000)

20,000

170,000

320,000

470,000

Positive Cash Flow?

FALSE

TRUE

TRUE

TRUE

TRUE

Undiscounted Payback Period

2

First Year Positive

Partial Year Payback Period

1.71

Actual Number of Years

Partial Year Payback Period

1.71

Using arrays and index

Discounted

Payback Period Analysis

Project

B

Year 1

Year 2

Year 3

Year 4

Year 5

Undiscounted Net Cash Flow

(175,000)

50,000

100,000

250,000

250,000

250,000

Cumulative Net Cash Flow

(125,000)

(25,000)

225,000

475,000

725,000

Positive Cash Flow?

FALSE

FALSE

TRUE

TRUE

TRUE

Undiscounted Payback Period

3

First Year Positive

Partial Year Payback Period

2.10

Actual Number of Years

Partial Year Payback Period (One

Cell)

2.10

Using arrays and index

Year

0

1

2

3

4

5

Project A

Cash flow

(100,000)

50,000

70,000

150,000

150,000

150,000

PV factor

100%

93%

86%

79%

74%

68%

PV of cash flow

(100,000)

46,500

60,200

118,500

111,000

102,000

NPV

338,200

IRR

78%

Project B

Year

0

1

2

3

4

5

Cash flow

(175,000)

50,000

100,000

250,000

250,000

250,000

PV factor

100%

93%

86%

79%

74%

68%

PV of cash flow

(175,000)

46,500

86,000

197,500

185,000

170,000

NPV

510,000

IRR

66%

4.

NPV & IRR Calculations

Project

B has a higher net present value but has a validity of five years compared to

the same term in Project A. Since this project will be used to produce the

output of the manufacturing enterprise, it can be assumed that Project A will

be replaced at the end of the third year, so that the NPV above is

underestimated. In other words, suppose the project will be used indefinitely.

The

internal rate of return for both projects is 50%, but apparently Project takes

precedence over Project B. Note that NPV rules correctly identify

cost-effective alternatives. The IRR rule fails in this case because it ignores

the order in which it is flowing. Project A is a case where we are now

investing 1000, accumulating up to 1500 in a single period. It’s a very good

return on our investment. In project B, we borrowed 1000, but also pay 1500 in

1 period. It’s a very high interest rate, we have to pay. However, IRR does not

consider whether we borrow or not, and reports that exchange rates for both

projects are the same.

The

internal rate of return for projects A and B was 78% and 66% respectively.

Therefore, you should choose point B. However,

NPVA = 338 and NPVB = 510

From the point of view of maximizing shareholder wealth,

Project A is therefore better than Project B. The inconsistency comes from the

size of the investment question. The internal rate of return method only gives

the profitability of a project invested in each investment and does not measure

absolute profitability.

One attraction of the payback period is that it provides

“risk currency” measures. At the beginning of the project, we have a

great deal of uncertainty about future cash flows, the economic environment and

cash flow may be more or less than expected, and there is more and more

uncertainty about the future. However, the performance standard is the wrong

way to solve this problem. There are two tools for analyzing the risks

associated with long-term cash flows. The first is the setting of the discount

rate. As we will see below (Conferences 9 and 10), the discount rate can be

calculated according to the risk of the investor by breaking it down into a

risk-free rate, a time value offset and a risk premium.

5.

Conclusion

In addition, we know much less about the near and distant

future, and if things change in the future, we usually change the design of the

project. Therefore, we have to take into account that one project took a lot of

time in our analysis and the other project took a lot of time because the

longer projects gave us less flexibility. As we will see later, this argument

also has some merit because flexibility has economic value. However, the right

tool for analytical flexibility is the analysis of the decision tree or the

analysis of options (so-called “real options”).

6.

References

· Gotze,

U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL.

SPRINGER-VERLAG BERLIN AN.

· Pasqual,

J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability

criteria with the net present value. International Journal of

Production Economics, 142(1), pp.205-210.

· Weber,

T.A., 2014. On the (non-) equivalence of IRR and NPV. Journal of

Mathematical Economics, 52, pp.25-39.

· Bas,

E., 2013. A robust approach to the decision rules of NPV and IRR for simple

projects. Applied Mathematics and Computation, 219(11),

pp.5901-5908.