INVESTMENT as a discount method because the general

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.

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