Investment Appraisal: Financial Management Essay

Exclusively available on Available only on IvyPanda® Made by Human No AI

Introduction

The case project was a new product which a company was considering investing in. Several costs such as direct and indirect costs, inventory, and receivables were provided. I used this information to calculate the incremental cash flows of the project for 8 years. I then used these cash flows in appraising the project using both the pay-back period (P/B) and the net present value (NPV).

Incremental cash flows

Incremental cash flow refers to the increase in cash outflow related to operations that an organization will experience as a result of undertaking a new project (Investopedia, 2012). I began by calculating the cash flow from operations that the company would expect from the new project. To arrive at this, I used the sales figure for each year which was $950,000 for the first year and $1,500,000 for each subsequent year. I calculated the direct cost at 45% of sales, which resulted in a direct cost figure of $427,000 for the first year and $675,000 for each of the 7 subsequent years. The resultant figure after deducting the direct costs was the gross income.

I then deducted the annual depreciation of the plant from each of the five years of its useful life. I calculated the annual depreciation rate by dividing the value of the plant, $1,500,000, by its useful life of 5 years, which resulted in an annual depreciation rate of $300,000. I also deducted the indirect incremental cost of $95,000 per year. The result of these deductions was a net income of $127,000 for the first year, $430,000 for the second to the fifth year, and $730,000 for the sixth to the eighth year.

The tax rate was given at 35%. I calculated this from the net income to arrive at taxes of $44,625 for the first year, $150,000 for the second to the fifth year, and $255,000 for the sixth to the ninth year. After deducting the tax from each year, I arrived at an income after tax of $82875 for the first year, $279,500 for the second to the fifth year, and $474,500 for the sixth to the eighth year.

I then added back the depreciation amount to each of the first five years of the useful life of the plant, which resulted in cash flow from operations of $382,875 for the first year and $579,000 for the second to the fifth year. I arrived at the final figure of incremental cash flows by deducting the annual incremental cash outflow of inventory and receivables from the cash flow from operations. This resulted in incremental cash inflows of $182,875 for the first year, $379,500 for the second to the fifth year, and $274,500 for the sixth to the eighth year. I have presented the full statement with all calculations in the excel worksheet.

Pay-back period

The pay-back period is the amount of time it takes for a project’s cash inflows to recover the initial outlay (Gitman & Zutter, 2012). To arrive at this, I deducted the annual incremental cash inflow from the initial outlay up to the fourth year. For the fifth year, the cash outflow was greater than the remaining balance of the initial outlay. I divided this balance by the cash outflow for the fifth year to arrive at the period remaining in months which resulted in a figure of 5.64. I rounded off this figure to 6 months. The total payback period was therefore 4 years and 6 months.

Net Present Value

The net present value is the difference between the present value of the future cash flows of a project and the project’s initial outlay (Baker, 2009). In order to arrive at the present value of the cash flows, the cash flows must be discounted using the formula 1/[(1+r)^n] where ‘r’ is the cost of capital and ‘n’ is the number of years since the initial outlay (Baker, 2009). I calculated the discounting factor for each year and then multiplied each cash flow by its respective discounting factor. I added up all the resultant figures to arrive at a present value of cash flows of $1,706,773 for the project. I then deducted the initial outlay of $1,500,000 from this figure to arrive at a net present value of $206,773.

Appraisal of the project

I appraised the project using both the P/B and NPV. The P/B of the project was approximately 4 years and 6 months. The company does not accept projects whose P/B is beyond 3 years. Based on this method, the project should not be accepted.

The NPV method, on the other hand, allows a project to be accepted only if its NPV is positive (Gitman & Zutter, 2012). The project’s NPV was $206,773. Since this figure is positive, the project should be accepted.

Increase in costs

The project, in this case, does not require any additional costs on land building. This is, perhaps, because the company had idle capacity. If this was not the case and the company had to incur costs to procure extra land and buildings, the company would have had to incur an extra initial outlay if the assets were to be purchased or extra annual cash outflows if the assets were to be leased or rented. This would have increased the payback period and reduced the NPV.

The P/B method had rejected the project before, therefore with an increased P/B, the project would still have been rejected hence no change in decision. For the NPV method, however, the increased costs would have resulted in a lower NPV which, depending on the magnitude, would have resulted in a rejection of the project if the NPV fell below zero and hence a change in decision.

References

Baker, S. L. (2009). NPV and IRR: Measures for evaluating investments. Web.

Gitman, L. J., & Zutter, C. J. (2012). Principles of Managerial Finance, 13th ed. Upper Saddle River, New Jersey: Prentice Hall.

Investopedia. (2012). . Web.

More related papers Related Essay Examples
Cite This paper
You're welcome to use this sample in your assignment. Be sure to cite it correctly

Reference

IvyPanda. (2020, August 29). Investment Appraisal: Financial Management. https://ivypanda.com/essays/investment-appraisal-financial-management/

Work Cited

"Investment Appraisal: Financial Management." IvyPanda, 29 Aug. 2020, ivypanda.com/essays/investment-appraisal-financial-management/.

References

IvyPanda. (2020) 'Investment Appraisal: Financial Management'. 29 August.

References

IvyPanda. 2020. "Investment Appraisal: Financial Management." August 29, 2020. https://ivypanda.com/essays/investment-appraisal-financial-management/.

1. IvyPanda. "Investment Appraisal: Financial Management." August 29, 2020. https://ivypanda.com/essays/investment-appraisal-financial-management/.


Bibliography


IvyPanda. "Investment Appraisal: Financial Management." August 29, 2020. https://ivypanda.com/essays/investment-appraisal-financial-management/.

If, for any reason, you believe that this content should not be published on our website, please request its removal.
Updated:
This academic paper example has been carefully picked, checked and refined by our editorial team.
No AI was involved: only quilified experts contributed.
You are free to use it for the following purposes:
  • To find inspiration for your paper and overcome writer’s block
  • As a source of information (ensure proper referencing)
  • As a template for you assignment
Privacy Settings

IvyPanda uses cookies and similar technologies to enhance your experience, enabling functionalities such as:

  • Basic site functions
  • Ensuring secure, safe transactions
  • Secure account login
  • Remembering account, browser, and regional preferences
  • Remembering privacy and security settings
  • Analyzing site traffic and usage
  • Personalized search, content, and recommendations
  • Displaying relevant, targeted ads on and off IvyPanda

Please refer to IvyPanda's Cookies Policy and Privacy Policy for detailed information.

Required Cookies & Technologies
Always active

Certain technologies we use are essential for critical functions such as security and site integrity, account authentication, security and privacy preferences, internal site usage and maintenance data, and ensuring the site operates correctly for browsing and transactions.

Site Customization

Cookies and similar technologies are used to enhance your experience by:

  • Remembering general and regional preferences
  • Personalizing content, search, recommendations, and offers

Some functions, such as personalized recommendations, account preferences, or localization, may not work correctly without these technologies. For more details, please refer to IvyPanda's Cookies Policy.

Personalized Advertising

To enable personalized advertising (such as interest-based ads), we may share your data with our marketing and advertising partners using cookies and other technologies. These partners may have their own information collected about you. Turning off the personalized advertising setting won't stop you from seeing IvyPanda ads, but it may make the ads you see less relevant or more repetitive.

Personalized advertising may be considered a "sale" or "sharing" of the information under California and other state privacy laws, and you may have the right to opt out. Turning off personalized advertising allows you to exercise your right to opt out. Learn more in IvyPanda's Cookies Policy and Privacy Policy.

1 / 1