Investment Decision Analysis

Introduction

Investment function- among other roles such as allocation and finance function- is one of the manager's key functions according to corporate finance.  The investment function is a vital element in making strategic economic decisions in an organization since any new project, or investment affects the financial future of the company. The success of the new venture increases the profitability of the organization while the failure of an investment proposal contributes to the economic decline of the firm. Coming up with a proper decision concerning whether an agency should adopt a particular project or drop it requires a careful analysis of the viability of the project using various techniques of investment appraisal. (Scholleova, Svecova, & Fotr, 2010, p. 1). Therefore, the primary purpose of this advisory report is to analyze various investment decision-making models for example net present value (NPV), profitability index (PI), and internal rate of return (IRR).  The analysis of the techniques will concern their theoretical backgrounds, their comparison and the reasons why various firms and individuals prefer the methods. Additionally, I will critically evaluate the company's decision to whether to replace the old machine with the new machine or retain the old equipment. I will then give my recommendation regarding the evaluation of the two machines.

Theoretical Background of the Investment Criteria

Net Present Value (NPV)

Needles, Powers, & Crosson (2010, p.128) define net present value as an investment technique which is used to evaluate the feasibility of a capital project by discounting the project's future cash flows and subtracting results from the initial capital outlay. Bierman (2010, p.64) summarizes the earlier definition by stating that NPV is the resultant difference between present value of a project and capital outlay of an investment. The working of this model involves finding the present value all cash inflows of the investment and subtracts the result from initial capital outlay. This investment analysis method is used by managers to make informed decisions on what project to pursue. (Gallo, 2014, par.4). Various organizational managers highly recommend the technique due to its ability to incorporate the concept of time value of money. Hofstrand (2013, p.1-2) explains that time value of money as the general idea that the present amount of money available will be more worth compared to the same sum of money in the future.

The theory of net present value was first put forward by Irving Fisher and Maynard Keynes who in their opinion stated that the present value of future inflows equals the opportunity cost of capital. Since the introduction, the model has gone through various changes due to the emergence of different theories which build their concept from earlier models. Through the design, various investment models have emerged such as portfolio theory, arbitrage theory, capital asset pricing theory, and efficient market hypothesis. The gearing of models is towards minimizing various uncertainties and increase the returns.

The Internal Rate of Return

The internal rate of return (IRR) is the capital budgeting model used to determine the viability of an investment project. (Davis & Davis, 2012, p.501). Schmidt (2014, par. 2) explains the definition of IRR as the percentage rate which an investor earn for each dollar invested for a particular period. Schmidt (2014, par. 2) continues to say that the technique enables the investor to compare various projects based on the yield and come up with a more viable plan which will give maximum returns. The decision rule of IRR states that all independent investment projects whose IRR is higher than the company's cost of capital need to be selected. In a situation of mutually exclusive investments, the investor should take the project with the highest IRR.

Although IRR is among the widely used investment appraisal tool, some researchers argue that the technique should not be utilized to analyze especially the dependent investment proposals. IRR builds its decision based on the value generated after calculation and the higher the IRR value, the greater the chances of the project being selected. Boundless (2016, par. 2) argues that an investment may have low IRR but at the same time have high NPV (Increase in shareholder's possession). In such a situation, the company is supposed to take the investment since one of the key functions of management is to increase shareholders' wealth.

The Profitability Index (PI)

"Profitability index is a financial tool which tells us whether an investment should be accepted or rejected." (The Economic Times, 2016, par. 1). Shim, Dauber, & Siegel (2010, p.363) define profitability index as the correlation of cumulative value of the present value of future inflows to the initial investment. One is required to find the summation of the present value of future cash inflow and dividing the result by first capital expenditure to get profitability index. The result after the division is the profitability index. The decision regarding whether one should accept or reject an investment proposal is based on the value of PI. If PI is more than one, then the project should be approved. On the other hand, if PI is less than one, then the proposal should be rejected. In case the PI is equal to zero i.e. indifferent, then the investor can reject or accept the project.

 PI being greater than one implies that present value of future inflows is more than the initial cost, therefore, indicating a profit to the company. If PI is less than one, then it indicates that present value of future inflows is less than the initial payment value hence indicating a loss to the investing organization. In a circumstance where PI is equal to zero, then it means that the value of present value of future cash inflows is equal to present value of initial outlay. The investor will not make any profit if PI is equivalent to zero. Just like NPV and IRR, PI also has received some criticisms one of it being the lack of consideration of future investment periods when carrying out capital rationing. The process of capital rationing is performed only for the present time. The other limitation according to Damodaran (2011, p. 267) is that the method does not give an assurance that the overall investment will total to the capital rationing constraint. Due, to lack of guarantee, Damodaran continues to say that organization has to consider a wide variety of investments whose NPV is higher.

Comparison between the Methodologies

The Profitability Index and Net Present Value

As NPV and PI methods of investment choices are closely interrelated with each other, both give indistinguishable results from far as the rule of accept-reject is concerned. (Hawawini, 2011, p. 212). This is on the grounds that, regarding NPV technique, an investment is accepted on the off chance that it gives a positive net present value and under PI strategy, a project is accepted on the condition that PI value is more than one. Profitability index will be more than one just when NPV result is positive and thus they generate the similar accept/reject decision. On the other hand, if there should be an occurrence of mutually exclusive investments with distinctive sizes of speculation, that is, where initial outlay in the second project is not equal, a contention in NPV and PI classifications may happen.

The weakness connected with PI is its relativity. A venture can have the same PI with various projects and the inconceivable contrast in absolute dollar return. Net present value has a high ground for this situation. Accordingly, the question may emerge as to which proposition the company should accept in the event of the above scenario. If there should arise an event of such independent investments, net present value technique (NPV) ought to be favored for reasons clarified before for predominance of NPV.

Net Present Value (PI) and Internal Rate of Return (IRR)

One of the approaches to compare net present value and IRR is by utilizing the decision rule of accept-reject. With the IRR model, the standard rule is to accept an independent investment if its internal rate of return is more prominent than the company’s minimum accepted cost of capital. If the cash flow comparing to the investment comprises of at least one period of capital outlays followed by times of cash proceeds, this technique will give the same accept or reject choices as the NPV strategy, utilizing a similar discounting rate. Since most independent projects have cash flow designs that meet the particulars described, any reasonable person would agree that practically speaking, the IRR and NPV techniques tend to give the same accept or reject the proposal for investments.

However, the difference between the two investment criteria exists when the organization is faced with mutually exclusive projects. Mutually exclusive projects are investments in which the cash flow of one project is dependent on the cash flow of another investment. In such a scenario, when calculating the IRR and NPV of the two projects, the value of NPV and IRR will be different. When value of NPV is high, the IRR value will be low and vice versa. This differentiation is what creates conflict on which project to undertake. But since maximizing the shareholders' wealth is among the essential functions of managers, then it is prudent to take NPV.

Reasons why the Techniques are Preferred by Firms in Calculating the Accounting Rate of

Return (ARR) and the Payback Period (PB).

The net present value

One of the reasons why investing companies prefer NPV method is that it allows easier and apt comparison of potential investments. The firm through this approach can be able to determine the level of viability of each option as long as the investment options are carried out at the same period. Given the NPV from various investment proposals, the company can be able to choose the most positive investment scheme which will add extra value to the firm. On the other hand, if the results are negative, the company should not choose the proposal since it will add losses to the organization. Therefore we can say that the model is used by corporations to make informed decisions regarding investment projects.

Another reason as to why companies prefer to use NPV strategy is that the technique is customizable. Being customizable means that the company can be able to adjust the cost of capital to meet demands such as opportunity cost and premium on long-term debts. Additionally, the theory utilizes all the cash inflows happening throughout the whole lifespan of the venture in ascertaining its value. Subsequently, it is a measure of the investment's real profitability. The net present value strategy depends on estimated cash inflows and the discounting rate as opposed to any discretionary presumptions, or subjective contemplations. The ability of the technique to acknowledge the concept of time value of money gives it an upper when compared with other methods.

The internal Rate of Return

One preferred advantage of IRR strategy is that it is easy to comprehend. Assuming total investment proposals need a similar quantification of up-front investment, the plan whose IRR is higher would be seen as more profitable and attempted first. A company should, in principle, embrace all investments whose IRRs exceed the cost of capital. Eventually, a business is seen as viable if the internal return rate is greater than the recommended cost of equity. Many companies and financial analysts can understand the opportunity cost of an enterprise. If IRR exceeds this minimum rate, then the venture generates monetary accumulation. On the contrary, in case the investment rate is expected to be below IRR, then the project will pulverize firm value. IRR is used as a section of numerous organizational budgetary profiles because of its clarity to all parties involved.

The IRR methodology additionally uses cash flows and acknowledges the concept of time value of money. Like payback period approach, IRR considers time value of money. This is based on the account that IRR methodology expects high return rate on investments. Also, the internal return rate of organization is a pointer of the productivity and yield of an investment. This is conversely with NPV, which indicates the value of an investment.

Profitability Index (PI)

Just like IRR and NPV, profitability index considers the idea of time value of money, cash flows from the investment, and risk which an investor is likely to encounter in the future through the use of cost of capital. Additionally, the technique is simple to use in that even an individual with no solid background in finance can use it. The method utilizes simple mathematical operation of division and with present value of all future cash inflows and the initial capital expenditure, one can be able to get an answer and make a decision. The decision to whether to accept or reject a proposal will depend on the resultant value from the division.

Analysis of the Problem

The company is facing a problem on how to increase the revenues and reduce the operating costs. One of the alternatives to solve the problem is to replace the old machine with the new machine which has the capacity to increase sales and cut down the costs. But the decision whether to buy the new machine or remain with old one solely depends on the viability of the new machine over its productive life. As the company's external project advisor, I have analyzed the two machines for the purpose of making an informed decision whether to replace the old machine or retain it.

 My analysis starts with finding the initial capital outlay which will be available if the firm decides to dispose the old machine and buy the new machine. Apart from finding the original investment cost, I have tabulated the year to year cash flows for the two machines and the terminal value of the two machines. Additionally, as part of finding the solution to the problem, I have identified the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI) of the project. All these undertakings are directed towards coming up with a concrete solution concerning the cost-effectiveness of the new machine. 

The initial capital outlay based on the calculations is $540,000, and the present value of all future cash inflows is $689,276.23. To determine whether the organization should accept this independent project, I have utilized various investment decision criteria including internal rate of return, profitability index, and net present value. All these techniques are geared towards enabling the management to make an informed choice regarding the investment. Based on the tabulated results, NPV value is 149,276.23. Using IRR, the tabulated rate is 15.38%, and PI shows a ratio of 1.28. Depending on the results, the project is viable since theoretically, under NPV, a proposal is accepted if its net present value is positive. In IRR model, an investment is approved in the event that the calculated IRR rate is more compared to the firm's cost of equity and based on the results, IRR rate (15.38%) is more than the firm's required cost of equity (10%).

Additionally, under profitability index model, a project is accepted if the PI ratio is more than one. In our case, tabulated PI is 1.28. Therefore, we can comfortably say that the project is viable since it has satisfied all the above requirements. Also, I conducted a sensitivity analysis on NPV to determine how various levels of costs of capital under a given level of growth affected the value of NPV. From the results, varying the dependent variables i.e. growth rate and cost of capital provided no change in the independent variable i.e. NPV.

Recommendation

Based on the above calculate results, I recommend the organization to replace the old machine with new machine since the new machine will help to revenues and reduce the cost operations.

References

Bierman, H., 2010. An introduction to accounting and managerial finance: a merger of equals. Singapore, World Scientific. http://public.eblib.com/choice/publicfullrecord.aspx?p=731271.

Boundless., 2016. Disadvantages of the IRR Method - Boundless Open Textbook. Boundless. Available at: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-budgeting-11/internal-rate-of-return-93/disadvantages-of-the-irr-method-404-874/ [Accessed October 25, 2016].

Damodaran, A.,2011. Applied corporate finance. Hoboken, NJ, John Wiley & Sons.

Davis, C. E., & Davis, E., 2012. Managerial accounting. Hoboken, N.J., John Wiley & Sons

Gallo A., 2014. Refresher on Net Present Value. Harvard Business Review. [Online]. Available from: https://hbr.org/2014/11/a-refresher-on-net-present-value [25 October, 2016).

Hawawini, G. A., & Viallet, C., 2011. Finance for executives: managing for value creation. Mason, Ohio, South-Western/Thomson Learning. http://www.dawsonera.com/depp/reader/protected/external/AbstractView/S9781408093313.

Hofstran D., 2013. Understanding the Time Value of Money. [Online]. Available from: https://www.extension.iastate.edu/agdm/wholefarm/pdf/c5-96.pdf. [25 October 2016]

Needles, B. E., Powers, M., & Crosson, S. V., 2011. Principles of accounting. Mason, Ohio, Cengage Learning.

 Schmidt R., 2014. What is IRR and How Does it Work? PropertyMetrics. Available at: http://www.propertymetrics.com/blog/2014/06/09/what-is-irr/ [Accessed October 25, 2016].

Shim, J. K., Dauber, N. A., & Siegel, J. G. (2013). The vest pocket cpa. Hoboken, N.J., Wiley. http://rbdigital.oneclickdigital.com.

Scholleová, H., Švecova, L. & Fotr, J., 2010. Criteria for The Evaluation and Selection of Capital Projects. Available at: https://www.mruni.eu/upload/iblock/12a/svecova1doc.pdf [Accessed October 26, 2016].

The Economic Times, 2016. Definition of 'Profitability Index' - The Economic Times. The Economic Times. Available at: http://economictimes.indiatimes.com/definition/profitability-index [Accessed October 25, 2016].

 

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