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Investment Appraisal Techniques

Abstract

The aim was to discuss the investment appraisal methods and evaluate the method concerning the data set presenting the investment cash inflows and outflows over the next five years. The main purpose of investment appraisal is to assess and analyze different portfolio decisions and their future value. The investment scenario was created by looking at an investment prospect of a specific project only, which consisted of purchasing an asset and using it for five years.

The asset generated inflows during the five years of use and was sold at a scrap value of 2000 pounds. The initial amount was 25000 British pounds. The accounting rate of return came out to 34 percent. The payback period was computed as three years and 313 days, which is almost four years, and the net present value of the asset invested was concluded at 10,000 British pounds approximately. Moreover, financial fraud has been the result of several companies where ethical values are not taught.  Furthermore, some of the widespread economic, ethical issues commonly found are insider trading and campaign financing.

Introduction

The complexity and uncertainty related to strategic capital investment increase the likelihood of presenting challenging situations for the investors. The utilization of financial appraisal tools is likely to contribute to making appropriate decisions for strategic investment projects (Olawale, Olumuyiwa, and George, 2010).  The appraisal of the existing capital investments within the projects is fundamental for the business organizations’ success.

The business entities experience challenges in allocating scarce investment resources within the manufacturing projects and processes (Gotze, Northcott, and Schuster, 2016). The traditional business entities rely on utilizing capital budgeting methods to evaluate and justify investment-related decisions (Bouwens, 2017). In this regard, using the investment appraisal methods contributes to analyzing, evaluating, and deciding whether allocating resources within the project is appropriate.

This assignment aims to discuss the investment appraisal methods and evaluate the data set presenting the investment cash inflows and outflows over the next five years. This assignment will also present the impacts of ethical considerations on financial decisions.

Investment Appraisal

Several factors are taken under consideration in this case, such as legal and financial issues.  The overall value of an asset may help the organization in meeting its obligations and legislation.  However, it was argued by Emmanuel, Harris, and Komakech (2010) that investment appraisal is mostly quantified, but financial returns are received in the future against it.  There are several types of techniques in investment appraisal, as described in the next section.

The best method for investment appraisal is the payback method. It is the time taken for the inflow to equal the investments made through cash.  However, to compare different investments made is ARR, expressed through the percentage of the total costs.

It is so because of the uncertainty of the assets and their value in the future. The first issue that is raised is related to business investments that are made continuously. The level is a risk that is involved is predicted at the initial stage and the outcomes.  If a person intends to make any investments, they also expect to receive a return on it for which the risk factor can be ignored or mitigated.

However, the risk factor also varies depending on some other factors. One of the factors that can create risks is the project’s length (Hoesli and MacGregor, 2014). The size of the investments made also increases the risk because when a small number of assets are made, there are fewer chances of loss.

Most of the studies conducted in a similar domain have highlighted that projects face more investment risk when making assumptions about costs, demand, and pricing. The market changes are so rapid that they involve changes in the price and demand for products.

Therefore, this exposes the high level of risks for making investments. Though the investment decisions are taken by considering the methods and techniques at the same time, they also have to consider other factors such as investment decisions and their objectives, image of the company, involvement of the stakeholders and quality of products and the services offered to the customer (Agarwal and Thakur, 2013). Therefore, it is evident from the existing studies that investment appraisal is a risk involving a method that gives higher returns to the investors for the future. Many researchers have also stated that it involves contradictory results. Still, it depends on the payback periods.

Evaluation of Appraisal Methods

The accounting appraisal method is one the most widely utilized method for understanding the payback period. This method includes the concept of net earnings and earnings excluding depreciation and tax, which is vital to consider for appraising the investment proposal (Christodoulou, Clubb, and Mcleay, 2016).  This method also facilitates comparing the new product with the cost of the other projects of a similar nature; therefore, this method demonstrates a clear picture of the project’s profitability.

Despite various advantages, the method of investment appraisal has a range of disadvantages. For instance, if the return on investment is calculated by considering ROI and ARR separately, the results are likely to demonstrate clear variation, creating difficulty in decision-making (Bouwens, 2017). This method lacks consideration of the time factor; therefore, ignoring the time value of the fund is a potential weakness of this method.  The investment appraisal method also lacks the considerations related to the external factors and cash inflows, which are essential for assessing profitability.

Payback

The payback method is a more straightforward method requiring few inputs and is easy to calculate compared to other methods used for measuring capital budgets. The utilization of this method contributes to making quick decisions by considering a few inputs, which is one of this method’s potential strengths.  Häcker and Ernst (2017) mentioned that the payback method does not consider the time value of money, which is a potential limitation to this method.

For some projects, the largest cash flows are not likely to occur until the end of the payback period, whereas the payback method neglects the cash flows received after the payback period.  Some of the entities require the capital investments to exceed the return rate limit to reduce the risk of the decline of products (Schlegel, Frank, and Britzelmaier, 2016). The payback method is not applicable in these situations, as this method does not consider the project’s rate of return.

Net Present Value

The net present value method considers the basic idea of depreciation within the value of the currency. It believes that the cash flows are discounted by another period of capital cost. The present nest value also demonstrates whether or not the investment effectively creates value for the business organization and the investors, which is one of the potential strengths of this method (Häcker and Ernst, 2017).

The method also considers the cost of capital and the risk inherent while making future projections. Schlegel, Frank, and Britzelmaier (2016) demonstrated that the net present value method requires assumptions related to the business firm’s cost of capital, which is one of the limitations of this method. Assuming the very low price of assumption is likely to make suboptimal investments, considering the cost of capital very high is likely to contribute to making effective investments. For this reason, the net present value might also provide less relevant results.

Internal Rate of Return

The internal rate of return considers the time value of money while evaluating the project, which is one of the most significant advantages of this method. DeFusco et al. (2015) mentioned that the internal rate of return is simple to interpret and has been widely utilized by managers. Mellichamp (2017) stated that the internal rate of return is not dependent on the hurdle rate or required rate of return; therefore, using this method of investment appraisal further reduces the risk of decision-making due to wrong calculation of hurdle return.  Also, the internal rate of return is not based on the required rate of return, such that estimation rates can also be considered by calculating the internal rate of return.

Patrick and French (2016) mentioned that utilizing the internal rate of the method lacks the considerations related to the project size while comparing the projects. In this regard, using the internal rate of return method reflects the smaller project as more attractive, without considering the likelihood of acquiring higher cash flows and generating higher profits from larger products (Mellichamp, 2017). Also, this method only emphasizes the projected cash flows generated by the capital injection. It does not consider the future cost, which is anticipated to impact the future cost significantly.

Scenario Creation

The investment scenario was created by looking at a specific project’s investment prospect only, which consisted of purchasing an asset and using it for five years. The asset generated inflows during the five years of use and was sold at a scrap value of 2000 pounds. The initial outlay was 25000 British pounds. The use of the asset produced positive cash flows in manufacturing and selling goods made from it, as per the explanation provided by Francis et al. (2013). After which, the asset also required costs to repair and maintain it. The net cash flows had been used to estimate the returns, payback period, and net present value.

Moreover, it can be seen that the scenario used 6 percent as the cost of capital. This percentage is usually around 5 percent. As the company uses multiple sources of funds and practices using general borrowing funds to finance its assets, it gets this value as a capital cost.

The results of the appraisal also need a discussion. The accounting rate of return came out to 34 percent. This computation assumes that the cash flows are the profits earned by the business. Besides, there are no non-cash expenses charged to using the assets, similar to what has been mentioned by Alin-Eliodor (2015) in the article. The return of 34 percent over the value of the investment is sufficient. However, the same if spread for five years comes out to 7 percent only.

This is somewhat above the cost of capital. Therefore, the project can be undertaken by the business. However, the return may not be very high, and the company may not be very viable in the long run. The business requires higher volumes of profits to run profitable operations in the future. The payback period was computed as three years and 313 days, which is almost 4 years. The asset is used for 5 years, while the asset pays back before that period, which may seem permissible.

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The net present value of the asset invested was concluded at 10,000 British pounds approximately. Having a positive NPV means there is a go at the investment. Considering all the cash flows, discounted at the business’s capital cost, gives a positive net present value. It means that inflows’ value is more than the outflows, both after the due discounting. The discounted cash flows’ net value was 10041.8 pounds, similar to the work of Mousavi et al. (2013).

The internal rate of return is the value at which the discount rate yields zero cash flows from the investment. The internal rate of return (20.79%) is higher than the accounting rate of return, which means that costs used to arrive at the accounting rate of return are more than the cash flows used in arriving at the internal rate of return.

Year Inflow Outflows Net cashflow Discount factor 6% Discounted Cash flow Cost of Capital Discount Factor 10% Discounted Cash flow Discount Factor 30% Discounted Cash Flow
0 0 (25,000.00) (25,000.00) 1.00 (25,000.00) 1.00 (25,000.00) 1.00 (25,000.00)
1 12,000.00 (6,000.00) 6,000.00 0.94 5,660.38 0.91 5,454.55 0.77 4,615.38
2 23,000.00 (13,000.00) 10,000.00 0.89 8,899.96 0.83 8,264.46 0.59 5,917.16
3 15,000.00 (7,000.00) 8,000.00 0.84 6,716.95 0.75 6,010.52 0.46 3,641.33
4 56,000.00 (49,000.00) 7,000.00 0.79 5,544.66 0.68 4,781.09 0.35 2,450.89
5 29,000.00 (18,000.00) 11,000.00 0.75 8,219.84 0.62 6,830.13 0.27 2,962.62
10,041.79 6,340.76 (5,412.61)

Accounting Rate of Return

Average annual profits   x   100

Initial capital costs

8400    x   100

25000

34 %

Payback 3 years 313 days

Net present value (using investors cost of capital)

As computed in the table above = 10041.8 pounds

Internal Rate of Return

10 % + __6340.755413___   x 20% = 20.79%

6,340.76-(-5,412.61)

Application of Investment Appraisal Techniques

The application of investment appraisal techniques can be considered to evaluate the methods considered for the portfolio designed in this study. For the current scenario that has been created, the accounting rate of return was 34%, payback was 313 days, NPV was 10041.79, and the internal rate of return was 20.79%. Based on this, it can be considered that Net present value was an appropriate method of evaluation as it provides the exact pound value of the return to be received in the future.

The methods that are used for making the investment portfolio are NPV (net present value), ARR (accounting rate of return), payback, and IRR (internal rate of return). Firms commonly use all these methods and techniques to analyze and evaluate investment appraisal techniques (Mackevičius and Tomaševič, 2010). However, based on the existing studies that are considered, it was found that NPV is the best investment appraisal technique. It is so because the return received in the future is much higher than the present value of the investment.  It shows the number of pounds that it will create for the company.

Therefore, it was found from the existing studies that NPV is highly beneficial for determining what value the investment will create for the investor.  Unlike the other methods and techniques, NPV considers the cost of the capital used to discount the value in every period and calculate the risk of projects (Sartori et al., 2014).  The cash flows are used to predict the risk.

However, even though the firms and other investment agencies should consider this, it is essential to depend on a single method such as NPV, but the investment appraisal should be analyzed through all methods. It is also validated from the different project portfolios where the investors concentrate on a single method and consider other methods for finding the value of their assets in the future (Carmichael, 2011).

Apart from NPV, the portfolio designed in this report has used other methods such as ARR (accounting rate of return), payback, and IRR (internal rate of return).  The discount factor was used as 6% on each of the capital costs over 5 years. Thus, indicating that over 5 years, different returns will be received on a certain amount invested 25000 pounds.

Ethical Considerations

Ethical considerations are described as the regulations or set of morals that are diligently followed in an organization. However, ethical principles are different for every organization and every sector, depending on the culture.

Furthermore, it was also determined that several scandals occur in many business activities that affect or tarnish the company’s image in the market (Pandey, 2017). These scandals raise questions against the ethical principles and morality of the firm.  However, based on the different financial scenarios, it has been evaluated that the involvement of accountants and financial managers is mainly involved in financial frauds and scandals.  Most of the financial frauds and scandals in the limelight result from weak ethical principles and values embedded in employees in a firm.

Reporting systems, auditing, and bringing improvement in morals and ethics are possible ways of eliminating this issue. Several types of financial frauds take place in organizations. Some of the common examples of financial fraud are manipulating financial accounts of any company, misrepresenting financial information in annual reports or elsewhere, false signatures, concealing the original assets or the company’s fixed property, and deliberately distributing fake documents (Parmar, 2015).

In addition to this, it was also found from the existing studies that though it entirely depends on the nature of the offense. Still, the management has to ensure that all the employees are communicated the regulations and values.  Financial fraud has resulted from several companies where ethical values are not inculcated (Skaife, Veenman, and Wangerin, 2013).  Furthermore, some of the popular economic, ethical issues commonly found are insider trading and campaign financing.

Insider trading is defined as illegal misconduct of inside management of a company that buys and sells stocks within the company only and breaks trust and confidence. Some of the studies had termed insider trading as “tipping.” On the other hand, campaign finance is defined as raising funds to promote political parties and organizations.

Conclusion

To sum up the report, in a nutshell, it can be stated that investment appraisal is the collection and methods that are used to identify the extent to which an investment is beneficial for a project or not.  It was also found from the existing studies that investment appraisal is an important technique that involves the identification of the value of an asset. The primary and most common methods that are involved in evaluating are NPV (net present worth), ARR (accounting rate of return), payback, and IRR (internal rate of return). Firms commonly use all these methods and techniques to analyze and evaluate investment appraisal techniques. The current scenario taken was to purchase an asset and use it for five years. Based on it, the entire report has been evaluated.

References

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