Accounting Rate of Return Arr Finance Essay

The aim of this Capital Investment Appraisal Report is to evaluate two transport infrastructure projects for the city of Coventry using four different appraisal techniques and make a recommendation based on the calculations as to which project would be most profitable. The budget is £30 million and the projects are mutually exclusive, which means only one can be undertaken. Project 1 is a new tram network and would link major parts of the city. Project 2 is a new toll road that would link the M69 and M6 motorways.

Accounting Rate of Return (ARR)

ARR is a non-discounted cash flow method and the only appraisal technique that is profit based. It is calculated by dividing the average annual profit by the initial investment and multiplied by 100 to give a percentage figure. ARR is easy to calculate as it is based on accounting principles. it reflects the value of the project over it's entire life and is preferred by most managers as they can compare the returns from different projects and select the one which offers the highest return. ARR is usually used internally when it comes to project selection. It is rarely used by investors as cash flows are more important and ARR does not take into account non-cash items. The profit is subjective and does not equate to cash and it uses arbitrary depreciation methods. It does not take into account the time value of money, which means the value of cash flows does not diminish with time. The ARR for project 1 is 11.98% and for project 2 is 13.17%. If we were to choose between these two projects purely based on the ARR then we would select Project 2 as it offers a higher rate of return.

Payback Period (PBP)

PBP calculates the time taken for the net cash inflows to equal the initial investment. The shorter the payback period, the more attractive the project. Payback Period is very simple to compute and it provides some information on the risk of the investment and a crude measure of liquidity. It does not however take into account the time value of money, this can be corrected however by using the discounted payback period. Cash flows after the cut-off period are ignored, the cut-off period itself is arbitrary and it ignores the risk of future cash flows. This means you could hypothetically get a huge cash flow injection after the cut off period which would be ignored. There is also no concrete decision criteria to indicate whether an investment increases the firm's value. (https://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf) PBP for Project 1 is 6 years and 5 months and for Project 2 it's 5 years and 9 months, this means we recoup our investment quicker with the latter investment despite it costing more and taking longer to build. this would imply that it would generate a higher revenue based on the forecasts. Comparing the payback period for both projects, we would recommend investing in project 2 as the payback period is shorter.

Net Present Value (NPV)

This is the sum of all the present values of all the relevant cash flows connected to the project. If the NPV is positive then we accept the project and if we have several projects that are mutually exclusive then we accept the project with the highest NPV. We reject any projects that have a negative NPV. (https://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf) NPV tells us whether the investment will increase the firm's value. It considers all the cash flows, includes the time value of money and considers the risk of future cash flows through the cost of capital. One of the few weaknesses of this technique is that it requires an estimate of the cost of capital in order to calculate the net present value and the answer is expressed in terms of currency and not as a percentage. The NPV for both projects is positive but Project 2 has a much higher NPV, difference of £4,495,921, more than double that of Project 1, thus we would recommend investing in Project 2 based on this method.

Internal Rate of Return (IRR)

IRR is the discount factor at which NPV is equal to zero. The strengths of this appraisal method is that it tells us the firm's value will be increased by the investment. It considers all the cash flows of the project, takes into account the time value of money and considers the risk to future cash flow through the cost of capital. Some of the flaws of this technique are that the cost of capital has to be estimated through trail and error in order to make a decision. It may not give the profit-maximising decision when used to compare mutually exclusive projects or help choose projects when capital rationing is involved. Finally it cannot be used for projects with unconventional cash flows. (https://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf) Through the trial and error method and using a difference of one percent for greater accuracy, where NPV switches from positive to negative, using the total present value rounded to the nearest pound and using a discount factor to three decimal places, I interpolated the IRR for both projects. IRR for Project 1 is 13.28% and for project 2 it was 15.31%. Again the latter offers the higher rate of return, so the advice would be to invest in Project 2 based on this method.

Non Financial Factors -

When assessing the feasibility of a project, non-financial factors are just as important as the economic benefit of a project and have to be considered in making any meaningful investment decision. It is important to analyse whether or not the customer will be satisfied before making an investment, as that will affect the return generated. Government policy is another important non financial factor when making investment decisions, as the rate of interest or tax could affect loan repayments, price of materials and labour. Comparing what your competitors are doing in the market could lead to investing in projects that are based on non financial factors. Analysing any trends before making an investment to see if there is a potential return from the investment. The City Council would need to consider if there is enough skilled labour force to operate the equipment that is to be invested in. The effect an investment will have on staff motivation is also a key factor before going ahead with any project. (https://www.accountantnextdoor.com/investment-appraisal-8-non-financial-factors-that-every-accountants-and-managers-should-consider/) Customers attracted by the product might see another product that they may like, this is known as backend profit and could be another non financial factor to consider before making an investment. Environmental issues have recently become very important to companies as they do not wish to be seen as irresponsible by the public, who could be potential customers. Companies will often invest in equipment that are seen as preserving the environment to project a positive image even though it may not be financially in their interest. The government is strongly committed to avoiding tolls on any existing roads. Campaign for Better Transport has stated the problem experienced by a number of road and toll projects, including the Mersey Gateway bridge and the loss-making M6 motorway. There is strong evidence to suggest that forecasts for traffic on existing roads, and toll roads in particular, are over-optimistic worldwide and in the UK, as the M6 toll experience shows. A 2011 analysis of 100 completed road toll projects around the world found that road traffic forecasts have been over-optimistic by 20-25%. In the UK there has been driver opposition to pay-as-you-drive. The UK has a very highly developed existing network with large numbers of alternative routes available to drivers who wish to avoid tolls. Campaign for Better Transport review of the M6 Toll showed a drop in traffic level and revenue on the toll roads. (The M6 Toll, five years on. Campaign for Better Transport, August 2010) In other countries, toll roads have also experienced problems with over-optimistic traffic forecasts. In Brisbane, Australia, operator River City Motorway went into receivership in 2011 after predicted traffic flows on the tolled Clem7 Tunnel fell to less than a third of what was predicted. (https://www.bettertransport.org.uk/files/admin/Problems_with_Private_Roads_FinalWeb.pdf) A recent study published, examined the problems faced by toll roads in the UK and the findings included some of the points listed below. There is a certain element of risk to investors that require large guarantees from the local council or government to make this type of investment attractive, thus making them vulnerable to political changes and pressure. Community opposition to the building of new roads is often seen and this could add further risk by increasing the timescale in getting project approval. Strong evidence suggests that forecasts for traffic on existing toll roads are over-optimistic worldwide and in the UK, as the M6 toll experience shows. Females tend to be more reluctant to change routes and low to medium income earners are more sensitive to tolls. (Lake, M. and Ferreira, L. (2002). Modelling tolls: values of time and elasticities of demand: a summary of evidence.) If we were to look briefly at the tram proposal, the tram would result in a reduction in the number of car trips, compared to the 'no tram' scenario. This would mean fewer parking spaces will be taken, and these benefits are likely to be focussed in the areas served by the tram and result in less traffic on the roads in these areas. (WEST LONDON TRAM: EALING COUNCIL BUSINESS CASE 2005) In the future, government might introduce traffic limitation measures, such as congestion charges and parking control charging. In this scenario the tram would provide an attractive alternative for those choosing to use their cars less. (HS2 Ltd, 2011, HS2 London to the West Midlands Appraisal of Sustainability, A report for the Department for Transport)

Conclusion

Any major project, like a motorway or tram network which affects millions of people has many factors besides the economic factor that have to be taken into account. It has been observed that noise pollution, particularly air pollution, damages people's health. The public's adverse reaction to certain projects might jeopardise government's chances of re-election. The proposed projects's pros and cons has to be evaluated. Social, environmental and political factors are very important. Sometimes a non-financial factor could influence a company into accepting a project with a lesser return for a better image, this is the opportunity cost. If the environmental and non-financial factors were more important to the City Council then Project 1 would be the better option. It is still making a profit and would cost £8,000,000 less to invest in. My recommendation though, to Coventry City Council, based on the results from the four appraisal techniques would be to invest in Project 2. That would be the correct decision if financial factors are the only motivation.

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