According to the current situation of Glee Plc, this company is underperforming in term of profit and the new projects are not going as well. To solve this problem, the manager of Glee Plc should conducts investment appraisal to appraise the investment opportunities.
Investment appraisal refers to the ”evaluation of proposed investment ”(DC, Blood, 2010) and also known as capital budgeting. In order to improve the profit, Glee Plc should undertake the projects which may give sustainable competitive advantage to them. However, they will be faced with different investment projects such as launching a new product or opening a new outlet and purchasing new machinery. Normally, such investment projects might take a long term period (more than a year) and a lump sum will be involved, but a company will have a limited amount of funds to invest. As such, investment appraisal needed to be conduct by the manager of Glee Plc to evaluate whether which investment project is more profitable.
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The main factor that caused Glee Plc underperforming probably is that they have no making any investment analysis during the decision making process and therefore the company unable to make evaluation of the investment project and could lead the company to loss or earn lesser profit. By conducting the investment appraisal, the manager of Glee Plc able to compare and evaluate which investment proposal is better and should be undertake. Thus, investment appraisal is playing an important role during the decision making process.
There are four techniques can be apply into the evaluation of investment proposal such as Payback Period (PP), Accounting Rate of Return (ARR), Net Present Value (NPV) and Internal Rate of Return (IRR).
Payback method is a method that uses to ”measure the time required for the cash inflow from the investment project to recover the initial investment cost” (INVESTOPEDIA, 2010). Usually, a manager using payback method is to calculate whether how long the time their cash inflow can cover the cost of the investment project.
Based on the appendix 1, a company planning to purchase new machinery but there are two different machines available and the cost of machine also different. From the payback method, it resulting that the payback period for machine X is 2 year and 8months and the payback period for machine Y is 3 years. Thus, the company might considered machine X first since the payback period is shorter and the investment risk will be lower and the capital will not be tied up and compared to machine Y the payback period is longer and probably the investment risk will be higher.
Payback method is the quickest and simplest to understand method among others method of investment appraisal. ItâÃ¢â€šÂ¬Ã¢â€žÂ¢s easy for the Glee Plc manager to apply. In addition, this method handled the risk effectively because from the concept of payback method it shows that the shorter the period the better the investment, if the payback period is shorter the company able to focuses on other investment and also enhancing the liquidity. On the other hand, if the payback period is longer means that the capital is tied up and the investment risk will be increase.
Although payback method is quick and simple but this method is not appropriate for long-term financing because this technique did not considered the time value of money and Inflation might be occurs during the payback period, the money value will decrease so the companies have to pay more than they expected since the money value is dropped. Other than that, if the projects payback period is similar or same the company unable to distinguish which project is better.
From the AllBusiness.Com Inc (2010), it stated that ARR is a method of investment appraisal that uses to estimates the rate of return from an investment. This method also known as comparative method which is often used by a company when there are several competing investment proposals and usually the result is shown as a percentage which the higher the percentage the higher the return. This calculation is using the average profit derived by the average investment and converts the answer into percentage. By using this method, company able to see the return on investments and make a comparison whether which investment proposal is more profitable and should be undertaken.
According to the appendix 2, the Accounting rate of return (ARR) of machine X is 20% and the ARR of machine Y is a bit lower which is 16%. Thus, the company should purchase machine X since the rate of return is more higher compared to machine Y.
This method provides a quick, simple and easy understand concept to Glee Plc which is similar to Payback method that I mentioned previously. When there are different competing investment proposal, the Glee Plc manager can use this method to estimate the profitability of the investment. This can help the manager to make a comparison between the different projects and the accounting rate of return method is relatively simple and can be quickly calculated by the manager.
While showing the advantages of accounting rate of return, there are some disadvantages need to be taken into consideration. This method is same as payback method which they ignores the time value of money and does not take into account of the timing of the profits earned from a project and the length of the project. In addition, this method is based on accounting profit which is subject to a number of different accounting treatments.
”Net present value analysis is the process to taking a current investment and projecting the future net income from this investment ”(Penton, 2010). In more specific term, NPV is the difference between present value of cash inflow and present value of cash outflow. This method is mostly used by companies to estimate the profitability of an investment projects. Therefore, net present value is the amount that indicates how much value an investment will increase to the company and this calculation is done by the present value of an investment in the future cash flow minus the amount which is initially invested. Additionally, there are three decision rules for this method, if the amount of net present value results in positive it indicates that the project is profitable and should be undertaken by the company. On the other hand, if the NPV amount is negative the project should not be undertaken and if the NPV amount is zero the project is worth to undertake.
NPV= Present Value (PV) of cash inflow âÃ¢â€šÂ¬" Present Value (PV) of cash outflow
As can be seen in the appendix 3, after conducted the net present value analysis, it shows that the NPV of machine X is positive value which is RM5, 100 and the NPV of machine Y is negative value âÃ¢â€šÂ¬"RM200. Thus the machine X should be purchased, since the NPV amount is positive and is considered a profitable investment.
While the NPV analysis is conducted, the manager of Glee Plc able to forecast the investment project is positive or negative value and thus the decision will be taken whether to undertake or reject it. This method is different from other two methods (PP and ARR). Because while doing the NPV calculation it will consider the time value of money and the risk of future cash flow.
However, the flexibility and uncertainty will not be taken into account for this method, and NPV do not consider the intangible benefit. Other than that, this method only indicates the value of the money and it does not provide the rate of return of an investment project.
An investment project’s internal rate of return refers to the discount rate that commonly used in capital budgeting that makes the NPV of all cash flows from a particular investment equal to zero. There is a decision rule for IRR method which the projects with an IRR greater than the cost of capital should be accepted. This method is often used by the companies to decide and evaluate the desirability of the investment or projects which they are considering. The higher a project IRR it mean the project is more desirable to be undertaken. As such, a number of several investment projects can be ranks by using this method and the project with the highest IRR could be considered the best and should be undertake first. However, there is a similarity between NPV and IRR which both methods are widely used to decide which investment should undertake and which investment should be reject.
Regarding to the appendix 4, Lee Plc is considering whether to purchase machine X or Y and the cost of capital is 15%. From the result of IRR analysis, the machine X IRR is 18% and the IRR of machine Y is a bit lower which is 14.91%. Therefore, Lee Plc will purchase machine X because the IRR of machine X is greater than cost of capital (15%) is considered a profitable investment and the machine Y probably will be rejected by the company since the IRR is lower than the cost of capital.
IRR analysis provides easily understood concept to the manager of Glee Plc and the discount rate doesnâÃ¢â€šÂ¬Ã¢â€žÂ¢t need to be specified before IRR is calculated. Other than that, the time value of money will be taken into consideration in this technique. Thus, Glee Plc need not to worry about they might be paying more during the investment period.
However, while conducting this method the Glee Plc manager can be easily confused, it ignores the relative size of the investments. IRR and NPV both methods gives conflicting rankings when faced with which project should be undertake first. This method assumes that the cash flow will be reinvested at the IRR rate but not at the cost of capital.
Despite the four techniques (PP, ARR, NPV, and IRR) that I mentioned previously have the merits and limitations, but the better techniques that should be applied by the Glee Plc to make an evaluation of investment project are the NPV and IRR analysis. During the investment period, the economic recession might be occurs and which could lead to inflation. If a company make an investment and evaluated by using the Payback Period and ARR techniques which both techniques are not considered the time value of money, in consequences the company might have to spend more than they expected, because the money value will decreased during the economic recession period. On the other hand by using the NPV and IRR analysis, Glee Plc can be avoid this issue because the time value of money and risk of future cash flow are taken into consideration. Hence, the investment risk will be lower compared to using other 2 methods.
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