Investment Appraisal Techniques: The Case Study
The payback period gives information the duration of time it will take the management to recover the initial investment. Based on the payback period criterion, Epoxy resin will be selected because it has a shorter payback period. However, Tim should not rely on this criterion because it does not provide any information on the profitability of a project. Also, it does not take into account the time value of money. Finally, the method does not use cash flow generated during the full life of a project. It ignores those that arise after the payback period. The management can only use this criterion to rank the project.
Discounted payback period
This criterion makes use of discounted cash flows to estimate the number of years it will take the business to recover the initial investment. Based on this criterion, Epoxy resin will be selected because it has a shorter discounted payback period. Tim should not ask the board to base their decision on a discounted payback period because it does not estimate the profitability of projects. Also, the method does not use cash flow generated during the full life of a project. It ignores those that arise after the payback period. Therefore, it is not a suitable method because it provides little information. It can also be used to rank projects. The management can also compare the discounted payback period with the benchmark period.
Accounting rate of return (ARR)
The ART of the two products is greater than the 40% that is preferred by the management. Further, Synthetic resin has a higher value of ARR than Epoxy resin. Therefore, it will be preferred. However, the decision will be misleading because the criterion does not take into account the time value of money, it does not use the cash flow from the project. It uses the profit that is generated from a project. Finally, this approach does not use the terminal value of the assets bought. This value is important because at the end of the life of a project, a company can generate cash flow from the assets that were being used in the project.
Internal rate of return
The IRR for Epoxy resin is higher than that of Synthetic resin. Therefore, Epoxy resin will be selected based on this criterion. However, the method is not adequate because it gives conflicting results. For instance, Synthetic resin yields higher NPV than Epoxy while IRR gives different results. Also, it does not take into account the size of the project. Also, this criterion has a potential of overstating the rate of return of a project. The criterion also cannot be used to compare projects that have different useful lives. This is based on the fact that it does not use the cost of capital. Finally, IRR cannot be used reliably if the cash flow of a project is not consistent, especially if the project has an alternating stream of positive and negative cash flow.
Net present value (NPV)
The NPV for Synthetic resin is greater than that of Epoxy. Therefore, Tim should select Synthetic resin based on this criterion. The NPV criterion is a suitable way of selecting projects because it takes into account the cash flow for the entire life of the project. Secondly, it applies the concept of discounting cash flows. Also, the criterion can be used to estimate the profitability of projects. This approach also takes into account the element of risk. Finally, as can be seen in the calculations, the approach makes use of cash flow that is generated throughout the entire life of the project. The crossover rate is important because it gives information about the point where Synthetic resin will no longer be feasible.
Modified internal rate of return (MIRR)
Synthetic resin will be selected based on this criterion because it has a higher value of MIRR than Epoxy resin. MIRR is a better measure because it takes into account the wealth and the cost of a project. The method solves the shortcoming of both the internal rate of return and the net present value criterion. Thus, it takes into account both the negative and positive cash flow.
Profitability index (PI)
The PI for Synthetic resin is higher than that of Epoxy resin. Therefore, it will be selected. The criterion cannot solve the problem because it is too simple and may give misleading results.
Impact of conservative revenue projection
Some of the criteria discussed above are sensitive to the pattern of cash flows. If large amounts of cash flow occur at the beginning of the period, then the project is likely to have a high amount of NPV. Therefore, higher value of NPV will be achieved for Synthetic resin if the cash flows are adjusted.
Impact of technological development
Technological development can delay the timing of cash flow. During the period of technological development, a company will receive a lower amount of cash flow. Therefore, Synthetic Resin will receive cash inflow at a later period than Epoxy and this makes it appear to be less profitable. Therefore, technological development affects results.