35,624 4 G ? 300,000 12% H ? 39,000 Calculations for A, B, C, D, E, F, G, H The four projects have a useful life of 10 years. For project 1: Total Cash flow for 10 years: ? 1,000,000. IRR: NPV= -? 449,400 + 100,000/ (1+R)1 + 100,000/(1+R)2 +¦+ 100,000/(1+R)10 = 0. A = 18%; IRR = 18%. By using the trial and error technique we calculated the IRR to be 18%. NPV: -449,400/(1+0. 14)0 + 100,000/(1+0. 14)1 + 100,000/(1+0. 14)2 +¦+100,000/(1+0. 14)10 = -449,400 + 521,611. 56 = 72,211. 56; B = 72,211. 56.
For Project 2: IRR: NPV = -Initial Investment (C) + 70,000/(1+0.2)1 + 70,000/(1+0. 2)2 +¦+ 70,000/(1+0. 2)10 = 0; C = ? 293,474. NPV = -293,474/(1+0. 14)0 + 70,000/(1+0. 14)1 + 70,000/(1+0. 14)2 +¦. + 70,000/(1+0. 14)10 = 71,655; D= ? 71,655 For Project 3: Annual Net Cash Flow: IRR: NPV = -200,000 + E/(1+0. 14)1 + E/(1+0. 14)2 +¦. + E/(1+0. 14)10 = 0; E = ? 38,343. Cost of Capital: 35,624 = -200,000 + 38,343/(1+F)1 + 38,343/(1+F)2 +¦+ 38,343/(1+F)10 ; F = 11. 00% : through trial and error we calculated the value of cost of capital as 11. 00%. For Project 4: Annual Net Cash Flow: 39,000 = -300,000 + G/(1+0. 12)1 + G/(1.12)2 +¦. + G/(1. 12).
10 ; G = ? 60,000; IRR (H): NPV= -? 300,000 + 60,000/ (1+R)1 + 60,000/(1+R)2 +¦+ 60,000/(1+R)10 = 0. H = 15. 1%; by trial and error method we calculated the IRR of the 4th project as 15. 1%. Project Selection Based on Available Data The investment techniques that have been used to evaluate the 4 projects have given us some important factors to consider before making the final decision. In light of the data available we suggest that project 3 should be chosen because firstly the initial investment is the lowest amongst all the four projects.
Secondly another important factor is that the difference between the cost of capital and the IRR is less than some of the other projects more importantly the IRR is 14% which is the lowest amongst all the four projects. This means that if project 3 is pursued the company the is likely to achieve quick returns and even if the performance of the project is not outstanding due to external factors the company can make substantial returns from the project. The critical factor is that project 3 can bring in returns far more quickly than other available projects as any returns beyond the 14% mark would be real returns on the investment.
Another significant factor would be the saved money from the initial capital that can be used for other projects with similar or even better returns prospects. The cost of capital for this project is also the lowest amongst all other projects; this is also an indicator that change can be absorbed by the company. With project 3 we see that the annual cash flows are amongst the highest if we use the annual cash flow/ initial investment basis for comparison between all the four projects. This also indicates that project 3 is more viable than some of the other projects such as project 1.
The only criticism of project 3 is that the gap between cost of capital and IRR is smaller than lets say from project 1 or project 2. This creates a potential problem if and when interest rates start to increase then the project might become non-profitable in terms of real rate of return.
Conclusion The investment appraisal techniques have become an essential methodology to solve and answer critical questions when it comes to selecting major expansion projects. When companies go to venture capitalists or other financial institutions they must fulfill certain criteria before being given the amount of money they are looking for.
Even in the investor industry most investors are required to provide there rate of return requirements before companies or other financial institutions could make tailored products for the investors. It must be emphasized here that companies must understand that other economic data is crucial in relation with the financial data that these appraisal techniques provide.
Bibliography: The Institute of Chartered Accountants England and Wales, Investment Appraisal Techniques, viewed February 5, 2010 < http://financial. kaplan.co. uk/Documents/ICAEW/MI_Ch3_p. pdf> Schuster, Northcott, Gotze, 2008. Investment Appraisal: Methods and Models, Springer-Verlag Berlin Heidelberg Martina Rohrich, 2007, Fundamentals of Investment Appraisal, Oldenbourg Coursework4you. co, Advantages and disadvantages of different appraisal techniques viewed February 5, 2010 < http://www. coursework4you. co. uk/essays-and-dissertations/finance-and-accounting/investment-appraisals/P_F_61_Advantages_and_disadvantages_of_different_investment_appraisals_techniques. php>.