Investment Appraisal Report For Herts Gadgets International PLC

Investment Appraisal Report

For

Herts Gadgets International plc

[Name of Student]

[Name of Professor]

[Date of Submission]

Introduction

            Hertz Gadgets International PLC has been selling wide range of machine tools accessories in three different markets; South Korea, Spain and Canada. Contemporarily, the company has been considering an investment project of expanding the production capacity by investing into the new production plant and machinery. It expected that this new investment project will require £13 million initial investment along with £2 million working capital that would be recovered at the end of project life-cycle which is 5 years. Meanwhile, due to the investment into the new production plant and machinery, the company will experience incremental revenues and cost savings by £2,865,000 and £1,680,000 respectively. The given background information of the company suggests that company tend to make a significant incremental revenues and cost savings but the decision cannot be made whether the company should undertake the project or not? Hence, following report is presented to the Hertz Gadgets International PLC which undertakes project appraisal analysis by using the capital budgeting techniques; payback period, accounting rate of return, net present value (NPV), internal rate of return (IRR) and profitability index (PI). In addition to, the report also discusses the potential effect of exchange rate risk over the project and alternate sources of finance that could be used by the company to finance the project. Meanwhile, other non-financial considerations, value creation and key drivers are also discussed that could be considered to analyze the feasibility of the project.

Methodology

            In following report, five different performance appraisal techniques have been used to assess feasibility of the project and application of these techniques is explained and discussed as follows

            Capital Asset Pricing Model (CAPM): CAPM refers to an asset pricing model that explain interrelation between the systematic risk and return; and it has been widely used for the purpose of estimating the expected return of a stock or company based on the associated systematic risk (Lee and Upneja, 2008). Similarly, CAPM was used to calculate cost of equity which is prerequisite to calculate the cost of capital for the company and following formula was used

            Where,  refers to the beta representing the systematic risk of the company,  represents the risk-free rate at which an investment can earn a profit without taking any risk such as government investments and  refers to the market return representing a yearly return provided by market index.

            Weighted Average Cost of capital (WACC): WACC refers to the minimum expected rate of return that company must pay to all of shareholders and it is also commonly referred to firm’s cost of capital (Brusov et al., 2011). In accordance with explanation of Frank and Shen (2016) it is most likely an expected return that shareholders of the company expected to earn over the investment in the company. Similarly, in order to appraise the investment project, WACC was calculated through following formula

            Where,  refers to the cost of equity calculated through CAPM,  refers to the portion of equity in the capital,  refers to the cost of debt,  refers to the portion of debt in the capital and  refers to the tax.

            Payback period: It provides the length of the time a project takes to recover the initial investment or in other words it also refers to a point in time at which the project will break-even (Ardalan, 2012). This technique has been used in following report to determine how much time project takes to recover initial investment.

            Accounting rate of return (ARR): It is used to determine average yearly return that could be expected from a project with respect to the initial investment made into the project (Brief and Lawson, 2014). It is calculated through following formula

            This technique allows to put a quick glimpse on the project that how much it generate an average return over the initial investment and it also does not account for the time value of money concept.

            Net present value (NPV): It refers to present value of the cash flows after deducting the initial investment. It is calculated by applying discount factor to each year’s cash flow and sum of cash flows minus initial investment is described as net present value (NPV) that is to be generated if the project is undertaken (Gallo, 2014). Hence, a positive NPV is more preferred and favorable that suggests that project tend to generate a value for firm.

            Internal rate of return (IRR): It refers to the discount rate at which the cash flows turn zero and it has been used to assess the feasibility of the project. Meanwhile, an IRR greater than cost of WACC said to be a value generating project. Hence, it is also used in the following report to assess whether project worth investment or not?

            Profitability index (PI): It is used to assess the attractiveness of the project that whether it worth investment or not? It is calculated by sum of present cash flows divided by initial investment (Patrick and French, 2016). A project with value greater than 1 is said to be attractive and comparatively a project with higher PI is to be selected when multiple projects are analyzed.

Investment Appraisal Findings

Payback Period

            Table 1 presents payback period of the project, where it is evident that project will recover the initial investment in 3 years and 5 months. It is a period in which project will recover the initial investment and cash flows beyond that period would be considered return from the project. However, decision cannot be made alone on the payback period because it may be misleading given the fact that it does not account for the time value of money concept.

Table 1 Payback Period

Accounting Rate of Return

            Table 2 presents the accounting rate of return, where it can be observed that accounting rate of return of the project is 32.7% which suggest that on average the project will generate a return of 32.7% in a given year during the period of project. However, similar to the payback period, it is very early and less effective technique to make decision since it also ignores the time value of money concept. However, apparently investment project of the company seems to be profitable.

Table 2 Accounting Rate of Return

NPV and IRR

            In order to evaluate the project based on the NPV and IRR, firstly discount rate was calculated through weighted average cost of capital (WACC); but before calculating the WACC, the cost of equity and cost of debt was determined and following formula was used for the WACC

            After calculation of the WACC, it was used as a discount rate to calculate the net present value (NPV), where all incremental cash flows and cost savings were discounted on WACC to approach the present value of those cash flows and deduction of initial investment from cash flows led to NPV. The table 3 presents the calculations of the net present value (NPV) and internal rate of return (IRR); and it can be determined that calculate net present value of the project is £2,630,652 which suggests that project worth investment due to the fact that it has generate a significant positive NPV. Since, NPV is a positive and significant, hence it is an indication that project is worthwhile. Similarly, the internal rate of return of the project is found to be 17% which is greater than calculated weighted average cost of capital (WACC), hence it suggests that project generates value for the company. Because it effectively covers the minimum expected return of the shareholders but even provides significantly higher return. Therefore, based on the results of the NPV and IRR, the project can be accepted because it tends to generate a positive return over a life of project.

Table 3 NPV and IRR

Profitability Index (PI)

            Table 4 presents the calculation of the profitability index (PI), where it reveals that profitability index of the project is 1.18 which is greater than 1 and indicates that project worth investment. Because, a value greater than 1 shows that project generates more value than initial investment and also the return is based on the present value. However, application of the profitability index is more relevant and effective when decision is to be made on the similar multiple projects.

Table 4 Profitability Index (PI)

Discussion

Currency Risk

            The company is currently exporting its all of sales to three countries; South Korea, Spain and Canada. Hence, the company is exposed to three different types of exchange risks, where if the sterling becomes stronger against these currencies then it is more likely that overall sales will be affected negatively. Because, a stronger sterling will discourage customers to refer to alternate options rather products of the company. Similarly, company majority of the sales takes place out of home country, so in case of weaker sterling company’s overall net profit margin will be affected given the fact that it will be exposed to translation risk. Therefore, the project could be affected by exchange rate risk even if sterling gets stronger position or weakens against other currencies.

Sources of Finance

            There are three potential sources of finance that could be used to finance the project. These sources of finance include; internal financing, equity financing and debt financing. As per the pecking order theory, a firm prefers to finance itself through internal finance which is retained earnings, but if the retained earnings are not available then it should prefer to the debt finance and in case if the debt finance option is also not available then issuing equity into the market is last resort for the company (Ahmadimousaabad et al., 2013). However, the theory also further explains and argues that internal financing can trigger a signal to shareholders that shares of the company are undervalued but if the debt is used as finance option then it could also signal investors that shares of the company are undervalued and that company is going to make greater profits in future. Furthermore, if the firm issues equity into the market then it sends a negative signal to the investors that firm’s stock is overvalued. Therefore, considering the associated costs with the financing, debt financing is a cheaper source of finance due to residual claimant title, followed by internal financing and issuance of equity (Mukherjee and Mahakud, 2012). Thus, company is also recommended with suggested pattern of finance that it should prefer to debt financing first, secondly internal financing and lastly equity financing.

Other Non-Financial Matters

            The key non-financial matters that must be considered include meeting with the industrial practices and standards to remain competitive in the market and also compete with the competitors effectively. Similarly, other important non-financial matters are improving reputation of the firm, relationships with the suppliers and customers, and also enhance the morale of the employees. This will allow firm to ensure it has sufficient capabilities, skills and name into the market to capitalize the investment which tend to increase the production capacity of the company. Lastly, another important non-financial matter that should be considered is risk management and protection of intellectual property (Sectoropen, 2021). Because, it is important for the company that it should undertake a systematic and proper risk management processes to identify and eliminate any potential risks to company may be exposed in the future and also protect the property by means of registering with the government body.

Conclusion and Recommendations

            The payback period of the project suggests that it will recover the initial investment of £15 million within 3 years and 5 months which is attractive itself. Meanwhile, the accounting rate of return is found to be 32.17% which is also attractive and appealing but still decision cannot be made on these techniques since they do not consider the time value of money concept. Meanwhile, the net present value (NPV) of the project is £2,630,652 and has IRR of 17%; since NPV is positive and IRR greater than WACC. Hence, the project should be accepted given that it tends to generate a positive value for the company and shareholders. Thus, the project is acceptable and feasible on the financial basis. However, certain limitations are also associated with the capital budgeting techniques used; for instances, the payback period and accounting rate of return (ARR) does not consider the time value of money concept. Similarly, the NPV also holds certain limitations where it is highly sensitive to the cost of capital which might have underestimated or overestimated. Hence, overall the project might have been an attractive due to underestimated or may become an unattractive due to overestimated discount rate. 

References

Ahmadimousaabad, A., Bajuri, N., Jahanzeb, A., Karami, M. and Rehman, S., 2013. Trade-off theory, pecking order theory and market timing theory: a comprehensive review of capital structure theories. International Journal of Management and Commerce Innovations, 1(1), pp.11-18.

Ardalan, K., 2012. Payback period and NPV: their different cash flows. Journal of economics and finance education, 11(2), pp.10-16.

Brief, R.P. and Lawson, R.A., 2014. The role of the accounting rate of return in financial statement analysis. In The Continuing Debate Over Depreciation, Capital and Income (pp. 235-250). Routledge.

Brusov, P., Filatova, T., Orehova, N. and Brusova, N., 2011. Weighted average cost of capital in the theory of Modigliani–Miller, modified for a finite lifetime company. Applied Financial Economics, 21(11), pp.815-824.

Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.

Gallo, A., 2014. A refresher on net present value. Harvard Business Review, 19.

Lee, S. and Upneja, A., 2008. Is Capital Asset Pricing Model (CAPM) the best way to estimate cost‐of‐equity for the lodging industry?. International Journal of Contemporary Hospitality Management.

Mukherjee, S. and Mahakud, J., 2012. Are Trade-off and Pecking Order Theories of Capital Structure Mutually Exclusive?. Journal of Management Research, 12(1), pp.41-55.

Patrick, M. and French, N., 2016. The internal rate of return (IRR): projections, benchmarks and pitfalls. Journal of Property Investment & Finance.

Sectoropen Submenu. 2021. Non-financial factors for investment appraisal | nibusinessinfo.co.uk. Available from: <https://www.nibusinessinfo.co.uk/content/non-financial-factors-investment-appraisal>. [December 25, 2021].