UNIVERSITY OF SOUTH WALES

BUSINESS SCHOOL

STRATEGIC FINANCIAL ANALYSIS (AF4S031)

MBA

LECTURER: Chris Benjamin

ASSESSMENT 2

Capital Investment Analysis and Evaluation.

ENROLLMENT NUMBER: R1502D658467

SUBMISSION DATE: 23 February 2017

WORD COUNT: 3201

Contents

INTRODUCTION ......................................................................................................... 1

INVESTMENT APPRAISAL TECHNIQUES ............................................................... 1

Net Present Value ................................................................................................................ 1

Internal Rate of Return ........................................................................................................ 2

Payback Period .................................................................................................................... 2

PROJECT ANALYSIS AND EVALUATION ............................................................... 3

Other Considerations in Capital Investment Appraisal ....................................................... 5

PROJECT FINANCING .............................................................................................. 7

Equity & Debt ..................................................................................................................... 7

Comparative Advantages and Disadvantages of Debt & Equity ........................................ 9

CONCLUSION .......................................................................................................... 10

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Table Figures

Table 1 Project Metric Comparisons .............................................................................. 3

Table 2 Comparative Advantages_Debt vs Equity ......................................................... 9

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 INTRODUCTION
This document has been drafted to show an appraisal of the impending capital investment
decision by EML Co. between Projects Endeavour and Fox. The report will show the calculations and
results of three metrics which estimate the performance of each of the projects. The report then
presents an analytic comparison of the two thus creating a basis from which a decision can be
generated. Other factors which also affect the final decision are then presented.
Thereafter, the report provides a broad analysis of the financing options under consideration by the
EML Co.s board which are Debt and Equity. It then concludes with a presentation of the comparative
advantages of the two options as well as the pathway to finding the right capital structure.

INVESTMENT APPRAISAL TECHNIQUES

An analysis of both Projects Endeavour and Fox has been made with the intention of
determining which of the two is the most viable in terms of profitability and growth. This has been
carried out by means of three methods which provide measurables that take into account various
aspects such as the time value of money, timelines and taxation. The three methods are comparison
of Net Present Value (NPV), Internal Rate of Return (IRR) as well as Payback Period.

Net Present Value

In line with Corporate Tax Law, depreciation is a non-deductible expense therefore it will not
be subtracted from cash flows before tax for the purposes of calculating the tax expense. Corporate
Tax is paid a year in arrears therefore even though the period in question for both projects ends after
5 years, the tax expense for the fifth year will create a cash out flow in the 6th year. This has been
taken into account for all three of NPV, IRR and Payback Period. Another assumption which can be
made from the information available is that the provided Cost of Capital can be used as the Weighted
Average Cost of Capital (WACC) since there is no indication of its partitioning into the cost of equity
and the cost of debt. There is no indication of the need for risk adjustment in the discount factor hence
the given Cost of Capital will be maintained. The expected salvage value of the procured machinery
after project closure has been taken into account in terms of taxation as it is a cash inflow. Reference
is made to Appendix I and II for the calculation of Net Present Value for Projects Endeavour and Fox
respectively. Below are the values of NPV for both projects:

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 Project Endeavour NPV - $28,783
Project Fox NPV - $58,313

Internal Rate of Return

Trial and error has been utilised to find the Discount Rate when the value of NPV is zero for
each project. This has been achieved through the use of an excel sheet, feeding back various values
for the discount rate until the resultant NPV value reached zero. The IRR found shows the growth
rate that the project in question is expected to generate. In the absence of a stipulated Required Rate
of Return (RRR), the given Cost of Capital will be utilised for comparison. If the IRR is greater than
the RRR (or the Cost of Capital in this case), the project can be deemed profitable. For the purposes
of making an investment decision between Fox and Endeavour, a comparison of the two IRRs will
be made with the higher of the two being more sensible. This is applicable because the up-front
investment for both projects is the same. Below are the values of IRR for both projects:

Project Endeavour IRR - 10.66%

Project Fox IRR - 12.07%

Payback Period
The payback period has been calculated for each project through determination of the
cumulative balance of cash flows against the initial outlay. The point at which the cumulative balance
becomes positive is considered the payback period. Essentially, Payback Period is the time taken to
recoup the initial investment in terms of generated net inflows. Below are the values of IRR for both
projects Endeavour and Fox:

Project Endeavour Payback Period - 5 Years

Project Fox Payback Period - 3 Years

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 PROJECT ANALYSIS AND EVALUATION
The comparison between the two projects that EML Co. wants to undertake cannot be limited
to the bottom line especially considering the difference in direction the company would consequently
take in either case. It thus becomes necessary to consider other factors before reaching a final
investment decision. According to Magdy (2011), investment appraisal requires consideration of all
related aspects, whether financial or non-financial in order to make a fully informed decision. As a
result, more variables which are less predictable need to be considered. Three methods have been
utilised in this analysis with the intention of considering multiple factors affecting project
performance. Based on the analysis and comparison of these three metrics as shown in the following
passage, it is a reasonable deduction that Project Fox is the more profitable of the two. It is thus
recommended that consideration be given to Project Fox ahead of Project Endeavour. The table below
summarises the comparison of the two projects based on NPV, IRR and Payback Period:

Project
Endeavour Project Fox
Net Present Value 28,783 58,313
Internal Rate of
Return 10.66% 12.07%
Payback Period Year 5 Year 3

Table 1 Project Metric Comparisons

a) NPV comparison:
The NPV method is a very popular method of appraisal for capital investment decisions.
Azeez (2015) suggests that this method is effective in determining present value of an
investment through accounting for the sum of discounted cash flows received from the project.
The important factor in this method is that it assists in estimating the profitability of a project
before commencement thus providing, at least in part, a basis for making the investment
decision. The NPV method however has a certain drawback in that in and of itself, it does not
particularly account for factors other than monetary value. The NPV method is suitable for
idealised projects that consider values or funds as the major factor. (Song et al, 2015, p.186).
Beaves (1988), as quoted by Song et al (2015) indicates that for NPV to be applicable, there

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 is need for reinvestment rate to be the same as the firms opportunity cost. In this case, the
reinvestment rate would be the discount rate which must equal the opportunity cost of the
owners/investors. The utilised discount rate is taken as the cost of capital which equates to the
opportunity cost of the owners/investors. Since the method is applicable and is being used in
conjunction with other methods that consider other factors such as efficiency and yield, it
serves as a valuable indicator of the likelihood of project success. The NPV for Project Fox
was higher than that for Project Endeavour by $29,530 thus indicating higher value of the
investment. Project Fox is estimated to generate just over double the returns in comparison
therefore it makes more business sense to invest in it. Since NPV indicates value and not
efficiency of the investment in terms of yield, it is sensible to utilise another metric which
does so in order to get a full appreciation of the factors affecting the investment decision.

Project Fox is therefore considered the better option.

b) IRR comparison:
Reinhardt (2017) points out that IRR is determined strictly by internal cash flow and not by
the cost of financing. It therefore shows the efficacy or growth rate of the investment in
question. Also according to Gallo (2016), IRR assumes that future project cash flows are re-
invested at the same IRR and not at the Cost of Capital. The time value of money is not
properly considered especially when the timelines of the investments being compared is
different. Fortunately, in the case of Projects Fox and Endeavour, the timelines are the same.
Whenever cash flows change between positive and negative over the life cycle of the project,
it means that there are multiple IRRs. It is also important to note that when a firm has higher
returns per dollar invested per year than the overall cost of capital for the investment (hurdle
rate), the project is thus profitable. (Reinhardt, 2017, p7). The IRR is the rate at which the
project breaks even whilst the hurdle rate is the required rate of return for that investment.
The IRR for Project Fox was higher than that for Project Endeavour by 1.41 percentage points.
This indicates that the growth rate of Project Fox is calculated to be higher than that of Project
Endeavour. The IRR for Project Fox is higher than Cost of Capital (10%) by 2.07 percentage
points than that for Project Endeavour which is higher than Cost of Capital than only 0.66
percentage points. Again, this indicates lower profitability for Project Endeavour in

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 comparison. Overall, it is best to utilise IRR in conjunction with NPV and Payback or even
other methods to ensure that the investment decision is sound.

c) Payback Period comparison:

The Payback Period method of capital investment appraisal is a well favoured one owing to
its simplicity in terms of calculation and use. It utilises cash flows which are relatively realistic
and objective. It essentially shows which investment choice presents a lower risk in terms of
the time it takes to recover the initial outlay. The assumption is that the longer it takes to
recover the initial outlay, the higher the risk that it will not be recovered at all. According to
Woodruff (2017), it is however important to note that Payback Period does not take into
account the time value of money. It also does not consider cash inflows that are predicted to
be received after recovery of the initial investment. In most instances, major capital
investments have a long life cycle with a high probability that significant inflows are received
well into the timeframe of the project. Moreover, depending on the nature of the project, the
larger bulk of inflows may in fact be received after the Payback Period. Therefore, utilising
Payback Period alone may cause the firm to make a bad investment decision by not
considering long term profitability. Payback Period is thus best utilised in conjunction with
other appraisal techniques. The Payback Period for Project Endeavour is 5 years whilst that
of Project Fox is 3 years. This indicates a significantly shorter turnaround time of invested
funds for Project Fox.

Other Considerations in Capital Investment Appraisal

It is fortunately clear that based on the 3 metrics utilised, Project Fox is the best choice of the
two. Project Fox has a higher NPV thus indicating higher value, it has a higher IRR in
comparison as well as against the Cost of Capital and it has a shorter Payback Period.
However, several other factors need to be considered before making the final decision on the
investment as follows:
a) Alignment with overall business strategy Project Fox would take EML Co. in a different
direction and if not considered properly, this could derail the overall business strategy of
the firm.
b) Timing of fund flows from the project There is need for the company to consider the
timing of the estimated cash flows to ensure this is in line with required fund flows.

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c) Financing It is important for the company to consider the kind of financing to be utilised,
be it retained profits, debt or equity. The repayment structure is dependent on this.
d) Capacity of the companys staff The proficiency of staff in executing the project in
question.
e) Environmental and Market factors The business environment and the market as a whole
must be analysed to ensure overall feasibility of the project. The actions of competitors
can affect the success of the project in question.
f) Technological changes These may affect the output of the project or may give
competitors with newly acquired superior technology the edge.
g) Government regulation Regulations need to be considered to ensure all is above board.
h) Fiscal Incentives These may affect the project in that items such as tax cuts reduce the
tax expense and will thus increase value of the project in question.
i) Use of other metrics It can be an advantage to utilise one or two other metrics for
confirmation of the likelihood of project success.
j) Ethical considerations These include employee safety and security as well as
environmental performance of the project.
Capital-investment.co.uk (2017)

Once these and several other factors not mentioned are considered, the final decision may then
be taken.

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 PROJECT FINANCING
It is important to consider the sources of finance for the mooted projects as this will have an
impact on the capability to invest. The repayment structure is also different for the two sources being
considered which implies that cash flows can be affected differently over the life cycle of the project
so chosen. Below is an analysis of Equity and Debt.

Equity & Debt

Benyasrisawat and Basiruddin (2017) suggest that whatever combination of Debt and Equity
of a firm can be considered as its Capital Structure since its value amounts to the total sum of the two.
This value will not change as long as investors receive their expected payoffs whatever combination
makes up the capital structure. It is important however to differentiate between equity and debt in
order to clearly define the risks associated with each choice as well as the costs involved.

Debt This is capital that is raised by a firm through borrowing in the form of term loans
(financial institutions), bonds and debentures (general public). The firm in this case, simply put, owes
money to the individual or institution that has advanced the funds. Debt is paid back at the expiry of
the specific term with a pre-agreed interest rate. These interest rates are normally market related which
means that with many lenders competing for promising investments, there is opportunity to acquire
debt at fairly low cost. Debt is thus generally cheaper than equity in terms of financing cost. It is also
short term in comparison and can be securitised through the pledging of an asset such as real estate
as surety in the event of failure to repay the debt owed. In that event, defaulting is thus covered by
forfeiture of the asset pledged. Debt is a less risky proposition than equity in that the interest charge
is fixed and repayment is regular. In the event of liquidation of the company, creditors and other
stakeholders are repaid first before shareholders. The firm knows what to expect essentially over the
entire course of repayment and has the added advantage that interest is tax-deductible which offers
some form of tax relief. In the case of debt, lenders are creditors to the company as opposed to equity
holders who become part of the ownership.

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 Equity Equity is regarded as a permanent source of capital and essentially represents the Net
Worth of a company. It is the owners funds divided into shares which for each shareholder represent
part ownership of the company commensurate to the amount invested. Equity is divided into ordinary
shares, preference shares and reserve and surplus. The return on investment for shareholders is called
a dividend which is not a charge against profit (interest on a loan) but rather an appropriation of profit.
Payment to ordinary shareholders is neither fixed nor periodic. Dividends paid out to preference
shareholders are fixed and based on their investment however they are also not regular. They are only
paid off after a specific period. Payment of dividends by the firm is voluntary. Equity is more
expensive than debt on several levels especially in terms of ceding of part of the ownership of the
firm. It must be considered that investors that have a seat on the Board for instance may end up
causing the passing of bad decisions if they accumulate enough clout. This may end up being
detrimental to the firm because unless the investor sells up their stocks, they will remain in that
position. Equity is therefore a long term arrangement and so the capital structure must be well thought
out so as to avoid untenable situations. (Surbhi, 2015).

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 Comparative Advantages and Disadvantages of Debt & Equity
The comparative advantages of these two sources of capital are summarised below:

Equity advantages The involvement of high profile investors in the firm brings to it much needed
over Debt credibility especially if it is a new firm.
Existing assets of the firm do not need to be used as surety in obtaining equity.
There are no debt payments to be made. Dividend payments are voluntary.
This assists especially start-ups which may not have sufficient cash flows to
service debts. Relying more heavily on the equity route would be sensible in
this case.
Firms that are highly leveraged find it difficult to have significant growth due
to the high cost of servicing debt. Equity does not bring about high cost of
capital in comparison.
High and positive cash flows are not constantly required under equity
financing whereas under debt, obligations do not change even if cash flows do
so. The firm may find it difficult to service loans as a result.

Debt advantages Lenders are only liable for repayment of principal of the loan plus the agreed
over Equity upon interest charge whereas equity investors gain part-ownership of the firm
under which management cede some control (which may be significant).
Under debt, there is no dilution of ownership of the firm. Under equity,
investors have some claim on future profits of the firm.
Interest charges are tax-deductible and this lowers the tax expense for the firm.
Dividends are not tax-deductible.
Planning and forecasting is much simpler since repayment obligations are
known and payments are regular.
Stakeholders with a need for information on company performance and other
issues are few fewer. Under equity, there are a lot more who need this
information and must be communicated with.

Table 2 Comparative Advantages_Debt vs Equity

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 CONCLUSION
The three metrics utilised to comparatively analyse the two investment options, Project
Endeavour and Project Fox, have fortunately given a clear indication of which is the more
reasonable choice with higher expected returns. Project Fox has been shown to be the more
profitable of the two even after considering metrics that base on different aspects. The mix of
metrics covers the time value of money as well as efficiency and other important factors. After
further consideration of the aforementioned non-financial factors affecting the final decision, it will
be easier to make.

Appraisal of Capital Investments requires a multi-stage process which is well planned and well
executed as there are usually significant funds at stake. For start-ups, a bad investment decision can
cause the firm to collapse before it has made much progress. A bad investment decision by even a
well-established firm may also initiate its downfall. The Capital Structure of a firm must be well
thought out and must be executed such that it caters to the specific requirements of the firm. It is
essential that firms do not cede too much power to investors whilst they do not saddle themselves
with excessive debt which cripples operations and decimates cash flows. Balance is required for the
good running of the firm and the advantages and disadvantages of each of the two financing options
under consideration must be taken cognizance of.

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REFERENCES

Azeez, W. (2015). IOSR Journal of Business and Management (IOSR-JBM): Capital Investment
Appraisal in Retail Business Management: Sainsburys as a Case Study. [Online] Volume 17, Issue
7.Ver. I, p.104-109. Available at: http://iosrjournals.org/iosr-jbm/papers/Vol17-issue7/Version-
1/L01771104109.pdf. [Accessed: 18 February, 2017]

Benyasrisawat, P. & Basiruddin, R. (2017). [Online] Debt, Equity and Dividend. Executive Journal
p.61-69. Available at:
http://www.bu.ac.th/knowledgecenter/executive_journal/july_sep_12/pdf/aw08.pdf. [Accessed 22
February, 2017].

Capital-investment.co.uk. (2017). Capital Investment Decisions. [Online] Available at:

http://www.capital-investment.co.uk/capital-investment-decisions.php. [Accessed 19 February,
2017]

Gallo, A. (2016). A Refresher on Internal Rate of Return. [Online] Harvard Business Review.
Available at: https://hbr.org/2016/03/a-refresher-on-internal-rate-of-return. [Accessed: 19 February,
2017].

Magdy G. A. (2011). Review of Management Accounting Research. Basingstoke: Palmgrave

Macmilan

Reinhardt (2017) Capital Budgeting. [Online] Available at:

https://www.princeton.edu/~reinhard/pdfs/CAPITAL_BUDGETING_LECTURE_X.pdf.
[Accessed: 18 February, 2017]

Song, N. et al. (2015) Evaluation of the GNPV Method for Decision-making in Non-conventional
Projects. Asia-Pacific Journal of Management Research and Innovation [Online] Institute of
Management SAGE Publications 11 (3). p.185-197. Available at:
http://journals.sagepub.com/doi/pdf/10.1177/2319510X15588392. [Accessed: 19 February, 2017]

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Surbhi, S. (2015). Difference Between Debt and Equity. [Online] Available at:
http://keydifferences.com/difference-between-debt-and-equity.html. [Accessed 22 February, 2017].

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APPENDIX I: Project Endeavour Workings

a) Net Present Value

Year 1 2 3 4 5 6
Revenue inflows 390,000 409,500 429,975 451,474 474,047 -
Costs outflows 18,000 18,810 19,656 20,541 21,465 -
Before-tax net cash flows 372,000 390,690 410,319 430,933 452,582 0
Capital Allowances 400,000 260,000 230,000 200,000 160,000 -
Income before taxes -28,000 130,690 180,319 230,933 292,582 0
Taxes @ 20% 0 0 26,138 36,064 46,187 58,516
After-tax net income -28,000 130,690 154,181 194,869 246,396 -58,516
Capital Allowances + 400,000 260,000 230,000 200,000 160,000 -
After-tax cash flows 372,000 390,690 384,181 394,869 406,396 -58,516
After-tax salvage value + 200,000
Working Capital Repaid + 90,000
After-tax total net cash flows 372,000 390,690 384,181 394,869 696,396 -58,516
Discount Factor @ 10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
Present value of cash flows 338,182 322,884 288,641 269,701 432,407 -33,031
Total present value 1,618,783

NPV = Total Present Value

less Initial Outlay 28,783

Discount
Asset Disposal Rate
Cash Proceeds 250,000 10%
Book Value 0
Tax Rate 20%

After Tax Salvage Value 200,000

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 b) Internal Rate of Return

Initial Outlay 1,590,000

Year 1 2 3 4 5 6 Discount Rate

After-tax total net cash flows 372,000 390,690 384,181 394,869 696,396 -58,516 10.6563%
Discount Factor 0.9037 0.8167 0.7380 0.6670 0.6027 0.5447
Net Present Value 0

c) Payback Period

Inflows Balance
Outlay -1,590,000
Yr 1 372,000 -1,218,000
Yr 2 390,690 -827,310
Yr 3 384,181 -443,129
Yr 4 394,869 -48,260
Yr 5 696,396 648,135
Yr 6 -58,516 589,619

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APPENDIX II: Project Fox Workings

a) Net Present Value

Year 1 2 3 4 5 6
Revenue inflows 750,000 620,000 620,000 250,000
250,000 -
Material Costs 9,600 10,080 10,584 11,113
11,669 0
Other Expenses 12,000 11,400 10,830 10,289
9,774
Before-tax net cash flows 728,400 598,520 598,586 228,598
228,557 0
Non-cash expenses 0 0 0 0 0 -
Income before taxes 728,400 598,520 598,586 228,598
228,557 0
Taxes @ 20% 145,680 119,704 119,717
45,720 45,711
After-tax net income 728,400 452,840 478,882 108,881
182,837 -45,711
Non-cash expenses + 0 0 0 0 0 -
After-tax cash flows 728,400 452,840 478,882 108,881
182,837 -45,711
After-tax salvage value + 0
After-tax total net cash flows 728,400 452,840 478,882 108,881 182,837 -45,711
Discount Factor @ 10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
Present value of cash flows 662,182 374,248 359,791 74,367 113,528 -25,803
Total present value 1,558,313

NPV = Total Present Value

less Initial Outlay 58,313

Discount
Asset Disposal Rate
Cash Proceeds 0 10%
Book Value 0
Tax Rate 20%

After Tax Salvage Value 0

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b) Internal Rate of Return

Initial Outlay 1,500,000

Year 1 2 3 4 5 6 Discount Rate

After-tax total net cash flows 728,400 452,840 478,882 108,881 182,837 -45,711 12.0736%
Discount Factor 0.8923 0.7961 0.7104 0.6339 0.5656 0.5046
Net Present Value 0

c) Payback Period

Inflows Balance
Outlay -1500000
Yr 1 728,400 -771,600
Yr 2 452,840 -318,760
Yr 3 478,882 160,122
Yr 4 108,881 269,003
Yr 5 182,837 451,841
Yr 6 -45,711 406,129

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