Appraisal Techniques: Jones PLC

Jones Plc.
Appraisal Techniques
Author:
Trivikram Nath Pandey
4/19/2010
Jones Plc.
Appraisal
Techniques
Managing Financial Principles and Techniques
Bentham Institute of Management & Languages

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Prepared for
Dr. Shaik Moulali, Phd. Finance
Faculty of Bentham Institute of Management & Languages
Bentham House, Ring Road, Rethibowli
Hyderabad – 500028
Prepared by
Enrolment Number: BAP – 0210 – 10002
Level 7 BTEC Advanced Professional Diploma In Management Studies
19 April 2010

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ACKNOWLEDGMENT
This project has been made in the guiding of the respected faculties. The project report is
about “The objective it to apply financial techniques, select appropriate information and make
recommendations in the process of investment decision making.” Given case company’s name is
Jones Plc. which deals in public sector business.
This have prepared a detailed report after a survey in the market, conducting in depth
research using both primary & secondary data, studying about Appraisal Techniques, factors
infusing investment decision and business financial environmental factors. On conclusion part
suggestions for investment in the TransportExpress Plc. and Semicon Pvt. is given. All this had
been possible because of the guidance of the faculties of Bentham Institute of Management &
Languages.
Highly obligation is made to the best faculty. Dr. Shaik Maulali who guide for
completing this project report. Thanks to the academic head Mrs. Firdaou Khan who provide
moral and subjective support to complete this project. At last acknowledge to all team of
Bentham Institute of Management & Languages and class mates for helping in completion of this
project.
Yours Truly

PGDMS Student
Enrolment: BAP-0210-10002

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Table of Contents
Appraisal Techniques..................................................................................................................2
ACKNOWLEDGMENT.............................................................................................................3
Introduction:................................................................................................................................6
TransportExpress Plc.:.............................................................................................................6
Semicon Pvt.:...........................................................................................................................6
Report to the CEO of Jones Plc.:.................................................................................................7
Pass Criteria P2.1:........................................................................................................................8
Current Appraisal Methods:....................................................................................................8
Applications of Appraisal techniques:.....................................................................................8
Steps of Appraisal Techniques:...............................................................................................9
Cash Inflow and Outflows in Appraisal technique:.................................................................9
1. Payback Period (PBP):.......................................................................................................11
2. Average Rate of Return (ARR):.........................................................................................11
3. Profitability Index (PI):.......................................................................................................12
4. Net Present Value (NPV):..................................................................................................13
5. Internal Rate of Return (IRR):............................................................................................14
Comparison of NPV and IRR:...............................................................................................16
Problem solving:....................................................................................................................17
Using NPV method for TransportExpress Plc.:.....................................................................18
Using IRR method for TransportExpress Plc.:......................................................................18
Using NPV method for Semicon Pvt.:...................................................................................19
Using IRR method for Semicon Pvt.:....................................................................................20
Conclusion:................................................................................................................................21
Pass Criteria P2.2:......................................................................................................................21
Appraisal Techniques:...........................................................................................................21

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Risk and Managerial (Real) Options in Capital Budgeting:..................................................24

Pass Criteria P2.3:......................................................................................................................27
Expected cash flow calculaton:............................................................................................27
Results for Semicon Pvt.:......................................................................................................27
Conclusion as per expected cash flow:..................................................................................28
Actual cash flow calculaton:..................................................................................................28
Using NPV method for TransportExpress Plc.:.....................................................................29
Using IRR method for TransportExpress Plc.:......................................................................30
Using NPV method for Semicon Pvt.:...................................................................................31
Using IRR method for Semicon Pvt.:....................................................................................31
Conclusion:............................................................................................................................32
Recommendations:....................................................................................................................33
Abbreviations:............................................................................................................................33
Bibliography:.............................................................................................................................33
Bibliography:

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Aim: The objective it to apply financial techniques, select

appropriate information and make recommendations in
the process of investment decision making.
Introduction:
Jones Plc is considering two mutually exclusive investment projects one each in public sector
and private sector on year 2005.
Jones Plc has 100 million pounds to invest in two different companies. The investment is as part
of its business expansion strategy. Jones Plc has two options to invest:
1. TransportExpress Plc.
2. Semicon Pvt.
TransportExpress Plc.:
TransportExpress Plc. works in road transport services in the city of Workshire.

TransportExpress Plc. has business expansion strategy, the company plans to enter into new
markets and purchase a fleet of new buses, purchase land and necessary equipment needed for its
new venture. For business expansion TransportExpress Plc has to invest 100 million pounds.
Semicon Pvt.:
Semicon Pvt. has business in manufacturing semi-conductor parts which can be used in other
equipments. As part of its business expansion strategy, the company has to plan on launching
new products. The company has to purchase new equipment for the production of new product,
employing/hiring man power for its new product, and above all else for pursuing R&D. The
company has an investment around 100 million pounds.

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Report to the CEO of Jones Plc.:

Date: 19th April, 2010
To
The CEO
Jones Plc
India
Sub: Business report for recommending the project.
Sir,
As the work is given, all appraisal methods, tools and techniques are used to understand which
company (TransportExpress and Semicon.) is best for investment. According to findings and
analyses the result is in helpfulness of Semicon.
In all compressions of TransportExpress and Semicon the recommendation is in favour of

Semicon. Hope that this recommendation will be accepted.
Thanks for your kindness and valuable time.
Yours Truly

Executive

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Pass Criteria P2.1:

Current Appraisal Methods:
Appraisal techniques are also called Capital Budgeting. Appraisal technique is the process of
making long term investment decisions. It is decision-making process that enables a company to
evaluate the viability of a long-term project and whether it is worth undertaking or not.
In other words Appraisal techniques or Capital budget is also a plan of proposed outlines for
adopting long-term assets and includes the means for financing the purchase of company or
acquisition.
Basically there are two type of investment, first is current investments and second is capital
investments. These are:
• Current investments: Current investment is also called current expenditure. These

investments are short term investments. This investment takes all expenses in same
financial year. This investment includes many administrative expenses like: wages,
salaries, rent, bills, expenditure of row materials etc.
In other words operating budget is a plan for the operating expenses and revenues
associated with activities for the current period.
• Capital investments: Capital investment is also called capital expenditure. Capital

investment in long-term investment. A capital investment results in current cash outlay
with the expectation of future benefits.
A company’s constancy and potential achievement often depends on its capital
investment. It is extremely difficult for a company to a company to recover money tied
up in bad capital investments.
Applications of Appraisal techniques:

Appraisal techniques proposals can come from a diversity of sources. For the process of result
analysis of appraisal techniques are often grouped in one of the following categories:
• New technology and gadgets

• Substitution of existing equipment
• A number of allocations for do research and development for new products and the
expansion of existing products.
• Compulsory projects etc.

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Steps of Appraisal Techniques:

An Appraisal technique consists of a logical progression of activities. These activities are as
follows:
Step 1. Detection: The first stage in Appraisal technique is to identify which type of capital
expenditure are necessary and are in line with organisational strategies, objectives and missions.
Step 2. Search: Appraisal investment proposal to be thoroughly invested and alternative

investments explored.
Step 3. Estimation: Non-financial benefits, revenues, financial, cost, and cash flows for each
option must be predictable and compared for the projects whole time series.
Step 4. Selection: Naturally projects selections for implementation are those in which the
predicted financial benefits go beyond expenses by the highest margin.
Step 5. Funding: Project funding must be secured through internal cash, externally in the capital
market or through some combination.
Step 6. Implementation and control: An appraisal technique must be monitored and evaluated.
Predictions at the time the project was selected need to be compared with actual results.
Cash Inflow and Outflows in Appraisal technique:

Category Description Cash flow activities
Initiation Initial cash • Outflows to fund the investment and initiate the
investment project.
• Communication for working capital.
• Inflows or outflows if there is an asset being
replaced.
Operation Interim incremental • Outflows for operating expenditures.
net cash flows • Outflows for additional capital investments.
• Commitment for additional working capital for
operations.
• Inflows generated by the investment and cash
released from working capital no longer needed
for operations.
Disposal Incremental net cash • Inflows or outflows related to the investments
flow for the final year disposal.

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• Cash inflows from the release of working

capital no longer committed to the investment.
Basically there are two types of Appraisal techniques. Under these two techniques there is two
and three type of methods. These can be easily understood by diagram given below:

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As per above table this is understood that there are total five methods of Appraisal techniques.
Details of these methods are as follows:
1. Payback Period (PBP): The target payback period represents what the company
considers to be acceptable length of time for a project. Project with a payback shorter
than the target payback period are accepted. Those with a payback longer than the target
payback period are rejected.
Payback period = Investment required / Net annual cash inflow
Acceptance/Rejection Criteria:
• In case of single project; if PBP is less than life of the project then accept the
project.
If PBP is greater than life of project then reject the project.
If PBP is equal to life of the project then result is neutral. Here project may accept
or not.
• In case of two or more project; the project with less PBP should be accept.
Advantages and Disadvantages of payback period method:
Advantages Disadvantages
Uses a simple calculation. Ignores the time value of money with cash
flows with no regard to timing.
Results are easy to understand. Ignores cash flows happening after the
payback period expiration.
Gives an uneven measure of liquidity. Provides no measure of profitability.
Gives an uneven measure of project risk. May incorrectly promote short-term projects
if the objective payback period is too short.
1. Average Rate of Return (ARR): The rate of return on an investment that is

calculated by taking the total cash inflow over the life of the investment and dividing it
by the number of years in the life of the investment. The average rate of return does not
guarantee that the cash inflows are the same in a given year; it simply guarantees that the
return averages out to the average rate of return.

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• In case of single project;
If ARR > COC then, accept the project.
If ARR < COC then, reject the project.
If ARR = COC then, neutral project may accept or not.
• In case of two or more projects; a project with higher ARR will be selected with
ARR > COC.
1. Profitability Index (PI): The PI is the ratio of the present value of a project’s
future net cash flows to the project’s initial cash outflow.
PI = ( CF1/(1+K)1 + CF2/(1+K)2 + ... + CFn/(1+K)n) / ICO
OR
PI = 1 + (NPV / ICO)
Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio (VIR), is the ratio of investment to payoff of a proposed project. It is a useful tool for
ranking projects because it allows you to quantify the amount of value created per unit of
investment.
The ratio is calculated as follows:
Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. If value is less than one then it would indicate
that the project's PV is less than the initial investment. As the value of the profitability index
increases, so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:

 If PI > 1 then accept the project
 If PI < 1 then reject the project
 If PI = 0 then neutral project may be accepted or not.

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1. Net Present Value (NPV): The present value of an investment's prospect net
cash flows minus the first investment. If positive, the investment should be made or else
it should not.
NPV (Net Present Value) is the differentiation between the present value of cash inflows and the
present value of cash outflows. NPV is used in appraisal techniques to analyze the productivity
of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that
an investment or project will yield. The net present value brings into consideration all the cash
flows over the life of a project. The weights applied are based on the time value of money, means
the sum of money received in the future are insignificant then the sum received today. Before
getting into the NPV analysis, company has needed to recognise the market and with strength,
weakness, opportunity and threat. In performance domination in the market is the definitive way
out for fetching revenue and sustainability of the company.
• In case of single project.
If It means Then
NPV > 0 The investment would add The project may be
value to the company. accepted.
NPV < 0 The investment would
The project should be
subtract value from the
rejected.
company.
NPV = 0 Company should be
indifferent in the decision
The investment would whether to accept or reject
neither profit nor lose value the project. This project
for the company. adds no monetary value.
Conclusion should be based
on other criteria.
• In case of two or more project; a project with higher NPV may be accepted.
Steps in NPV:
1. Calculate present value of cash inflows.

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2. Calculate present value of cash outflows.

3. Find out NPV by deducting total PV of cash inflows form total PV of cash outflows.
NPV = Total cash inflow – cash outflow
In other words NPV is the present value of an investment project’s net cash flows lesser amount
the project’s original cash outflow.
NPV= CF1/(1+K)1 + CF2/(1=k)2 + …+ CFn/(1=k)n – ICO
Strengths and Weaknesses of NPV:
Strengths Weaknesses
Cash flows unspecified to be reinvested at the
obstacle rate.
May not include decision-making options
Financial records for TVM. entrenched in the project.
It considers all cash flows.
1. Internal Rate of Return (IRR): The IRR estimates the discount rate that
makes the present value of net cash inflows equal to the initial investment. In other words
IRR is the discount rate that equates the present value of the future net cash flows from
an investment project with the project’s initial cash outflow.
IRR interpretation: The IRR method evaluates a capital investment by comparing the
estimated IRR to a prearranged principle. This criterion is based on whatever rate the
company uses to evaluate investments, such as its minimum rate of return, the rate from
another desirable alternate investment or an industry average.
ICO = CF1/(1+IRR)1 + CF2/(1+IRR)2 + …+ CFn/(1+IRR)n
IRR calculation: The IRR method has two basic steps:
1. Establish the rate of return that makes the present value of net cash inflows equal the
investments initial amount.
2. Measure up to the estimated rate of return with the company’s desired rate or return to
assess the investments appeal.

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Uniform net cash flows: The steps in decisive IRR for an appraisal project with uniform net cash
flows are:
1. Decide the total initial investment for the project.

2. Recognize the predetermined criterion cut-off rate of return.
3. Establish net cash inflows for each year.
4. Divide the initial investment (step 1) by the annual cash flow (step 3) to obtain a value
for IRR.
5. Pass on to a present value annuity table to locate a discount rate at the specified number
of years that matches the IRR value.
6. Evaluate the IRR rate (step 5) to the chosen criterion cut-off rate (step 2).
If the intended IRR exceeds the decisive factor cut-off rate, the project is an advantageous
investment.
Uneven cash flows: for a project with irregular cash flow projections, the IRR calculation
becomes audition and fault and interruption.
• In case of single project;
If IRR > COC, then accept the project.
If IRR < COC, then reject the project.
If IRR = COC, then neutral, project may be accepted or not.
• In case of two or more project; a project with higher IRR is accepted, with IRR >
COC.
Strengths and Weaknesses of IRR:
Strengths Weaknesses
Financial statement for TVM. Expected all cash flows reinvested at the IRR.
Takes all cash flows. Problems with project rankings and numerous
IRRs.
Smaller amount subjectivity.

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Comparison of NPV and IRR: The basic assumption underlies both the NPV and IRR
methods: risk or uncertainty, is not a major problem. In addition both NPV and IRR consider:
• The time value of money.

• The initial cash investment.
A major difference is that the end result of NPV is a pounds figure whereas the final computation
for IRR is a percentage. Therein is an advantage for NPV, as the NPV values of individual
projects can be added to estimate the effect of accepting some possible combination of project.
Because IRR yields a percentage, multiple projects cannot be added or averaged to evaluate any
combination of capital investment projects.
Another advantage of the NPV method is its usefulness in evaluating a project in which the
required rate of return varies over the life of the project. The total present value of the cash
inflows can be determined and compared with the total initial investment to evaluate the
attractiveness of a project. Again, it is not possible using the IRR method to infer if the project is
unattractive. Different required returns for each of the year’s means that there is no single rate of
return or a single IRR value.
Both methods have some reliability coutions:
• NPV is only as reliabe as the discount rate that is selected. An unrealistiv discount rate
can result in an erroneous decision to accept/reject a project.
• A capital investment project should not be accepted solely on the basis of a high IRR
value. A high IRR result must be looked ar further to assess if and opportunity to invest
cash flows at such a high IRR is realistic.
But among all the various methods to analyze capital investment, the DCF methods are
theoretically some of the most reliable. The NPV and IRR methods will typically yield similar
results as long as there are no differences in:
• The amount of the initial investment.

• The net cash flow pattern.
• The life of the project.
• The cost of capital over the life of the project.

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Single-Point Estimate and Sensitivity Analysis:

Sensitivity Analysis: A type of “what-if” uncertainty analysis in which variables or assumptions
are changed from a base case in order to determine their impact on a project’s measured results
(such as NPV or IRR).
• Allows us to change from “single-point” (i.e., revenue, installation cost, salvage,

etc.) estimates to a “what if” analysis.
• Utilize a “base-case” to compare the impact of individual variable changes.
• If result of NPV and IRR is opposite to each other, than result of NPV is selected.
Therefore problem is arising between NPV and IRR in that case organisation follow NPV
results. Otherwise both methods are good and mostly these two NPV and IRR are used.
Problem solving:
As the problem given by Jones Plc. company there is a requirement of using current methods to
analyse competing investment project in the public and private and make justifiable decisions.
Company is in year of 2005 & use the data give in case.
The data’s of TransportExpress Plc. and Semicon Pvt. are given below:
Year Expected Cash Flows

TransportExpress Plc. Semicon Pvt.
2005 -100 (Out Flow) -100 (Out Flow)
2006 50 10
2007 40 30
2008 30 40
2009 10 65
Note:
1. Amount in millions of pounds.
2. Cash flows are discounted at cost of capital of 10%.

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As per above discussion company has to use NPV and IRR method because these two methods
are more acceptable in current scenario.

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Using NPV method for TransportExpress Plc.:

Year CFAT PV factor at 10 % PV of cash inflows
2005 -100 (Out Flow)
2006 50 .909 45.45
2007 40 .826 33.04
2008 30 .751 22.53
2009 10 .683 6.83
Total = 130 Total = 107.85
NPV = PV of cash inflows – Outflows
NPV = 107.85 – 100 = 7.85
As per project acceptance/rejection criteria is concern, if NPV is positive than project will be
accepted.
Therefore NPV = 7.85 which is positive so, this project will be accepted as per NPV method.
Using IRR method for TransportExpress Plc.:

Fake PBP = Total cash outflow/Average CFAT
Average CFAT = 130/4 = 32.5
So, FPBP = 100/32.5 = 3.077
The PV factor closes to 3.077 against 4 years as per annuity table A-4 are 3.1024 (11%) and
3.0373 (12%). It is better to take between 10% - 13% so, that result will be perfect.
Let calculate PV of CFAT at 10% and 13%.

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Year CFAT PV factor PV of cash PV factor at PV of cash

at 10 % inflows 13 % inflows
2005 -100 (Out Flow)
2006 50 0.909 45.45 0.885 44.25
2007 40 0.826 33.04 0.783 31.32
2008 30 0.751 22.53 0.693 20.79
2009 10 0.683 6.83 0.613 6.13
Total = 130 Total = 107.85 Total = 102.49
Since, IRR = Lower PV factor + (difference between PV of cash inflow with lower rate and
outflow/difference between PV of inflows) * Difference between PV factor rate.
IRR = 10% + (107.85-100/107.85-102.49) *
IRR = 10% + (7.85/5.56) * 3 = 10% + (1.412) * 3
IRR = = 10% + 4.236 = 14.236%
As per project acceptance/rejection criteria is concern, if IRR is greater than COC then, project
will be accepted.
Therefore IRR = 14.236 % which is greater than COC.
Here, IRR > COC so, this project will be accepted.
Conclusion for TransportExpress Plc.:
For TransportExpress both NPV and IRR gives positive result. Therefore it is better to invest in
TransportExpress.
Using NPV method for Semicon Pvt.:

2005 -100 (Out Flow)
2006 10 .909 9.09

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2007 30 .826 24.78

2008 40 .751 30.04
2009 65 .683 44.395
Total = 145 Total = 108.305
NPV = 108.305 – 100 = 8.305
accepted.

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Using IRR method for Semicon Pvt.:

Average CFAT = 145/4 = 36.25
So, FPBP = 100/36.25 = 2.759

Year CFAT PV factor PV of cash PV factor PV of cash
at 14 % inflows at 18 % inflows
2005 -100 (Out
Flow)
2006 10 0.877 8.77 0.847 8.47
2007 30 0.769 23.07 0.718 21.54
2008 40 0.675 27 0.609 24.36
2009 65 0.592 38.48 0.516 33.54
IRR = 14% + (100-97.32/97.32-87.91) * 4 = 14% + (2.68/9.41) * 4
IRR = 14% + (0.285 * 4) = 14% + 1.139 = 15.139%
Therefore IRR = 15.139 %
will be accepted.
Therefore IRR = 15.139% which is greater than COC.

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Conclusion for Semicon Pvt.:

For Semicon Pvt. both NPV and IRR gives positive result. Therefore it is better to invest in
Semicon Pvt.
Conclusion: As expected cash flows are concern, here NPV and IRR both give positive
results for both TransportExpress Plc. and Semicon Pvt. Companies. But Jones Plc. has to choose
only one company to invest 100 million pounds. As per comparison of TransportExpress Plc. and
Semicon Pvt. and according to selection/rejection criteria, Semicon Pvt. has higher NPV and
IRR.
Therefore Jones Plc. has to invest 100 million pounds in Semicon Pvt.
Pass Criteria P2.2:

It is understood that Jones Plc. has to invest 100 million pounds in one of the companies named
TransportExpress Plc. and Semicon Pvt. Company has to select appropriate and relevant
financial information for use in the process of making strategic decisions on investment.
Let discuses all topics related with appropriate financial information. Started with Appraisal
Techniques or Capital Budgeting.
Appraisal Techniques:
Appraisal technique is the process of making long term investment decisions. It is decision-
making process that enables a company to evaluate the viability of a long-term project and
whether it is worth undertaking or not.
In other words Appraisal techniques or Capital budget is also a plan of proposed outlines for
adopting long-term assets and includes the means for financing the purchase of company or
acquisition.
Basically there are two type of appraisal techniques these are given below:
1. Traditional method
a) Payback Period (PBP) method
b) Average Rate of Return (ARR) method
1. Discounted cash method or non traditional method

a) Net Present Value (NPV) method
b) Internal Rate of Return method (IRR) and

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c) Profitability Index (PI). Method
Total there are five methods. Details about these five methods are given in page no. 8 to 16.
Rest of the important things have discussed here.
Capital Budgeting and Estimating Cash Flows:

There are few points which are:
• The Capital Budgeting Process

• Generating Investment Project Proposals
• Estimating Project “After-Tax Incremental Operating Cash Flows
The Capital Budgeting Process:
• Generate investment proposals consistent with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash flows for the investment projects.
• Evaluate project incremental cash flows.
• Select projects based on a value-maximizing acceptance criterion.
• Reevaluate implemented investment projects continually and perform postaudits for
completed projects.
Classification of Investment Project Proposals:
• New products or expansion of existing products

• Replacement of existing equipment or buildings
• Research and development
• Exploration
• Other (e.g., safety or pollution related)
Screening Proposals and Decision Making:
• Section Chiefs
• Plant Managers
• VP for Operations
• Capital Expenditures Committee
• President
• Board of Directors

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Estimating After-Tax Incremental Cash Flows: Basic characteristics of relevant project flows:
• Cash (not accounting income) flows

• Operating (not financing) flows
• After-tax flows
• Incremental flows
Principles that must be adhered to in the estimation are:
• Ignore sunk costs

• Include opportunity costs
• Include project-driven changes in working capital net of spontaneous changes in current
liabilities
• Include effects of inflation
Tax Considerations and Depreciation: Depreciation represents the systematic allocation of the
cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or
both.
Generally, profitable firms prefer to use an accelerated method for tax reporting purposes
(MACRS).
Depreciable Basis: In tax accounting, the fully installed cost of an asset. This is the amount that,
by law, may be written off over time for tax purposes.
Depreciable Basis = Cost of Asset + Capitalized Expenditures
Capitalized Expenditures: Capitalized Expenditures are expenditures that may provide benefits
into the future and therefore are treated as capital outlays and not as expenses of the period in
which they were incurred.
Sale or Disposal of a Depreciable Asset:
Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells
for more than book value) or capital loss (asset sells for less than book value). Often historically,
capital gains income has received more favorable U.S. tax treatment than operating income.

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Corporate Capital Gains / Losses:
• Currently, capital gains are taxed at ordinary income tax rates for corporations.
• Capital losses are deductible only against capital gains
Calculating the Incremental Cash Flows:
• Initial cash outflow -- the initial net cash investment.

• Interim incremental net cash flows -- those net cash flows occurring after the initial cash
investment but not including the final period’s cash flow.
• Terminal-year incremental net cash flows -- the final period’s net cash flow.
Risk and Managerial (Real) Options in Capital Budgeting:

There are various options to in appraisal techniques these highly effected with:
• The Problem of Project Risk

• Total Project Risk
• Contribution to Total Firm Risk: Firm-Portfolio Approach
• Managerial (Real) Options
Total Project Risk: Projects have risk that may change from period to period. Projects are more
likely to have continuous, rather than discrete distributions.
Probability Approach: A graphic or tabular approach for organizing the possible cash-flow
streams generated by an investment. The presentation resembles the branches of a tree. Each
complete branch represents one possible cash-flow sequence.
Basket Wonders is examining a project that will have an initial cost today of 100 million pounds.
Uncertainty surrounding the first year cash flows creates three possible cash-flow scenarios in
Year 1.
Project NPV Based on Probability Tree Usage: The probability tree accounts for the
distribution of cash flows. Therefore, discount all cash flows at only the risk-free rate of return.
NPV = total no. of years (NPVi) (Pi)
The NPV for branch i of the probability tree for two years of cash flows is

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NPVi = CF1/ (1+Ri)1 + CF2/(1+Ri)2 - ICO
Simulation Approach: An approach that allows us to test the possible results of an investment
proposal before it is accepted. Testing is based on a model coupled with probabilistic
information.
Factors we might consider in a model:
• Market analysis: Market size, selling price, market growth rate, and market
share
• Investment cost analysis: Investment required, useful life of facilities, and
residual value
• Operating and fixed costs: Operating costs and fixed costs
Each proposal will generate an internal rate of return. The process of generating many, many
simulations results in a large set of internal rates of return. The distribution might look like the
given graph.

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Contribution to Total Firm Risk: Firm-Portfolio Approach Combining projects in this manner
reduces the firm risk due to diversification.
Managerial (Real) Options: Management flexibility to make future decisions that affect a
project’s expected cash flows, life, or future acceptance.
Project Worth = NPV + Option(s) Value
• Expand (or contract): Allows the firm to expand (contract) production if conditions
become favorable (unfavorable).
• Abandon: Allows the project to be terminated early.
• Postpone: Allows the firm to delay undertaking a project (reduces uncertainty via new
information).
As discussed Jones Plc or any other company has many type of option to select appropriate and
relevant financial information for using in the process of making strategic decisions on
investments. At last company has to collect all available data regarding investment and forecast
the future of the investment by using given techniques in above discussion. After these
calculations and analysis Jones Plc. or any company is able to make easy effective strategic
decisions.

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Jones Plc.
Pass Criteria P2.3:

As per appraisal techniques, NPV and IRR are most common techniques which is used by many
companies and it is proved above that these two methods are the best current appraisal methods.
Here expected cash flow and actual cash flow both are required.
Expected cash flow calculaton:

Expected cash flow is already calculated in Pass Criteria P2.1 so, that result of expected cash
flow can be taken from above calculation. Therefore as expected cash flow is concern the results
are as follows:
Results for TransportExpress Plc.:
NPV method for TransportExpress Plc.:

accepted.
Here, NPV = 7.85
IRR method for TransportExpress Plc.:

Here, IRR = 14.236 %
will be accepted.
For TransportExpress both NPV and IRR gives positive result. Therefore it is better to invest in
TransportExpress.
Results for Semicon Pvt.:
NPV method for Semicon Pvt.:

accepted.

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Jones Plc.
Here, NPV = 8.305
IRR method for Semicon Pvt.:

Here, IRR = 17.204 %
will be accepted.
For Semicon Pvt. both NPV and IRR gives positive result. Therefore it is better to invest in
Semicon Pvt.
Conclusion as per expected cash flow: As expected cash flows are concern, here NPV and IRR
both give positive results. But Jones Plc. has to choose only one company to invest 100 million
pounds. As per comparison of TransportExpress Plc. and Semicon Pvt. according to
selection/rejection criteria, Semicon Pvt. has higher NPV and IRR.
Now, for final conclusion calculations as per actual cash flow must be calculated. Let calculate
the results from actual cash flows. Calculations are given in next page.
Actual cash flow calculaton:

As the problem given by Jones Plc. that, company there is a requirement of using current
methods to analyse competing investment project in the public and private and make justifiable
decisions. Company is in year of 2010 & use the data give in case.

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Jones Plc.
The data’s of actual cash flow of TransportExpress Plc. and Semicon Pvt. are given below:
Year Actual Cash Flows

TransportExpress Plc. Semicon Pvt.
2005 -100 (Out Flow) -100 (Out Flow)
2006 30 5
2007 50 30
2008 40 50
2009 10 70
Note:
1. Amount in millions of pounds.
2. Cash flows are discounted at cost of capital of 10%.
As per above discussion company has to use NPV and IRR method because these two methods
are more acceptable in current scenario.
Using NPV method for TransportExpress Plc.:

2005 -100 (Out Flow)
2006 30 .909 27.27
2007 50 .826 41.3
2008 40 .751 30.04
2009 10 .683 6.83
Total = 130 Total = 105.44

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Jones Plc.
NPV = 105.44 – 100 = 5.44
accepted.
Using IRR method for TransportExpress Plc.:

Average CFAT = 130/4 = 32.5
So, FPBP = 100/32.5 = 3.077

Year CFAT PV factor PV of cash PV factor at PV of cash
at 8 % inflows 15 % inflows
2005 -100 (Out Flow)
2006 30 0.926 27.78 0.870 26.1
2007 50 0.857 42.85 0.756 37.8
2008 40 0.794 31.76 0.658 26.32
2009 10 0.735 7.35 0.572 5.72
IRR = 8% + (100-109.74/109.74-95.94) * 7

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Jones Plc.
IRR = 8% + (9.74/13.8) * 7 = 8% + (0.706) * 7
IRR = 8% + 4.941 = 12.941%
will be accepted.
Therefore IRR = 12.941 % which is less than COC.
Here, IRR < COC so, this project will be rejected.

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Jones Plc.
For TransportExpress both NPV gives positive result and IRR gives negative result. Therefore
here problem will arias. But as per above discussion about best method between NPV and IRR,
NPV is more acceptable. For comparison between NPV and IRR please refer page no. 16 of this
report. Hence NPV gives positive results the project will be selected and is better to invest in
TransportExpress.
Using NPV method for Semicon Pvt.:

2005 -100 (Out Flow)
2006 5 .909 4.545
2007 30 .826 24.78
2008 50 .751 37.55
2009 70 .683 47.81
Total = 155 Total = 114.685
NPV = 114.685 – 100 = 14.685
accepted.
Using IRR method for Semicon Pvt.:

Average CFAT = 155/4 = 38.75
So, FPBP = 100/38.75 = 2.581
The PV factor closes to 2.581 against 4 years as per annuity table A-4 are 2.589 (20%) and 2.540
(21%).

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Jones Plc.
Now calculate PV of CFAT at 13% and 20%.

Year CFAT PV factor PV of cash PV factor PV of cash
at 20 % inflows at 21 % inflows
2005 -100 (Out Flow)
2006 5 0.833 4.165 0.826 4.13
2007 30 0.694 20.82 0.683 20.49
2008 50 0.579 28.95 0.564 28.2
2009 70 0.482 33.74 0.467 32.69
IRR = 19% + (100-89.96/89.96-83.38) * 3 = 19% + (10.04/6.58) * 3
IRR = 19% + (1.526) * 3 = 19% + 4.578 = 23.578%
Therefore IRR = 23.578 %
will be accepted.
For Semicon Pvt. both NPV and IRR gives positive result as per acceptance/rejection criteria.
Therefore it is better to invest in Semicon Pvt.
Conclusion: As actual cash flows are concern, here NPV and IRR both give positive results. But
Transport Express Plc. has contradiction between NPV and IRR as that situation NPV result is
accepted. Also in Semicon Pvt. both NPV and IRR gives higher positive results. So, Semicon

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Jones Plc.
Pvt. is the best company to invest 100 million pounds. As per comparison of TransportExpress
Plc. and Semicon Pvt. according to selection/rejection criteria, Semicon Pvt. has higher NPV and
IRR.
Recommendations:
Recommendations based on a post – audit appraisal on the appropriateness of selected project
decisions. Here calculation is done by both expected cash flow and actual cash flow. In expected
cash flow the result shows the Jones Plc. has to invest in Semicon Plc. and actual cash flow also
give same result. It is common to take result on actual bases. Here actual data is available so
company has to believe in actual cash flow results. However in all phases the result in favour of
Semicon Plc.
Hence all criteria are cleared by Semicon Plc. Therefore Jones Plc. has to invest their 100 million
pounds in Semicon Plc.
Abbreviations:
R&D  Research and Development ICO  Initial Cash Outflow
ARR  Average Rate of Return TVM  Time Value of Money
NPV  Net Present Value IRR  Internal Rate of Return
PV  Present Value COC  Cost of Capital
CF  Cash flow DCF  Discounted Cash Flow
CFAT  Cash Flow after Tax FPBP  Fake Payback Period
Plc.  Public Company Pvt.  Private Company
Bibliography:
References:

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Jones Plc.
1. Damato, Karen. Doing the Math: Tech Investors' Road to Recovery is long. Wall Street
Journal, pp.C1-C19, May 18, 2001
2. A. A. Groppelli and Ehsan Nikbakht (2000). Barron's Finance, 4th Edition. New York.
pp. 442–456.
3. Barron's Finance. pp. 151–163.
4. Lin, Grier C. I.; Nagalingam, Sev V. (2000). CIM justification and optimisation.
London: Taylor & Francis. pp. 36
5. Khan, M.Y. (1993). Theory & Problems in Financial Management. Boston: McGraw
Hill Higher Education.
6. Baker, Samuel L. (2000). "Perils of the Internal Rate of Return". Retrieved January 12,
2007.
7. Weeks, W.B., Wallace, A.E., Wallace, M.M., Welch, H.G., "A Comparison of the
Educational Costs and Incomes of Physicians and Other Professionals," N Engl J Med,
May 5, 1994, 330(18), pp. 1280-1286.
Books Referred:
1. Cox D and Fardon M — Management of Finance (Osborne Books, 1997) ISBN: 1872962238
2. Glynn J, Perrin J and Murphy M — Accounting for Managers (Thomson Learning, 2003) ISBN:
186152904X
3. Harris R — Applied Time Series Modelling and Forecasting (Wiley, 2003) ISBN: 0470844434
4. Lumby S and Jones C — The Fundamentals of Investment Appraisal (Thomson Learning, 2000)
ISBN: 1861526075
5. Makridakis S et al — Forecasting, Third Edition (Wiley, 1998) ISBN: 0471532339
6. Pettinger R — Investment Appraisal: A Managerial Approach (Palgrave Macmillan, 2000) ISBN:
0333800591
7. White G I — The Analysis and Use of Financial Statements (Wiley, 2003) ISBN: 074142918X
Website visited:
1. http://www.venturechoice.com/articles/average_rate_of_return.htm accessed on 12th

April, 2010.

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Jones Plc.
2. http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_dec
isions.htm accessed on 12th April, 2010.
3. http://www.fao.org/docrep/w4343e/w4343e07.htm accessed on 15th April, 2010.
4. http://en.wikipedia.org/wiki/Net_present_value accessed on 15th April, 2010.
5. http://financial-dictionary.thefreedictionary.com/average+rate+of+return accessed on
16th April, 2010.
6. http://accountinginfo.com/study/pv/table-pv-s-01.pdf accessed on 18th April, 2010.
7. http://www.studyfinance.com/common/table4.pdf accessed on 18th April, 2010.
8. http://www.investopedia.com/terms/p/profitability.asp accessed on 18th April, 2010.
9. http://maaw.info/IRRNPVandCostofCapital.htm accessed on 18th April, 2010.
10. http://hadm.sph.sc.edu/courses/econ/invest/invest.html accessed on 18th April, 2010.

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Jones Plc.

Bentham Institute of Management & Languages

Dr. Shaik Moulali, Phd. Finance

Faculty of Bentham Institute of Management & Languages

Bentham House, Ring Road, Rethibowli

Trivikram Nath Pandey

Enrolment Number: BAP – 0210 – 10002

Level 7 BTEC Advanced Professional Diploma In Management Studies

Bentham Institute of Management & Languages

Trivikram Nath Pandey

Bentham Institute of Management & Languages

Bentham Institute of Management & Languages

Risk and Managerial (Real) Options in Capital Budgeting:..................................................24

Bentham Institute of Management & Languages

Aim: The objective it to apply financial techniques, select

TransportExpress Plc. works in road transport services in the city of Workshire.

Bentham Institute of Management & Languages

Report to the CEO of Jones Plc.:

Sub: Business report for recommending the project.

In all compressions of TransportExpress and Semicon the recommendation is in favour of

Thanks for your kindness and valuable time.

Trivikram Nath Pandey

Bentham Institute of Management & Languages

Pass Criteria P2.1:

• Current investments: Current investment is also called current expenditure. These

• Capital investments: Capital investment is also called capital expenditure. Capital

Applications of Appraisal techniques:

• New technology and gadgets

Bentham Institute of Management & Languages

Steps of Appraisal Techniques:

Step 2. Search: Appraisal investment proposal to be thoroughly invested and alternative

Cash Inflow and Outflows in Appraisal technique:

Bentham Institute of Management & Languages

• Cash inflows from the release of working

Bentham Institute of Management & Languages

Advantages and Disadvantages of payback period method:

1. Average Rate of Return (ARR): The rate of return on an investment that is

Bentham Institute of Management & Languages

PI = ( CF1/(1+K)1 + CF2/(1+K)2 + ... + CFn/(1+K)n) / ICO

The ratio is calculated as follows:

Rules for selection or rejection of a project:

 If PI < 1 then reject the project

 If PI = 0 then neutral project may be accepted or not.

Bentham Institute of Management & Languages

1. Calculate present value of cash inflows.

Bentham Institute of Management & Languages

2. Calculate present value of cash outflows.

NPV = Total cash inflow – cash outflow

NPV= CF1/(1+K)1 + CF2/(1=k)2 + …+ CFn/(1=k)n – ICO

Strengths and Weaknesses of NPV:

ICO = CF1/(1+IRR)1 + CF2/(1+IRR)2 + …+ CFn/(1+IRR)n

IRR calculation: The IRR method has two basic steps:

Bentham Institute of Management & Languages

1. Decide the total initial investment for the project.

Strengths and Weaknesses of IRR:

Bentham Institute of Management & Languages

Bentham Institute of Management & Languages

• The time value of money.

Both methods have some reliability coutions:

• The amount of the initial investment.

Bentham Institute of Management & Languages

Single-Point Estimate and Sensitivity Analysis:

• Allows us to change from “single-point” (i.e., revenue, installation cost, salvage,