W5_Austin_Evaluating Investment Decisions

1.  Problem recognition, definition and evaluation

A case study of my investment decisions (Capital Budgeting or Capital expenditure decisions), to invest my current funds most efficiently in long-term assets, such as Building Apartments for Rent in selected commercial Locations. Investment decisions can help identify which investment proposals are in the "ballpark." That is, it can be used as a screening tool to help answer the question, "Should I consider this proposal further?" or What is the project worth in today’s dollars or gold equivalence? How much is the ARR and Payback period? A number of investment criteria or capital budgeting techniques are available for consideration. They may be grouped in the following two major categories:

1.   Discounted Cash Flow (DCCF) Criteria;

a.   Net present value (NPV)

b.   Internal rate of return (IRR)

c.   Profitability index (PI)

2.   Non-discounted Cash Flow Criteria

a.   Payback period (PB)

b.   Discounted payback period

c.   Accounting rate of return (ARR)

2.   Development of the feasible alternatives

Payback Period: The payback period (PB) measures the time required to recoup the initial investment in the capital asset. The time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. It is calculated as thus;

Payback period = Initial Investment/Average Annual Cash Flow.

Accounting Rate of Return: The accounting rate of return (ARR) is also known as the return on investment (ROI), uses accounting information as revealed by financial statements, to measure the profitability of an investment. The accounting rate of return is the ratio of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

Net Present Value: The net present value (NPV) of a capital project answers the following question: What is the project worth in today’s dollars or gold equivalence? The NPV is the sum of the present value of all current and future cash inflows and outflows. Since the present value of a cash flow that occurs today is its face value, the NPV of a project is the sum of any cash flows that occur at time zero, plus the present value of all future cash flows. An alternative interpretation of the positive net present value of an investment is that it represents the maximum amount a firm would be ready to pay for purchasing the opportunity of making investment, or the amount at which the firm would be willing to sell the right to invest without being financially worse off.

3.  Development of the outcomes and cash flows for each Alternative

 

  4.  Selection of the acceptable criteria

In the present scenario, except project A Location, all the three projects locations should be accepted, if the discount rate is 10%.  However, only projects Locations B and D should be undertaken if the discount rate is 30%. If we assume that the projects are mutually exclusive (differently located), then under the assumption of 30% discount rate, the choice is between B and D (A and C are unprofitable).

Both criteria IRR and NPV give the same results - Location D is the best.

Under the assumption of 10% discount rate, ranking (based on chosen location), according to IRR and NPV conflict may exists (except for project Location A). If we follow the IRR rule, Project Location D should be accepted. But the NPV rule shows that Project C is also good. The NPV rule generally gives consistent results in conformity with the wealth maximization principle. Hence, alternatively we would therefore, accept Project Location C as second choice following the NPV rule.

    5.  Analysis and Comparison of the alternatives

The forgoing analysis demonstrates that both criteria IRR and NPV offer the best investment options as shown in table below:

    6.  Selection of the preferred alternative

Both criteria IRR and NPV give the same results NPV vs IRR Dependent projects: - Location D is the best option with favorable rate of return. Alternatively we would also accept Project Location C as second choice following the NPV rule.

7.Performance Monitoring and Post Evaluation of Results

NPV vs IRR Dependent projects: Both criteria IRR and NPV for consideration give the same results and shows that - Location D is the most profitable investments. NPV clashes with IRR where mutually exclusive projects exist. However, under the assumption of 10% discount rate, ranking (based on selected locations), according to IRR and NPV conflict may exists (except for project Location A). If we follow the IRR rule, Project Location D should be accepted. But the NPV rule shows that Project C is also good. The NPV rule generally gives consistent results in conformity with the wealth maximization principle. Hence, alternatively we would also accept Project Location C as second choice following the NPV rule.

 8.   References/Bibliography

1.   Pandy, I.M. (2008) Financial Management ninth edition.

Retrieved from: http://books.google.nl/books/about/Financial_Management_9E_With_Cd.html?id=vdYVBV11Ex8C&redir_esc=y

2. Ishola, R. A. (2008) Investment Decisions in a Developing Economy: A Case Study of. Insurance Business in Nigeria. Retrieved from: http://www.eurojournals.com/irjfe_20_01.pdf

3.   Hashimu, B (2005). “Research Methodology” (Unpublished lecture note, University of Jos, Jos). Retrieved from:

http://www.scribd.com/doc/52996200/11/DEFINITION-OF-INVESTMENT-DECISIONS

4.   Ugwuanyim, G.U (2005). “Research Methodology” (Unpublished lecture note, University of Jos, Jos). Retrieved from:  http://www.scribd.com/doc/52996200/11/DEFINITION-OF-INVESTMENT-DECISIONS