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Table of Content
1. Ratio analysis and interpretation of big 3 UK supermarkets
1.1.Introduction………………………………………………………………3
1.2.Gearing Ratio……………………………………………………………3
1.2.1. Interest Coverage Ratio………………...…………………..4
1.3. Profitability Ratio…………………………………..………………...5
1.3.1. Gross Profit Margin………………………..…………….…..5
1.3.2. Return on Capital employed……………….……….……...6
1.4. Efficiency Ratio……………………………………….……..……….6
1.4.1. Fixed asset turnover………………………………………….6
1.4.2. Trade Debtor Collection Period……….…………………….7
2. Short- term decision making and CVP analysis
2.1. Breakeven sales and units…………………………………………..9
2.2. Tickets sold to earn $30,000.………………………………………..9
2.3. Result if 8,000 tickets are sold.…………………………….………10
2.4. Margin of safety for 10,000 tickets.………………………………..10
2.5. Ticket sales increase by 25%………………………………………10
2.6. CVP Graph.…………………………………………………………..11
2.7. The assumptions and limitations of CVP.…………………………12
3. Investment appraisal and decision-making
3.1. ARR method.………………………………………………………...13
3.2. If ROCE to be at 25% ………………………………………………15
3.3. Payback period method.……………………………………………16
3.4. Considering acceptable Payback Period to 3 years…………….18
3.5. Net Present Value method…………………………………………19
3.6. Which of the 3 projects are worth considering……………….....20
3.7. IRR method..…………………………………………………………20
3.8. If the rate of return is at 15%………………………………………21
3.9. Overall conclusion.………………………………………………….22
3.10. Advantages and disadvantages.…………………………………..23
4. Referencing………………………………………………………….…25
5. Appendix…………………………………………………………….….27
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1. Ratio analysis and interpretation of big 3 UK supermarkets.
1.1. Introduction
“Ratio is a technique that helps management and external uses…by
examining relationship with certain data” (Collis and Hussey, 2007). It
useful when comparing companies together, as the ratios will gave the
companies specific financial information, which based on it the
company, will improve their performance depending on those ratios.
This report going to evaluate the three big UK supermarkets Tesco,
Sainsbury and M&S, using three ratio analysing technique (Gearing
Ratio, Profitability Ratio and Efficiency Ratio), using last 5 years
financial information downloaded from Bloomberg. The reason behind
choosing those specific three ratios is because profitability ratio is to
maximize the wealth and profit of the business and we need to
compare which of the three companies has increased their profit over
the last 5 years. Efficiency ratio is useful only when comparing with
other companies (Dyson, 2010). This also shows how company is
turning their effectively business into cash. Lastly, gearing ratio is
chosen because, it describes the debt and equity used to finance a
business (Davies and Crawford, 2011).
Tesco was found by Jack Cohen in 1919. Tesco operating in 12
different countries, and employ over 530,000 people (Tesco plc, 2016).
The second largest supermarket is Sainsbury’s was founded in 1869.
Sainsbury’s operates over 1,200 supermarkets and convenience stores
and employs around 161,000 people (J-sainsbury.co.uk, 2016). Last
large supermarket will be considered in this report is M&S. M&S was
found in 1884, it has 852 stores in UK, which serves 33 million
customers (Corporate.marksandspencer.com, 2016).
1.2. Gearing Ratio
The gearing ratio measures how much a company's borrowed
funds to its equity. (Davies and Crawford, 2011). It shows the
financial risk that the business can get. A high gearing ratio leads to
a high debt, and a low gearing ratio leads to a low debt. Gearing
ratio can be measured by the formula below.
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Gearing Ratio=
𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛𝑠+𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠
𝑆ℎ𝑎𝑟𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 +𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛𝑠 +𝑚𝑖𝑛𝑜𝑟𝑖𝑡𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
From the above graph, it shows that M&S and Tesco gearing ratio in
2010 was really high as it was 0.51 and 0.45 compared to Sainsbury’s
it was 0.32. However, it decreased over the following four years, so in
2014 it reached 0.37 and 0.38. This is may be because the investor
has lower the amount of money going into the business. Sainsbury’s
increased over the years until 2013 the gearing was 0.34 this is
because they are depending on finance coming from their owners more
than external financing. But in 2014 it decreased to 0.27. Sainsbury’s
compared to the other two is in the same financial position, but is less
risky in terms of capital structure the other two. As if Gearing is low
then the company is borrowing less money, which means the
borrowing of the company, has reduced.
1.2.1. Interest Coverage Ratio
Interest coverage ratio, it calculates how easily can a company
pay the outstanding debt they have borrowed (Investopedia,
2004). It can be calculated by the below formula.
Interest Coverage Ratio=
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑎𝑡𝑖𝑜𝑛
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
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This above graph illustrate, that Tesco in 2012 has the highest interest
coverage ratio, as it was 9.20. Sainsbury’s has increased on the amount paid
from 4.57 in 2010, to 7.09 2014. On the other hand M&S seems to increase
and decrease of its ratio over the 5 years, this is a good indicate for M&S as
they generating enough profit after the tax to efficiently be out of its
outstanding debt. So it performs better than the other two companies.
1.3. Profitability Ratio
1.3.1. Gross Profit Margin
Gross profit ratio measures how much the profit of business was earned in
relation to the sale that was made (Dyson, 2010). Gross profit is what remains
from the sales after a company pays off the price of good sold
(InvestorWords.com, 2016). The company can calculate the gross profit by
the below formula.
Gross Profit Margin =
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟ℎ𝑖𝑛∗100
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
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The graph shows that M&S had the highest gross profit for 5 years compared
to the other two companies. Tesco preform a bit better than Sainsbury’s as its
gross profit in 2014 was 6.31, however Sainsbury’s was 3.391. So
Sainsbury’s is the least in generating good gross profit. However M&S has the
best gross profit. This means that they have more cash to invest on new
products and services to meet their company needs and wants. The
differences between gross and net is that gross is the full money and the net
is the money after taxation.
1.3.2. Return on Capital employed
This is a measurement of return that the company will take from its capital.
The result ratio it represents the capacity, which the capital is being used to
generate the revenue (InvestorWords.com, 2016). The company can calculate
the return on capital employed by the below formula.
ROCE=
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑎𝑡𝑖𝑜𝑛∗100
𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙+𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠 +𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑙𝑜𝑎𝑛𝑠+𝑚𝑖𝑛𝑜𝑟𝑖𝑡𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
The graph shows that M&S is the safest company for inventors to invest their
money at, as the return on capital employed is really high compared to the
other two companies. Sainsbury’s can be the second safest investor to invest
on as the figures increasing since 2010. However Tesco is the least save to
invest on as the figures is not stable since 2010 so more risk going to be on
Tesco. The difference between the net and grass profit are some expenses
that the business has, so if the graph has changed significantly from gross to
net that indicates the company has some additional expenses which are not
important so they can take it off from their expenses.
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1.4. Efficiency Ratio
1.4.1. Fixed asset turnover
Fixed asset is very important area in efficiency ratio as it examines the point
of view of efficiency. Fixed asset enables the business to function more
effectively, as high level of fixed assets will bring more sales and profit to the
company. This area is useful only when comparing with previous years or with
other companies, therefore it is really useful to be used in this report, to draw
a clear understanding of the three fixed asset supermarket (Dyson, 2010).
The formula below shows how to calculate the fixed asset turnover.
Fixed Asset Turnover=
𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑁𝐵𝑉
The graph above shows that Sainsbury’s in 2014,fixed asset turnover was
5.514 that has increased a lot since 2010 it was 2.169. M&S has not changed
at all since 2010. But Tesco has increased slightly between those 5 years.
This makes Sainsbury’s less risky to invest on as the turnover is increasing.
This means that Sainsbury’s is generating more revenue from every $ of
assets that has, which makes it more efficient in generating profit than the
other companies.
1.4.2. Trade Debtor Collection Period
Getting fixed assets is very good, but no need for the business to buy them if
the customer will not pay for them. Customers may be encouraged more by
buying lower selling price. If the debtor is paying back the money as quickly
as possible, then the business may have flow cash problems. Therefore the
business needs to watch trade debtor position very carefully. The business
can check how well it has been by doing the trade debtor collection period
ratio (Dyson, 2010). Which can be calculated by this formula.
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Trade Debtor Collection Period=
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑆𝑎𝑙𝑒𝑠
𝑥 365
This graph shows that M&S debtor collection period is decreasing as in 2010
it was 4.489 and in 2014 reached 2.92. Which shows that they are collecting
their money form customers more frequently, which increases the collection
period. However, Tesco and Sainsbury’s are preforming bad, as the period is
increasing not decreasing. Which M&S is the only company that preforms well
out of the other two.
Ratio analysis has some limitations, which needed to be considered such as;
comparison with other firms will lack the meaning if the other firms are
different so the result will be not accurate. Also one set of data for one year
would not allow the investigation to go through as it need more than one year
to have the proper calculations and the profit out of ratios. Furthermore, when
analyzing the ratio a huge care must consider seeing if the profit earned in a
good manner and does not have other illegal accounts that the money came
from. Lastly, ratios uses historical data and does assume any future data
which it will be no use for a company if want to plane for the next couple of
years (Horner, 2015).
The best preforming company from my opinion depending on the above
information is M&S as in most of the ratios above preforms better than the
other two companies which indicated that they are gaining profit and not
having any difficulties, unlike the other two companies, which the information
above show that they are a bit struggling. I would recommend that the other
two companies to work hard to find what is their weakness in those ratios and
try to fixe them up as soon as possible. Those companies should have some
additional expenses, so they can manage their inputs with outputs and in time
of difficulties they can use it.
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2. Short- term decision making and CVP analysis
2.1. The number of tickets that must be sold to breakeven (both in
terms of sales and units)? Explain your results.
Total Revenue = selling price x unit sold
25 x 10000 = 250,000
Fixed cost= $125,000
Sales per unit = $25
Variable cost per unit = $10
Contribution margin per unit= sales – variable cost
25 – 10 = 15 per unit
This mean that 15 unit could be generating, is to cover up the fixed
sales unit.
Contribution margin total = 250,000 – 100,000 = 150,000 - FC
(125,000) = profit
150,000 – 125,000 = 25,000 is the total contribution.
This means that the 25,000 amount of contribution which it is the sales per
unit, is the total cover up for the business. Manager at this time does not
consider the end of the financial of the year, as there is no tax at this time.
Break Even Point unit = FC / UCM
BEP = 125000/15= 8,333.33 need to sell for the business to
break even.
CMR = CM / Sales CMR = 150,000 / 250,000 = 0.6 = 60.00%
Any sales beyond this point are a loss, any sales after this point is a
profit, so this would consider as the break-even point.
BEP sales = total fixed cost / contribution margin ratio
BEP sales= 125,000 / 0.6 = 208333.33 break point for sales
2.2. How many tickets must be sold to earn $30,000 profit?
Unite sold to attain target profit= fixed expenses + target profit / unite
contribution margin.
USTATP= 125,000 + 30,000 / 15 = 10,333,33 tickets must be sold to
meet the $30,00 target.
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2.3. What profit/loss would result if 8,000 tickets are sold?
Revenue = 25*8000 = 200,000
- Variable cost = 10*8000 = 80,000
- Fixed cost 125,000
- Profit/loss = -5000
There is a $5000 loss if the business will sell 8,000 tickets;
therefore the business needs to sell more tickets to make a profit or
event reach it Break-even point
2.4. Estimate the margin of safety for a sale of 10,000 tickets (both
in sales and % age terms). Explain your result.
Margin of safety (Sales) = Revenue – BEP
MOS Sales = 250,000 –208333.33 = 41666.67
This means that when this number is reach then the company is above
their breakeven point.
MOS (%)= 41666.67 / 250,000 = 16.67 %
This to check the percentages of the MOS and to make sure that the
business is not falling beyond their target percentage.
2.5. Suppose if the management expectations of ticket sales
increase by 25%, with fixed cost and selling price per ticket
remaining constant, what would be the % age increase in
profit.
Old
Tickets: 10,000
Revenue: 250,000 25* 10,000
Variable cost: 100,000 10* 10,000
Contribution: 150,000 250,000- 100,000
FC: 125,000
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Profit 25,000 150,000 – 125,000
New
Tickets: 12,500
Revenue: 312,500 25* 12,500
Variable cost: 125,000 10* 12,500
Contribution; 187,500 312,500 – 125,000
FC: 125,000
Profit: 62,500 187,500 – 125,000
Percentage change in profit= old profit – new profit / old profit
PCP= (62,500 – 25,000)/ 25,000 = 15.0% is the age increase in profit if
the tickets sells increase by 15% which means the company will get
more profit from the percentage increasing.
2.6. Draw a CVP Graph for the given scenario based on volume
range of 0 tickets to 14,000 tickets sold? Label the graphs and
clearly indicate the BEP (units/sales), profit/loss region and the
cost lines.
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The profit earned at a certain level can be measured by the distance between
the total cost and the revenue at any level of the output. The low levels of the
output, the total is lower than the revenue, the gap between the two would
measure the loss at the output level. If we look to the break even point we can
see the total revenue is higher than the total cost, by measuring the distance
between the two, the profit earned by the company could be found. Break-
even point is where the company has not lost profit neither gained any.
Anything before the breakeven point is a loss and anything after it is a profit
for the company (Horner, 2015). Break-even point is where sales line meets
the total cost line. Moreover the loss is taking place until break-even point
then profit will take place. Margin of safety is the distance between the break-
even point and the maximum sales, which takes place. It called margin of
safety because it gives the management an idea of how much is remaining to
make a profit not just to break even (Black and Al-kilani, 2013).
2.7. Using appropriate literature, explain the results in light of the
assumptions and limitations of CVP analysis.
In every graph there is limitations, which would be a drawback to the
business such as, the output which in the CVP graph is the only
affecting cost factors, there is no external factors which included into it,
for example; inflation, efficiency and political factors. In reality the costs
cannot be split easily, but in this graph the total cost is divided into
fixed and variable cost, which is unreasonable to do if it does not
happen easily in reality. Moreover, the fixed costs do not remain at the
same level all the time beyond certain rangers, and the behavior
between the cost and revenue in liner, which is a rare thing to happen
between those two. Furthermore, the PVC graph does not have
uncertainty in the prediction of costs and sales revenue. Usually
businesses produce more than one product and sale mix this is not
constant but it changes due to the demand of the products, so the
graph does not gave a single product. (Davies and Crawford, 2011).
Lastly, the time value money is ignored, this means that this graph
does not realize the change in money over the next few years, then this
graph in 3 years time it wont be accurate to use so the business have
to do another one. Those limitations are very real which every business
which use this graph knows about, those limitation it wont change
overnight so needs time to be developed to be changed. Nerveless, the
principles of the CVP analyses continue to be true, and some of the
above limitations can be overcome, by considering alternative pricing
options, that use marginal and full absorption costing approaches
(Davies and Crawford, 2011). Those limitations will affect the answer
for the above CVP analysis, but it is still usable at this moment, if the
business will use this graph after 3 years time it will not be affective at
all. Therefore the business should update this graph nearly every year,
so they have accurate information.
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3. Investment appraisal and decision-making
3.1. Rank the 3 projects using ARR method
Accounting rate of return is a method to judge the project by its
profitability. Profit earned each year is referred to as a percentage in
the project. Because this method is using profit rather than cash flow
then any cash flow needs amendment so we can work out the profit of
the project (Horner, 2015).
Alpha
Depreciation-Straight line Method
The investment will lose value, if not applying the straight-line method
(Horner, 2015).
5,000 – 1,000
DEP = = 1,000
4
PBD – DEP
Year 1 1,000 – 1,000 = 0
Year 2 1,000 – 1,000 = 0
Year 3 3,000 – 1,000 = 2,000
Year 4 3,000 – 1,000 = 2,000
2,000 + 2,000 = 4,000
4,000 / 4 = 1,000
Average annual capital employed
Depending on the straight-line method the ACE needs to be done.
Here we want to show the average value investment rather than the
net value, which it will be not useful to this calculation (Horner, 2015).
5,000 + 1,000
ACE = = 3,000
2
Accounting Rate of Return
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1,000 * 100
ARR= = 33.33 %
3,000
Beta
Depreciation-Straight line Method
8,000 – 2,000
DEP = = 1,500
4
PBD – DEP
Year 1 3,000 – 1,500 = 1,500
Year 2 3,000 – 1,500 = 1,500
Year 3 3,000 – 1,500 = 1,500
Year 4 3,000 – 1,500 = 1,500
1,500 + 1,500 + 1,500 + 1,500 = 6,000
6,000 / 4 = 1,500
Average annual capital employed
8,000 + 2,000
ACE = = 5,000
2
Accounting Rate of Return
1,500 * 100
Alpha PBD DEP
year 1 1,000 1,000 0
yaer 2 1,000 1,000 0
year3 3,000 1,000 2,000
year 4 3,000 1,000 2,000
tottal 4,000
1,000
ARR 1,000 * 100
3,000 33.33%
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ARR= = 30 %
5,000
Delta
Depreciation-Straight line Method
10,000 – 3,000
DEP = = 1,750
4
PBD – DEP
Year 1 5,000 – 1,750 = 3,250
Year 2 5,000 – 1,750 = 3,250
Year 3 1,000 – 1,750 = -750
Year 4 1,000 – 1,750 = -750
3,250 + 3,250 + - 750 + - 750 = 5,000
5,000 / 4 = 1,250
Average annual capital employed
10,000 + 3,000
ACE = = 6,500
2
Accounting Rate of Return
1,250 * 100
ARR= = 19.23 %
6,500
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ARR is more useful because it takes into account the size of the return of the
investment, which aiming to increase the profit of the company (Horner,
2015). It is easy to understand, and not difficult to compute, also it draws and
attention to overall profit (Dyson, 2007). However, the drawback of this
method is that it treated all years equally does not consider the changes that
could happen over the years. This could be a low risk if planning for a short
period of time, which will be great method to use (Horner, 2015).
Rank 1: Delta
Rank 2: Beta
Rank 3: Alpha
3.2. Considering the company’s historical ROCE to be at 25%.
Which of the three projects are worth considering for
investment?
Alpha and Beta will increase the share value of the company, as they
are greater than 25% so it is feasible; however the Delta is not feasible
as it has lower percentages than the ROEC. Therefore the company
should choose Alpha and Delta to secure a profit and worth
considering for investment.
Rank 1: Alpha
Rank 2: Beta
3.3. Rank projects using Payback period method
Payback means the time taken for the nest flow to match original cash
flow out of the investment. It will be measured in years and it a good
method because it have a shortest payback period possible to meet
(Horner, 2015). This method is useful if a company wants to avoid
having large amount of capital tied up in project for period of time. By
counting how much they can recover the cost they have invested into
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this project. As any other methods there are limitations to this method
as well, such as the profitability of the project will be ignored, also the
cash flow after payback period will be ignored as well (Horner, 2015).
Ignoring a profit will be an issue as it could lead to serious problems to
the project. Finally this method does not take time value of money,
which means that no considerations of the changing of the value of
money in the years coming, which is a huge draw back for this method.
Year 0 is the current year, which start with negative number all the
times.
Alpha
CF – CCF
-5,000 – 1,000 = - 4,000
-4,000 – 1,000 = - 3,000
- 3,000 - 3,000 = 0
0 – 3,000 = 3,000
Payback period point is at year
Beta
CF – CCF
-8,000 – 3,000 = - 5,000
-5,000 – 3,000 = - 2,000
- 2,000- 3,000 = 1,000
1,000 – 3,000 = 4,000
Alpha CF CCF
year 0 5,000 -5,000
year 1 1,000 -4,000
year 2 1,000 -3,000
year 3 3,000 0
year 4 3,000 3,000
PP at year 3
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To find the exact months the following formula should be done
Amount needed to reach payback *12
Amount received in year
- 2000
Number of month after last cash flow = * 12 = 8 months
3,000
Payback period point is at 2 years and 8 months.
Delta
CF – CCF
-10,000 – 10,000 = - 5,000
-5,000 – 5,000 = 0
0 - 1,000 = 1,000
1,000 – 1,000 = 2,000
Payback period point is at 2 years
3.4. Considering company maximum acceptable Payback Period to
be 3 years. Which of the 3 projects are worth considering for
investment?
All three of the project can be considerable as feasible, they all meeting
the payback period. However, Delta is quickest payback period than
the other two projects as it pays back the company after 2 years. If
choosing from the three project Delta comes first, second would be
Beta and Alpha will be consider last as it payback at 3 years exactly.
Rank 1: Delta
Rank 2: Beta
Rank 3: Alpha
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3.5. Rank projects using Net Present Value method. Consider
discount rate of 5%
NPV is a method used to examine the technique in order to express all
future cash flow in the same terms; it takes into account the value of
money (Gowthorpe, 2011). Choosing an appropriate discount rate
would be depending on the cost of the capital as well as the riskiness
of the investment (Horner, 2015).
DF 5%
Alpha
PP for Alpha is at 3 years and 2months, it is less than max acceptable,
which is 4 years hence feasible investment option.
Beta
PP for Beta at 2 years and 11 months, it is less than max acceptable
PP of 4 years hence feasible investment option.
Delta
PP for Delta is at 2 years and 9 month; it is less than max acceptable
of 4 years hence feasible investment option.
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3.6. Which of the 3 projects are worth considering for investment?
All of the three projects are feasible and are worth of investment, but Delta
would be the best option as the PP is in 2 years and 9 months, which is
the quickest to pay back. Secondly would be Beta as the pay back period
would be 2 years and 11 months and lastly Alpha would be considered as
its payback period in 3 years and 2 months.
Rank 1- Delta
Rank 2- Beta
Rank 3- Alpha
3.7. Rank projects using IRR method
IRR is the discount rate, which applies to cash flow and produces an
NPV of zero. If the IRR greater than the business cost then the project
is acceptable. The higher the IRR the better the project is (Gowthorpe,
2011).
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3.8. If the company’s required rate of return is at 15%. Which of the
3 projects are worth considering for investment?
IRR Alpha 8.28%
Hurdle rate for the company is 15%
IRR (Alpha) is > hurdle rate so the project is feasible
IRR Beta -5.42%
Hurdle rate for the company is 15%
IRR (Beta) is > hurdle rate so the project is feasible
IRR 13.97%
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Delta
Hurdle rate for the company is 15%
IRR (Delta) is > hurdle rate so the project is not
feasible
Rank 1 Alpha
Rank 2 Beta
Alpha and Beta would be suitable for the business as they both have a
percentage more than 15%, which they are feasible to use for the business.
However, Delta is not a good project to consider, as it is less than 15%, which
will give a loss to the business.
3.9. Having evaluated the projects using alternative investment
appraisal technique, provide an overall conclusion of the most
appropriate method/methods you would consider for
appraising the three projects and Why?
Capital budgeting is designed to achieve more profit and reduce the
costs in private and public sectors. It has a broader perspective and
tries to explain and describe the process by “which projects become
identified, developed, justified and finally approved” (Capital
Budgeting Process: Theoretical Aspects, 2011).
Of all the methods evaluated in this report, the net present Value
method (NPV) the business should consider the best to use when
making investment appraisal decision. Based on the project Delta
would be the best option as the PP is in 2 years and 9 months,
which is the quickest to pay back project. The NPV method it
provide the investor with valuable tools, which will help on deciding
which project to use, it is also a financial measurement tools that
gave the time value money in a business, this techniques very
important to have moreover, the majority of the others methods
does not has this specific feature, that why the business should
consider the NPV when investing. Due to the above this technique
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is very popular for investment decision (An investigation into the
impact of investment appraisal techniques on the profitability of
small manufacturing firms in the Nelson Mandela Bay Metropolitan
Area, South Africa, 2010). Asma Arshad said that “NPV is the most
preferable and mostly used method to analyse the projects”, which
is very true to say (Net Present Value is better than Internal Rate of
Return, 2012). However, investors intend to find NPV does not
measure the amount relative to the amount invested. But many
investors prefer to use the NPV regardless this small limitation that
it has (Net Present Value is better than Internal Rate of Return,
2012).
Modigliani and Miller (1958) argued that managers should only
focus on the NPV and leave all the unnecessary calculations and
methods, which would increase the value of the firm. Similarly,
Hastie (1998) has recommended using the NPV, as a “utilization of
sophisticated techniques”, which it improves decision-making and
increase the value of the business. Those are the same reasons as
Modigliani and Miller (An investigation into the impact of investment
appraisal techniques on the profitability of small manufacturing firms
in the Nelson Mandela Bay Metropolitan Area, South Africa, 2010).
NPV it required a discount rate to value expected cash flow. This
may decrease the value of the project investing on and may cause
the management to give up investment opportunities. Therefore, the
manager does not have access to a flexibility they need to make a
investment decisions regarding this (An investigation into the impact
of investment appraisal techniques on the profitability of small
manufacturing firms in the Nelson Mandela Bay Metropolitan Area,
South Africa, 2010).
3.10. Provide a critical analysis of the appraisal methods used to
evaluate projects and Justify your recommendation in light of
the advantages and disadvantages of each of the method used
to evaluate long-term investment projects?
Accounting Rate of Return (ARR) has many advantages and
disadvantages. The advantages are the calculations is very
straightforward, is widely used measurements, it is also easy to
compare to ROCE for a business and non-financial managers can
easily understand it. On the other hand the disadvantages are it
does not account the time value money, it calculates depending on
the profits instead of the cash flow and it fails to take into account
the size of competing project (Gowthorpe, 2011). Another method
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used is payback period the advantages are; its calculation is very
straightforward, it can be useful when rapid recovery of funding is a
priority and non-financial managers can do its measurements.
However, its disadvantages are; Payback period does not take an
account of the time value of money, it provide very little useful
information, also all the cash flows beyond the payback period is
ignored (Gowthorpe, 2011).
Moreover, the net present Value method (NPV) advantages are; it
counts the time value of the money, it takes all the future cash flow
into account and it is very useful when ranking different projects. On
the other side its disadvantages are; it can be difficult to explain it to
non-financial managers also it is difficult to approach the discounted
rate (Gowthorpe, 2011). Lastly the Internal Rate of Return method
(IRR) it has only one advantage, which it builds the time value of
money into its calculations. However, it has a lot of disadvantages
such as, it can be difficult to explain to non financial managers,
because it expressed in percentage terms then the value is ignored,
it also difficult to approached a target discount rate, and finally it is
not always possible to calculate it (Gowthorpe, 2011).
The best method that the company should use in this case is the
NPV method because, it have very little weaknesses such as; it can
be difficult to explain it to non-financial managers also it is difficult to
approach the discounted rate. Its strengths are way more than it
weakness some strengths are; it counts the time value of the
money, it takes all the future cash flow into account and it is very
useful when ranking different projects. Furthermore, because most
of the companies now uses computers when doing any calculations
and the fact that the NPV available on computers, it is much easier
to be used and calculate with no time (Gowthorpe, 2011). The
positions that are good for the company are Positions Alpha and
Delta as both of them has first ranking for most of the above
discussed decisions, which means the company could use them to
be successful and generate more profit to the company.
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Referencing
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7. Payback period Method
7.1. Alpha
7.2. Beta
7.3. Delta
Alpha CF CCF
year 0 5,000 -5,000
year 1 1,000 -4,000
year 2 1,000 -3,000
year 3 3,000 0
year 4 3,000 3,000
PP at year 3
