A Report of Investment Decision Making System to the Rivits Main Board

 

As requested, the report is aim to impartially evaluate and discuss your company’s ( Rivits’) existing investment appraisal system, and to prepare related suggestions and recommendations as proper for your reference to improve and update your current system. The report would include three parts: first, it is the main body of the report which involves abstract, introduction, discussion, conclusions and recommendations if it is available. Second, it is appendixes which includes the workings of numbers and calculations with the aim to server the discussions and recommendations in the main body of the report. Third, it is the bibliography of the report. And the report would be constructed in the three parts as below:

  1. The Main Body of the Report
  2. Appendixes 
  • Bibliography

 

The Main Body of the Report

 

  1. Abstract

 

As some disadvantages realized by your company’s ( Rivits’) managers, the report  is aim to impartially evaluate and discuss your company’s existing investment appraisal system, and to recommend integrating NPV method as an improvement into the existing system. The new system would be more helpful for investment evaluation by considering three more variables: the timing and time value of cash flows, the clear and definite evaluation criterion and the taxation effects. At the same time, sensitivity analysis method would be applied for investment risks management in the new system.

 

  1. Introduction

 

This report is referred to our recent conversation regarding the evaluation of and the available improvements for your existing investment appraisal system. As requested, we have prepared a memorandum regarding the effectiveness of the using system and some available and practical improvements for your reference.

 

Our analysis and comments below are based on our understanding and assumption of the background information. Should the background information be incomplete or inaccurate, please inform us immediately so that we would verify if our comments are still relevant.

 

  1. Discussion

 

3.1 Our Understanding of Company’s Existing Investment Appraisal System

 

We understand the current investment decisions made in Rivits are evaluated and analyzed by Company’s existing system, and the techniques it applies are primarily based on the predicted future cash flows and the contribution on profit. At the same time, the system is likely to represent the scenario with the most probability for happening.

 

3.2 Our Comments on Company’s Existing Investment Appraisal System

 

According to your working process based on your existing system, we understand your existing investment appraisal system is clearly-represented and easily-understandable. However, we realize some elements miss considered in the system, which may partially cause the recent losses in your scheme. These elements include the criteria for investment evaluation, the timing and time value of future cash flows, and the taxation effects. At the same time, your existing system is less helpful for your project risks management by lacking risks warning system.

 

3.3 Our Proposed Improvements in Company’s Existing Investment Appraisal System

 

We propose to integrate net present value method (NPV) into the existing investment appraisal system by keeping the previous conceptual framework. Net present value measures the value of investment by discounting future cash flows generated from the project at a proper discount rate. The discount rate is connected with the risks in the project, and the riskier the project, the higher the discount rate. NPV method may assist your investment evaluation in three basic aspects. First, it may provide a clear criterion for project appraisal which states that the project is acceptable with positive NPV, and the larger the NPV, the better the project. Second, it may provide you an available method to evaluate equally the value of cash flows generated from the project in different time and to enhance the comparability between different projects with the same criterion. Third, it would help you to evaluate the project more completely with considering the taxation effects and more faithfully with eliminating irrelevant variables.

 

3.4 Our Exemplification of Net Present Value Method

 

Here we provide a demonstration of net present value method application with appropriate interpretations. The example is based on your schemes already evaluated previously, and the comparison with your existing investment appraisal system is also represented for your reference. The results are exhibited in the appendixes as below.

 

Firstly, we apply NPV to the appraisal of IT projects. Please refer to appendix 1. According to the results from the net present value method, the cost of purchasing new software alternative is cheaper than that of improving the old software alternative by approximate£38,700, while by company’s existing appraisal system, the gap between them is £100,000. The differentiation is mainly caused by whether or not considering the timing and the time value of cash flows generated by the projects. According to the theory of time value of the money, the amount of money in future is cheaper than the same amount in the present time, for the inflation would deteriorate the purchasing power of future money and the risk of getting the money is increasing with the time. For IT projects in your company, if company accepted the outcome in the existing investment appraisal system and reinvested the predicted savings of £100,000 in other capital investment, it would probably happen that the saving cash flows generated from IT projects afterward could not cover the capital needs generated from £100,000 for cash in the future is less valuable than that in the present time. At the same time, it can be seen in appendix 1 that the two alternatives are evaluated interdependently by comparing the cash flows from them. The new system would reduce the separation degree in existing investment appraisal system and increase the faithfulness in the comparison results by applying 7% as the discount rate because the estimations used for comparison are more equal in the value.

 

Secondly, we use NPV to re-evaluate the XYZ project. Please refer to appendix 2. By applying 7% as the discount rate, the expected net present value for XYZ project is £79,100. (To define 7% as the discount rate for XYZ project is based on a comprehensive evaluation of risks in XYZ project, in which risks in three different scenarios are considered evenly based on their respective weight probabilities for happening.) Compared with the outcomes from company’s existing appraisal system which only brings the most likely scenario represented, the results from NPV method is comparatively more completed and informative for it brings all the scenarios into consideration. By using expected measurements of variables based on weight probabilities for each scenario happening, all possible scenarios are integrated into one scenario and the results from it would neither too positive nor too negative. At the same time, with the application of expected net present value, the risk of the expected NPV could be measured by using standard deviation method, which measures the instability of the expected NPV by comparing the differences between the expected NPV and the NPV from each scenario according to their respective weight probabilities. The principles of standard deviation method is that the larger the standard deviation, the more instable the expected NPV, so as the riskier the project. For XYZ project, the standard deviation for the expected net present value is about £152,060. Another advantage bought by NPV method is to take more directly related variables into consideration and to eliminate not so relevant variables out of the system. For the evaluation of XYZ project, the influence from taxation is a directly related variable because the profits produced by XYZ project claim taxation liability, and miss consideration of the taxation variable would aggregate the profitability and increase the probability of incorrect investment-decisions making. Meanwhile, according to the taxation regulations applied by your company, capital allowances are available against the company’s taxation liability in certain cases. The policy allows your company to claim a reduction in your corporation tax bill for the purchase and installment of certain assets as long as corporation tax is paid. All these effects from taxation liability and capital allowance are complicated but are all bought into consideration in NPV method system. Some variables are eliminated from NPV system for these variables are not so relevant with XYZ project like interest cost and dividends which are connected with financing decisions. All of these adjustments made on company’s existing investment appraisal system would increase the faithfulness of the results and increase the probabilities of making correct investment-decisions. The third advantage of NPV method is to provide you a clear and definite criterion for your investment evaluation. According to NPV method, the project is acceptable with positive net present value, and the larger the NPV, the better the project. As stated in appendix 2, the results from NPV method communicate you an explicit signal that the XYZ project is acceptable because it is with a positive expected net present value of £79,100. A clear and definite criterion may also be helpful for eliminating unnecessary divergence of opinions by limiting the interpretations of the outcomes from investment appraisal system, which would save your decision-making time consumption. The forth advantage of NPV method is to provide you a convenient way to analyze the outcomes’ sensitivities of certain variables. For XYZ project, sensitivity analysis measures the range of the changes in the expected net present value caused by the changes in a certain variable. By increasing or decreasing the same proportion in certain variables one by each time, the ranges of the changes in the expected net present value would be divided. The larger the changes in the expected net present value, the more sensitive the project to the variable, and more attention and energy would be paid to enhance the stability of the variable. Sensitivity analysis is an effective way to evaluate potential risks. Please refer to chart 1. It can be seen that, compared with raw material cost variable and discount rate variable, selling price is the most sensitive variable for the expected net present value, and should be paid with the most attention to control its risk for XYZ project.

 

  1. Summary and Conclusions

 

To sum up, by applying NPV method into the existing investment appraisal system, the new system would be improved in three basic aspects. Firstly, it brings the timing and time value of cash flows into both IT projects and XYZ project investment appraisal which makes the evaluation results more faithful. Secondly, it brings the complicated taxation influence and a comparatively explicit decision-making criterion into the XYZ project evaluation which makes the evaluation results more completed and less time consuming. Thirdly, the new system applies sensitivity analysis into XYZ project which would be helpful for effective risk management.

 

  1. Recommendations

 

According to the discussion and analysis mentioned above, we recommend you integrating NPV method into the company’s existing investment appraisal system and paying attention to the risks management discovered in the new system.

Appendixes

Appendix 1: NPV for IT Project

IT Projects

Year

2012

2013

2014

2015

2016

TOTAL

£’000

£’000

£’000

£’000

£’000

Net cash flows of purchase

-810

40

40

40

40

-650

Net cash flows of improvement

-510

-60

-60

-60

-60

-750

Savings

-300

100

100

100

100

100

Discount factor

1.000

0.935

0.873

0.816

0.763

 

Present value of savings

-300.00

93.46

87.34

81.63

76.29

Net present value

38.721

 

Appendix 2: NPV for Production Project

Production Project

Year

2012

2013

2014

2015

2016

£’000

£’000

£’000

£’000

£’000

Cash Inflows

         

sales

1,800

1,800

1,460

1,160

508

Total Cash Inflows

1,800

1,800

1,460

1,160

508

Cash Outflows

         

machinery

800

       

in-house development

200

       

raw materials

1,125

1,125

913

725

318

direct labour

342

308

230

164

82

share of factory overheads

20

20

18

16

8

capital allowance

         

from production projects

200

200

240

160

adjusted capital allowance

200

200

240

153

taxable profit

-87

147

60

102

101

taxation rate

30%

30%

30%

30%

30%

taxes

0

44.1

17.85

30.72

30.3

Total Cash Outflows

2,487

1,497

1,178

936

437

Net Cash Flows

-687

303

282

224

71

Discount Factor

1

0.935

0.873

0.816

0.763

Present Value

-687

283

246

183

54

Expected Net Present Value

79.10

standard deviation

152.06

Chart 1: sensitivity Analysis of Selling Price, Material cost and Discount Rate

 

Bibliography

Brealey, Richard A. & Myers, Stewart C. (2003). Principles of Corporate Finance. 7th edition. London: the McGraw – Hill Companies.

 

Arnold, G. (2005). Corporate Financial Management. 3rd edition. London: Pearson Education

原文链接:Investment Decision Making