London School of Commerce

Assignment
On

Accounting Decision Making Technique

S A Palan

Submitted By

Mohammad Abu Huraira

Student ID- 0614KKKK1010

Group-D, MFP/MBA
Requirement 1: Calculation of Payback Period, NPV, and IRR

The Required Rate of Return for the AP plc is 10%

Proposal 1: Research & Development of a new product

Initial Investment £ 100,000.

Calculation of Payback Period:

Year Net Cash Flow Cumulative Cash Flow

1 0 0
2 0 0
3 73000 73000
4 73000 146000
5 73000 219000

100000−73000
Payback Period = 3+
73000

=3+.37 =3.37 years

Calculation of NPV:

Cash flow Discount Factor Present Value (PV)

0
0
73000 0.7513 54844.9
73000 0.6830 49859
73000 0.6209 45325.7
Total 150029

NPV = PV- Initial Investment

=150029-100000

=50030
 Cash flow PV @ Discount PV @ Discount
Year
Rate of 20% Rate of 25%
1 0 - -
2 0 - -
3 73000 42245.37 37376
4 73000 35204.47 29901
5 73000 29337.06 23921
106787 91198
Investment (100000) (100000)
NPV 6787 (8802)

Calculation of IRR:

6787
IRR = 20+ × (25-20)
6787+8802

= 22.18%

Summary of proposal 1 Payback Period = 3.37 years NPV= 50030 IRR= 22.18%
Proposal 2: Installation of mainframe computer System

Initial Investment 180000

Payback Period:

Cumulative cost
Year Cost Savings
Savings
1 66000 66000
2 66000 132000
3 66000 198000
4 66000 264000
5 66000 330000

180000−132000
PB =2+
66000

=2.727 years

NPV:

NPV = (Annual Cash flow × Annuity Factor) - Investment

= (66000×3.7908)-180000

=70193

IRR:

@20% @25%
Annual Cash flow Annuity Factor
2.99061 2.68928
PV of Cash flows 197380 177493
66000 Investment (180000) (180000)
NPV 17380 (2507)

17380
IRR = 20+ (25-20)
17380+ 2507

=24.4%

Summary of proposal 2 Payback Period = 2.727 years NPV= 70193 IRR= 24.4%
Proposal 3: Purchase of extra Warehouse Space

Initial Investment 200000

Pay Back Period:

Cumulative
Year Cash Flow
Cash Flow
1 145000 145000
2 145000 290000

200000−145000
Payback Period=1+
145000

=1.4 years

NPV:

NPV= (Annual Cash flow × Annuity Factor) - Investment

= (145000×1.7355) – 200000

= 51647

IRR:

@25% @30%
Annual Cash flow Annuity Factor
1.44 1.36095
PV of Cash Flows 208800 197337

145000 Investment (200000) (200000)

NPV 8800 (2663)

8800
IRR = 25+ (5)
8800+2663

=29%
 Summary of proposal 3 Payback Period = 1.4 years NPV= 51647 IRR= 29%

Proposal 4: Creation of a formal Staff training System

Initial Investment= 40000

Payback Period:

Cumulative Cost
Year Cost Savings
Savings
1 16000 16000
2 16000 32000
3 16000 48000
4 16000 64000
5 16000 80000

40000−32000
Payback Period = 2+
16000

=2.5 years or 2 yrs and 6 months

NPV:

NPV = (Annual Cash flow × Annuity Factor) - Investment

= (16000×3.7908)-40000

= 20652

IRR:

@25% @30%
Annual Cash flow Annuity Factor
2.6893 2.43557
PV of Cash Flows 43029 38969
16000 Investment (40000) (40000)
NPV 3029 (1031)

3029
IRR = 25+ (5)
3029+1031

= 28.73%
 Summary of Proposal 4 Payback Period = 2.5 years NPV= 20652 IRR= 28.73%
Proposal 5: Introduction of approved quality assurance scheme

Initial investment =70000

Payback Period:

Cumulative Cost
Year Cost Savings
Savings
1 70000 70000
2 70000 140000
3 70000 210000
4 70000 280000
5 70000 350000

Payback Period = 1 year

NPV:

NPV = (Annual Cash flow × Annuity Factor) - Investment

= (70000×3.7908)-70000

= 195356

IRR:

@95% @100%
Annual Cash flow Annuity Factor
1.015298 0.9688

PV of Cash flows 71071 67816

70000 Investment (70000) (70000)

NPV 1071 (2184)

1071
IRR = 95+ (5)
1071+ 2184

= 97%
 Summary of Proposal 5 Payback Period = 1 year NPV= 195356 IRR= 97%

Requirement 2: Assessment and Ranking the Investment Proposal:

Where there is single period capital rationing, projects should be ranked according to the NPV per scarce
initial investment capital. This also called Profitability Index.

The NPV per £ of investment and thus the ranking of the project is follows:

NPV
Proposal Rank
£ of Initial Investment
1 0.50 3
2 0.40 4
3 0.26 5
4 0.52 2
5 2.79 1

Project Evaluation Table:

Proposal Investment Payback period IRR NPV PI

1 100000 3.37 years 22.18% 50030 0.50
2 180000 2.727 years 24.4% 70193 0.40
3 200000 1.4 years 29% 51647 0.26
4 40000 2.5 years 28.73% 20652 0.52
5 70000 1 years 97% 195356 2.79

Capital Rationing:

The Board of Director should therefore take on the project in the order shown until the capital is
exhausted. This means taking on project as follows:

Proposal Amount
5 70000
4 40000
1 100000
Total Current Investment 210000
Unused Fund 90000
Fund Available for Current Investment 300000
 Combination of Proposal Total Investment Total NPV Average PI
5, 4 and 1 210000 266038 1.267

The objective is to maximize the NPV of the investments. Assumed that each project is
discrete and cannot be split up. Proposal with higher PI will be taken into the
combination that satisfies the limit placed on available funds. Here the addition of
proposal 5, 4 and 1 used the three highest ranked projects and had an investment of
£210000. Fourth ranked proposal is 2 but combining its investment to 5, 4 and 1 will
exceeds the limit.

Requirement 3: Other factors which the directors may wish to consider before coming to
final conclusion.

It is very much important to consider the qualitative (non-financial) factors along with
quantitative analysis. Qualitative factors are those which will have an impact affect on

When a project passes through the quantitative analysis test, it has to be further evaluated taking
into consideration qualitative factors. Qualitative factors are those which will have an influence
on project, but which are almost impossible to evaluate accurately in financial term. Such
factors are:

 Economical Factors: Inflation rates, Taxation, Monetary policy, Market’s trends are the
economical factors need to be considered before taking investment decision.
 Project Uncertainty: Though uncertainty of project cannot be measured, directors need
to consider this factor using their experience before investment appraisal.
 Motivation: Project with high return can never be executed if the working forces of the
project are not motivated. It is only when the workers are motivated by a project and its
outcome that the project will succeed. If, AP Plc goes for making investment in proposal
4 which is Creation of a formal staff training system, staff motivation is very important.
 Government actions and inactions: This is an obvious but the most neglected aspect of
investment appraisal. There is need to consider the government relevant laws before
making investment appraisal Good managers always consider the consequences of
government actions and inactions on any project they want to execute.
 SWOT (strengths, weakness, opportunities, threats) analysis: To develop a new
product, it is very much important to analyze the strengths, weakness, opportunities and
threats of the product.
 Competitors Action: While investing in quality assurance scheme like proposal 5
(Introduction of approved quality assurance scheme) it is very much significant to
consider the action of competitors. This will in most cases lead to companies making
investments that are not purely based on financial grounds.
  Customer Satisfaction: Before taking any investment decision, directors need to
appraise the impact of investment over customer. After all, customer is the king of any
business.
 Climatic issues: Directors need to consider the climate issues. They should not go for
any investment which has bad impact on Climates.
 Psychology of the immediate external environment of a business: The immediate
external environment of a company will simply revolt when they feel that the outcome of
a major project about to be embarked on by a company will cause them more harm than
good.
 Technological Factors: Directors must consider, the rapid change in technology with
making investment like proposal 2(Installation of a mainframe computer system).
 The Aim of the Business: Every business has vision and mission. Directors have to
consider this factor before executing any project to ensure that this project support
company’s mission.
 Shareholder Demand: There are various types of shareholder with different
expectations. Some prefer profit and some prefer maximization of share value. Directors
supposed to consider shareholder’s demand while investing any project.
 Supply and Support: Any interruption on the supply will cost a lot. Directors have to
build up a good relation with supplier, so that the supply will be on right time.
Additionally, when needed, they must get technical support (Project like proposal 2) from
the supplier.

Some of the items in the above list affect the value of the firm, and some not. The firm can
address these issues during project analysis, be means of discussion and consultation with the
various parties, but these processes will be prolonged, and their outcomes often unpredictable. It
will require considerable management experience and judgmental skill to incorporate the
outcomes of these processes into the project analysis.
Requirement 4:

Reasons for the relative popularity of IRR than NPV: The following are the reason for the relative
popularity of IRR than NPV-

 It is felt by some observers that financial decision makers respond more readily to a percentage
result than to an NPV expressed in £s.
 It is also felt by some observer the decision makers prefer to leave the question of the hurdle rate
until after the analysis. This is something that NPV will not allow since the NPV cannot be
deduced without selecting a discounting rate.
 IRR method always gives the same recommendation, where, NPV gives different
recommendation at different discount rate.
 IRR gives break-even cost of financing.
 When a project has an IRR greater than the required rate of return, then it generates a return
that is greater than the cost of the funds used to purchase the project.

Reasons for the superiority of the NPV method:

 The Rationale for the NPV method is straightforward.

 NPV method is directly related to the objective of maximization of share holder’s wealth.
 NPV properly takes account of the cost of financing the investment.
 All relevant measurable financial information concerning the decision is taken into account.
 It is practical and easy to use and it gives clear and unambiguous signals to the decision maker.
 NPV technique provides the same benefit as accepting a project using the IRR technique.
 In case of mutually exclusive projects NPV is the most reliable method to take better
decision.
 NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost
of capital, where as the IRR method assume that the firm can reinvest at the IRR.
 NPV is easy to calculate than IRR.

A relative comparison among the 4 investment decision making technique and why NPV is superior can
be cited in the following ways-

Payback
Criteria NPV IRR ARR
Period
Directly related to the wealth maximization Yes No No No
Fully accounts for timing of cash flows and time value of
Yes Yes No No
money
Take accounts of all relevant information Yes Yes Yes

Practically easy to use and provide clear signal Yes usually Yes Yes
These are the reasons for superiority of NPV.

Reference and Bibliography:

Colin Drury (2005). Management Accounting for Business, 3rd Edition. Page 722-255.

Clive Marsh. (2009) Mastering Financial Management: A step by step guide to

strategies, applications and skills. Page 285-300.

Don Dayanand, Richard Irons, Steve Harrison, John Herbohn and Patric Rowland (2002)
Capital Budgeting: Financial appraisal of investment projects.

Eddi Mclaney (2009). Business Finance (Theory and Practice) 8th Edition. Page 79-126.

Eugene F. Brigham and Michael C Ehrhandt (2008). Financial Management, 12th

Edition. Page 377-402.

John Tennent. (2008) Guide to Financial Management, Page 145-178

Pauline Weetman, (2006) Financial and Management Accounting (an introduction), 4th
Edition. Page 652-673.

Sheridan Titman, Arthur J keown and John D Martin (2010) Financial Management
(Principle and Application) 11Th Edition.