ARR
Accounting rate of return shows the percentage rate of return that the investment will make. If the ARR is higher then the rate paid for the borrowing then the investment will be worth it.
ARR is calculated by using the total net return and dividing it by the number of years. This is then divided by the initial cost of the investment and times by 100 to give the percentage.
Total: 79,800
79,800 / 5 = 15,960 15,960 / 150000 = 0.1064 x 100
= 10.64 %
This percentage shows that the transport investment will create a 10.64% return. If the borrowing has a lower interest then 10.64% then the investment is worth it. However the loan Lee ltd is taking out is costing them a 14% interest per annum therefore we can see the investment will make a lower return and it will not be worth it. The network project produces a 25% which is both larger then the transport project return and the investment interest. Therefore this is more efficient as there will be a higher amount of money made.
ARR is a good method as it measures the profit that will be achieved therefore companies can see how achievable each project will be. This will be appropriate for lee Ltd as they will be able to compare the success ability of each project and make a decision. On the other hand this method also ignores the timing of payments. The profit calculated are only average and there actual yearly figure may fluctuate and therefore they can be unreliable for example the 10.64% calculated could rise or fall by a substantial amount.
Net Present Value (NPV)
Net present value looks at the value of future inflows of today’s value. Money in the future is worth less then money now because you can be earning interest on it now which means you will have more money. Also there is no guarantee you will receive the money in the future and inflation can affect this.
Net present value is calculated by introducing discount factors to work out a discounted cash flow which shows how much money will actually be worth in the future.
Total: £3,924.06
The NPV for the Transport project is £3,924.06 this is lower then the Net work project of £4,500 and therefore this may mean the Network project would be more suitable for Lee Ltd as they will be earning more money long term. This is good for the business is they want to expand.
NPV makes an allowance for the opportunity cost of investing and also takes into account the cash flows and inflows for the duration of the investment therefore it is reliable. However choosing a discounted rate can be difficult and it will be unlikely that it is accurate. The method is also more complex and could be easily misunderstood by Lee ltd.
The Results & Comparisons
There are two very different investment options for Lee ltd, both investment opportunities will enable the business to grow in different ways. The investment appraisal was used to discover which investment would benefit Lee Ltd best.
Firstly the payback appraisal has shown that it would take three years and seven months for the initial investment cost to be earned back to the business using the transport project. By looking at the alternative of the outside delivery firm; this does cost Lee ltd £50,000 per year. We can see that the investment of £150,000 would be the same of the outside delivery firm for three years. The time it takes for the £150,000 to be paid back is over three years therefore we could say it may be better sticking with the outside firm. On the other hand, this would be a good long-term benefit as after the loan has been paid back Lee ltd do not have to pay yearly fees.
The Network project shows a payback period of three years and this is less time then the Transport project, and the shorter the pay back period is the better it is for a business because they can start earning a profit on the investment quicker, therefore it seems that the Network Project would be more suitable for Lee Ltd. However this may not attract Lee ltd as they may be looking at the long term results of the investment and therefore the timing of when the investment is paid back may not interest them much.
Secondly the Accounting Rate of Return appraisal has shown that the Transport Project would make a 10.64% return. This may seem like a good rate however the interest on the loan is 14% and therefore until the loan is paid of the ARR of 10.64% would not be worth it. This will not attract Lee Ltd because the loan is long term and therefore the company will not be prepared to pay a higher interest to the loan then they receive of the initial investment. Although you could argue that a return would be made after the loan is paid of we do not know how valuable the Transport project will be in the future and if it would still make the same return.
The Network project offers a 25% which is a lot higher then the 14% on the bank loan. This would attract Lee ltd as they would want to choose between the most efficient investment choice and this method of appraisal clearly shows it. However I feel that this data from the Network project may be unreliable as you cannot measure how well internet presence will be and also well new computers would suit Lee Ltd to their needs. If the new software is not used productively then the figure may be very inaccurate.
Lastly the Net Present Value has shown that the Transport project would make a value of £3,924.06 this is a good value but it is a lot smaller then £4,500 NPV from the Network project. If Lee Ltd wanted a long-term profit then The Network would attract Lee Ltd as it is a considerably larger amount then the Transport.
Benefits
Looking at all three methods of investment appraisal we can judge which would be the most suitable to attract Lee Ltd. Lee Ltd is a company who produces food for independent business for small retail chains. Lee Ltd may want to grow in bigger retail chains and for this Lee Ltd would need to ensure that the investment gave a good ARR, in order for the investment to be worth it and for Lee ltd to gain money in order to expand. Therefore by comparing the two figure of ARR; 25% from the network project and 10.64% from the Transport project, we can see that that the Network project would attract Lee Ltd a lot more.
As well as using investment appraisal to judge which project would be most appropriate for Lee ltd we can look at other benefits. The Transport Project has benefits of the own vans becoming a fixed asset, this will also be a long term asset and therefore will not be the risk of the delivery firm not being available for hire or other problems. By having own transport also means that Lee ltd will have more control; they could also decide to deliver to larger retail chains in order to expand and this would attract more businesses which may want to trade with Lee Ltd. Another benefit of the Transport project would be the financial side of not having to pay yearly instalments to the delivery firm, although it is good for a company being asset light Lee Ltd are likely to always need transport and therefore this is costly being long-term.
The benefits of the Network Project is that Lee Ltd will become a modern up to date company, with new software and the internet they can advertise more widely across the internet and this may attract new retailers which mean Lee Ltd can grow. Also new software will mean Lee Ltd can be more efficient and use software for ordering etc. They could also use the internet for online orders. There are obvious financial benefits as shown by the investment appraisal; the 25% return is a large amount and this would be very valuable for the company.
Problems using forecasted data and sensitivity analysis
The investment appraisal is calculated by using forecasted figures, this means that the figures are only predicted. Therefore the figures calculated in the investment appraisal may be unreliable and inaccurate. This can be risky as decisions in the business will be based on incorrect data.
By conducting a sensitivity analysis we can look at “what if” we are wrong? And how the investment will look then. A sensitivity analysis looks at a change and I will be using a-10% change in the initial figures of the net cash flow, to see how they affect each investment appraisal.
Payback (-10%)
Total: 56,820
The sensitivity analysis showing the payback method still shows that it will be paid back within the 4th year.
45,180 /12 = 3765 28,220 / 3765 = 7.495
Therefore the payback is 4 years and 7.5 months. This is roughly and extra month that it will payback; so even if the figures are not accurate it does not change the payback period dramatically. This is good as we can see that payback does give us a good accurate analysis.
ARR (-10%)
Total: 56,820
56820 / 5 = 11364 11364 / 150000 = 0.07576 X 100 = 7.5%
This shows that the ARR is 7.5% and it makes roughly a 3% less return. Although this can be seen as a small figure it may amount to a loss of a lot of money. What if the figures were -20%? This would make a substantial difference.
NPV (-10%)
Total: -11459.31
This figure shows a minus which is really bad for a business as it means the value of it in the future will be in minus. Therefore it may be a big risk for Lee ltd because if there figures are inaccurate and -10% it could cause big problems for them in the future, and the investment will not be worth it.
Conclusion
I would recommend that Lee Ltd choose the Network Project; all three investment appraisals showed that The Network project would be stronger. Also by conducting the sensitivity analysis we can see what if the figures are wrong? When looking at the NPV we can see there is a high risk for the Lee Ltd choosing the Transport project because of the minus figures.
On the other hand I feel that the Transport Project has better non financial benefits as it will be worth it in the long term as it becoming a fixed asset. And also the Network project may be outdated quickly and they will need to keep updating it. However by looking at all the strengths and weaknesses of each project I draw to conclusion that by choosing the Network project Lee Ltd will make a big return and also be able to expand in the modern type world.
