Going through the previous reports given to me by Denise, I have been looking at the way that Rivits Ltd formerly decided which investment project to choose.

University Degree Business and Administrative studies

To: Dan Kitson

Of Interest to

Those Responsible For: Investment Decision

Reference 2003/545

Publication Date: December 2003

Enquires to: Chris Hampton

01756 765329

Executive Summary
Aims

2.1 To justify why Rivits Ltd should change to the NPV investment decision system.

2.2 Examples of how NPV works

2.3 What other techniques can be used

2.4 Analysis of calculations – why I have included certain things

2.5 What is NPV?

What is wrong with the current system?

Good and Bad points of NPV

Sensitivity Analysis
What type of Company is Rivits Ltd

Introduction

3.1 Going through the previous reports given to me by Denise, I have been looking at the way that Rivits Ltd formerly decided which investment project to choose. After having looked at the reports I have come up with a new more systematic investment appraisal technique using the net present value. A poor appraisal technique that does not ask the right questions and provides an erroneous conclusion will destroy the wealth of the shareholder, which for Rivits Ltd and any company is not ideal. The objective of a company should be aiming to maximise the wealth of the shareholder, for reasons being

Practical, a single objective leads to clearer decisions
The contractual theory
Survival in a competitive world
It is better for society
They own the firm

3.2 The NPV method that I used is only a starting point to investment decision as there are other methods including payback and accounting rate of return which will aid in the decision making process for investment appraisal.

Accounting Rate of Return

The ARR is a Ratio of the accounting profit to the investment in the project, expressed as a percentage. The decision rule is that if the ARR is greater than, ...

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Practical, a single objective leads to clearer decisions
The contractual theory
Survival in a competitive world
It is better for society
They own the firm

Accounting Rate of Return

The ARR is a Ratio of the accounting profit to the investment in the project, expressed as a percentage. The decision rule is that if the ARR is greater than, or equal to, a hurdle rate then accept the project (Arnold)

Payback

Payback is the length of time for cumulated future cash inflows to equal an initial outflow. Projects are accepted if this time is below an agreed cut-off point. (Arnold)

Justifications of the New System

As you may well know the old system worked, but was very time consuming. It looks as if they have considered each investment separately and have used no explicit targets, just a consensus on whether something should go forward. The main problem of using the old system is that the project turned out to be more expensive than expected, and generated less income than predicted.
With shareholders investing money in an organisation they are going to want something back in return. So it is vital for management teams to employ the best techniques that are to be used when analysing which of the investment opportunities will give the best return in profit. It is also important to seek out new ideas and make better use of existing assets. Also it is important to keep decision makers well informed and educated because using the correct investment technique will lead to an accurate decision making process.
The Net Present Vale of a project is the present value of the future benefits minus the costs. It is the difference between what is to be received in current worth, and what will be paid for it. An example of how NPV works is the appendix.
The Net Present Value (NPV) based system would work a lot better than their old investment decision process as it would speed up the whole process of producing data which was one of the main problems with the old system. It will also produce accurate data which will result in better forecasting predictions in terms of sales, profit and investment decisions.
There are many good reasons for using the NPV which are:

NPV recognises that £1 today is worth more than a £1 tomorrow because the £1 today can be invested and start making an interest straight away.
If the investment is unpredictable, because the NPV is measure in today’s current pounds you can combine the NPV to get a weighted NPV.
It is not complicated
It allows you to consider the time value of the invested money.

Bad Points:

Everything that you put into NPV is uncertain as everything is an estimate apart from year 0
Non Financial factors do not go into NPV

Analysis of the Calculations

Now that I have explained why I feel that the NPV system would be better, and having used the new NPV system to come up with the NPV values for purchase of new software, improvements to the old software, and the XYZ project, I can now explain to you why I included certain things in my working and disregarded certain things in my workings.

My workings are very different to Rivits’ old investment decision, so I hope you will understand the new method. In some of the Figures provided to me by Denise using the old investment technique, I feel that some figures are not relevant for deciding which project to invest in, for example the paid and committed costs included in the report are irrelevant as they are past costs. Also in the working papers given to me for the XYZ project some of the figures are irrelevant when using the NPV system. I have included the Capital costs, scrap value, and in house development when finding out the NPV and I have also included the Sales and Variable costs. You can see from my workings which years I have put these figures into. Another thing that I included in my working which I thought was relevant is the annual savings of £15,000 for the redundant employers.

There were other things that I took into account when doing my workings including the tax implications. Previously in the old presentations of the figures Rivits ignored the effect of capital allowances for tax. It is not very wise to ignore tax and is important it is included; otherwise it does not enable the end results to be fair and representative. The capital allowances available are calculated at 25% of cost, and the present rate of corporation tax is 30%, so as you can see in my workings I have included these percentages.

Sensitivity Analysis

6.1 Companies like Rivits operate in an environment of uncertainty and risk, which means that managers can never be sure about what is going to happen in the future. There is not just one possible outcome, but an array of potential return. Furthermore as Rivits is hoping to substantially increase its business in the next three years it is seen as more of a growing risk rather than just a small risk. As shown in the workings there are different scenarios that firms have to take into consideration, the worst case scenario, where there is a possibility of everything going wrong or there is the best case scenario where there is a possibility of events turning out better than expected. The NPV values calculated in the workings give a static picture of the likely future out-turn of the new XYZ investment project, and as Rivits is a risky company I have included the NPV values for the ‘What if’ the project changes, i.e. sales changed or costs changed etc.

To assist further in the evaluation of risk associated with the project XYZ, I have conducted a sensitivity analysis. As you can see from the workings, I have calculated an expected NPV of £29,454.22 and a Standard Deviation of £136,336.15. The standard deviation measures the degree of variation of returns around the average return of the investment. The standard deviation will be lower if the volatility of investment returns is low. It is used as a measure of total risk, and the lower the standard deviation the better.