Introduction to Applied Finance
Introduction
With economic uncertainties rising all year round, it is essential to secure the future today through high yielding investments that guarantee returns while minimizing the risks. It is therefore essential to make sound judgment while deciding what investment to undertake. This report seeks to illustrate how to appraise investment options in order to rank them in order of the most favorable to the least favorable. Net Present Value, Payback Period and Internal Rates of Return for three investments to illustrate which among the three would be most preferable for your investment goals. The report includes a discussion of the risks involved with each of the three investment options. Also provided, is a discussion of the shortcomings of the investment appraisal methods used.
Discussion
The net present value of the first investment was positive, meaning the investment is worth taking from this perspective. The NPV of investment 1 is $423,765.00. At the end of the ten years, the money yielded by the investment at the rate of return of 12% would be this amount today. On the other hand, it shows that the investment would only payback at the end of the final year when the cash inflows will amount to the initial outlay. IRR shows the rate of return in which the NPV would be zero. The IRR suggests that an investment is only acceptable if its IRR exceeds the rate of return. In option 1, it is 9.4% (DiscussEconomics.com, 2008).
The second investment option has an NPV of $ 758,518.00, which suggests that the investment will have a bigger value at the end of the ten years than the first option. The pay back period for the second option is 8.3 years, meaning it will pay up the initial invested amount before the investment is over. The IRR at the rate of return of 12 is higher, meaning the investment should be accepted.
On to the contrary, the third option yielded quite negative result, showing a negative NPV of -507,216.00, which means that the investment will have no value towards the end. The pay back for this investment will not be possible within ten years of which the investment is valid. Its IRR is way below the rate of return expected, meaning it should not be accepted.
Choosing the investment
From the above analysis, it is now most preferable to take up the second investment of buying three apartments. This is a sure guarantee that the money will be paid back within the number of years it will be invested. The NPV of the second option was the highest meaning it is the most favorable. Additionally, at the end of the investment, the value of the initial investment will not go down. Rather, the three apartments can be bought at a higher rate than they were bought. Therefore, comparing the first option to the second, it shows that the second option has higher earnings and at the end will have a higher value. The other options would not payback within the ten years, especially the third option, that is unlikely to ever pay back even after the investment is over. Pay back time is the number of years it takes for an investment to earn the same amount of cash that was earned. The pay back rules states that the shorter it is the better since it means the investment will pay the cash invested within a short time that shows the investment is earning enough cash to payback (Graves & Ringuest, 2002). This makes the second option the best choice according to the pay back period. Additionally, it has lower risks compared to the third option that is likely to be affected by many factors such as weather and bad market for orange juice. As for the first and the second investment, their risks are similar since the returns are guaranteed at every end of year (Götze, Northcott & Schuster, 2008).
Risks involved
All investments involve risks, where some have higher risks while others have lower risks. Many may think that fixed savings earnings have no risks involved. However, they have their risks, as well. For option one, the biggest risk is inflation that will affect the value of the money (Shashikant, 2012). Since the amount is fixed and not subject to change despite anything, it means that if, inflation goes higher there is a high risk of losing. As the inflation changes, what cost $5 this year may cost $8 in ten years to come. The income will remain unchanged, meaning one will spend more money while the income is not growing (Siddiqui, 2006).
For rental property, risks involved are such as destruction of the houses by the tenants, which might require huge costs to repair (Sheeba, n.d). This is one of the risks involved in rental properties. However, for this investment, the houses are rented to the army that has already decided to buy the apartments after the ten years. This further eliminates the risk of the apartments going vacant for some time when they lack tenants or when they move (Pogue, 2010).
The third option carried many risks that are associated with the agricultural sector, as well as food markets. The first risk in planting of oranges is the uncertain weather that could ruin the crops even before they grow. One cannot hedge risks against this natural phenomenon since it is not controlled by man. The other risk is finding a ready market for the orange juice considering the high competition. Sales are not always guaranteed (Dayananda et al 2002).
Limitations of appraisal methods used
This report makes use of three appraisal methods for analyzing the worth of the three investment options. They happen to have their limitations, as well. One of the limitations of NPV method is that it uses forecasted values that might not be the real earnings. It also uses discounted rates that are quite difficult to calculate. Additionally, it might not be used to rank investments with different life periods. The IRR is very hard to calculate and requires many skills to arrive at the answer. Moreover, one has to solve it through trial and error or in a computer spreadsheet as done in this report (Groppelli & Nikbakht, 2006). IRR requires an initial investment that is negative with all others positive. It could show the investment with the best rate of return but not best value. Finally, the pay back method uses cash flows and does not consider the time value of money, which could contribute to wrong decisions. Additionally, it does not consider the cash flows that are earned after the pay back period (Röhrich, 2007).
Conclusion
From this report, it would be advisable to take up the second investment option that has scored well in the three appraisal methods used. Additionally, its risk has been hedged since the apartments are rented out to the army on a contract, which is also ready to buy them at the end of the ten years at a higher amount than the initial investment. For the other two methods, the risks as well as score against the appraisal methods do not offer a better earning than the second option. Considering the goal of the client to help the grandchildren, they will need a good amount of money in the future. The second option offers this chance more than the options considering the third option will only cause a loss.
Appendix
Net present value
| Option 1 | |||
| period | Cash flow | PVIF 12% | PV |
| 0 | -750,000.00 | 1.0000 | -750,000.00 |
| 1 | 75,000.00 | 0.8929 | 66,967.50 |
| 2 | 75,000.00 | 0.7972 | 59,790.00 |
| 3 | 75,000.00 | 0.7118 | 53,385.00 |
| 4 | 75,000.00 | 0.6355 | 47,662.50 |
| 5 | 75,000.00 | 0.5674 | 42,555.00 |
| 6 | 75,000.00 | 0.5066 | 37,995.00 |
| 7 | 75,000.00 | 0.4523 | 33,922.50 |
| 8 | 75,000.00 | 0.4039 | 30,292.50 |
| 9 | 75,000.00 | 0.3606 | 27,045.00 |
| 10 | 75,000.00 | 0.3220 | 24,150.00 |
| 10 | 750,000.00 | 1.0000 | 750,000.00 |
| NPV | 423,765.00 | ||
| Option 2 | |||
| period | Cash flow | PVIF 12% | PV |
| 0 | -750,000.00 | 1.0000 | -750,000.00 |
| 1 | 90,000.00 | 0.8929 | 80,361.00 |
| 2 | 90,000.00 | 0.7972 | 71,748.00 |
| 3 | 90,000.00 | 0.7118 | 64,062.00 |
| 4 | 90,000.00 | 0.6355 | 57,195.00 |
| 5 | 90,000.00 | 0.5674 | 51,066.00 |
| 6 | 90,000.00 | 0.5066 | 45,594.00 |
| 7 | 90,000.00 | 0.4523 | 40,707.00 |
| 8 | 90,000.00 | 0.4039 | 36,351.00 |
| 9 | 90,000.00 | 0.3606 | 32,454.00 |
| 10 | 90,000.00 | 0.3220 | 28,980.00 |
| 10 | 1,000,000.00 | 1.0000 | 1,000,000.00 |
| Net Present Value | 758,518.00 | ||
| Option 3 | |||
| period | Cash flow | PVIF 12% | PV |
| 0 | -750,000.00 | 1.0000 | -750,000.00 |
| 1 | -50,000.00 | 0.8929 | -44,645.00 |
| 2 | -50,000.00 | 0.7972 | -39,860.00 |
| 3 | -30,000.00 | 0.7118 | -21,354.00 |
| 4 | 0.00 | 0.6355 | 0.00 |
| 5 | 30,000.00 | 0.5674 | 17,022.00 |
| 6 | 60,000.00 | 0.5066 | 30,396.00 |
| 7 | 90,000.00 | 0.4523 | 40,707.00 |
| 8 | 120,000.00 | 0.4039 | 48,468.00 |
| 9 | 150,000.00 | 0.3606 | 54,090.00 |
| 10 | 180,000.00 | 0.3220 | 57,960.00 |
| 10 | 100,000.00 | 1.0000 | 100,000.00 |
| net present value | -507,216.00 | ||
Pay back period
Option 1
Cash investment = $750,000
Cash flow per year =$75,000
Pay back period = $750,000
$75,000
= 10 years
Option 2
Cash investment = $750,000
Cash flow per year = $ 90,000
Pay back period = $750,000
$ 90,000
Option 3
| Option 1 | ||
| period | Cash flows | Accumulated cash flows |
| 1 | -50,000.00 | -50,000.00 |
| 2 | -50,000.00 | -100,000.00 |
| 3 | -30,000.00 | -130,000.00 |
| 4 | 0.00 | -130,000.00 |
| 5 | 30,000.00 | -100,000.00 |
| 6 | 60,000.00 | -40,000.00 |
| 7 | 90,000.00 | 50,000.00 |
| 8 | 120,000.00 | 170,000.00 |
| 9 | 150,000.00 | 320,000.00 |
| 10 | 180,000.00 | 500,000.00 |
Internal rate of return
Option 1
= 9.4
Option 2
= 12.9%
Option 3
= 2.2%
References
Dayananda, D, Irons, R, Harrison, S, Herbohn, J & Rowland, P. 2002, and Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press, New York.
DiscussEconomics.com 2008, Internal Rate of Return, Cash Flow, and NPV, viewed 1 November 2012, http://www.discusseconomics.com/finance/internal-rate-return-cash-flow-npv/
Götze, U, Northcott, D, & Schuster, P 2008, Investment appraisal methods and models, Berlin, Springer.
Graves, B & Ringuest, L 2002, Models & Methods for Project Selection: Concepts from Management Science, Finance and Information Technology, Springer, New York.
Groppelli, A & Nikbakht, E 2006, Finance Barron’s Educational Series, Hauppauge, NY.
Pogue, M 2010, Investment appraisal, Business Expert Press, Ney York.
Röhrich, M 2007, Fundamentals of investment appraisal: an illustration based on a case study, München, Oldenbourg.
Shashikant, U 2012, Risks associated with fixed income products like deposits and bonds, viewed 1 November 2012, http://articles.economictimes.indiatimes.com/2012-07-30/news/32942465_1_inflation-rate-interest-rates-income-instruments
Siddiqui, S, A 2006, Managerial Economics and Financial Analysis, New Age International, New York.
Sheeba, K n.d., Financial Management, Pearson Education, India.
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