Northumbria University, City Campus
Programme: BA (HONS) Business Management

Overview about different investment appraisal methods
and possibilities how to finance an investment
Financial Management

by

Mona Assaid

Table of Content

1 Introduction 1

2 Part A 1

2.1 Definition Investment and Shareholder Value 1
2.2 Case Study 2
2.3 Investment appraisal methods 2

2.3.1 Payback method 2
2.3.2 Accounting rate of return 3
2.3.3 Net present value 3
2.3.4 Internal rate of return 4
2.3.5 Discounted payback method 5

2.4 Conclusion 5

3 Part B 6

3.1 Cost of Capital 6
3.2 Optimal capital structure 6
3.3 Conclusion 8

References 9

Bibliography 11

1 Introduction

Every economic organization has to make investments with the aim to increase their value. Arnold stated that “The objective of investment within the firm is to create value for its owners, the shareholders” (Arnold, 2005, p.63). To explain how this objective could be attained and implemented by evaluating various techniques is the purpose of this paper in part A. It must be also considered that every investment not only contains opportunities but also a certain degree of risks. For a better illustration of the problem the theory should be supported by the real example of an investment decision of Iberia Airlines. Moreover, the paper should outline in part B whether it is more beneficial to use gearing or equity to finance investment with respect to the idea of maximising shareholder wealth.

2 Part A

2.1 Definition Investment and Shareholder Value

For giving deeper consideration of the Arnold statement it is necessary to define the terms Investment and shareholder value. An investment is the decision to purchase an economic good for example a machine or buildings which have mostly a long-term purpose (Manz/Dahmen, 1999, p.4). Also it is important to know that the basic feature of an investment is time. Investment involves making an outlay of something of economic value, usually cash, at one point in time that is expected to yield economic benefits to the investor at some other point in time. Investment decisions are important for companies because there is mostly a large amount of resource involved. Therefore, a wrong decision could have tremendous effects (Atrill & McLaney, 2002, p.188-189). Thus, it is understandable that shareholders are interested in the correctness of those decisions because they own the shares of the company which present their equity. Therefore, the primary financial objective is normally the maximisation of shareholder wealth (Watson & Head, 2001, p.5). The question now is how to maximise shareholder wealth and how a capital investment contribute to this objective. In general it can be said that “maximising wealth can be defined as maximising purchasing power” (Arnold, 2002, p.11). Shareholders are interested in an increase of their dividends and capital gain through a long time span. Therefore, a maximisation of shareholder wealth will be obtained through rising dividends in a long term perspective. The share price of a company depends much on the undertaken investment decisions. If the decision seems beneficial to shareholders the share price will rise because dividends increases and the other way around (Arnold, 2002, p.11). To make the right decisions there are various investment appraisal methods which can be conducted. A practical example of an investment decision should be given before explaining the different appraisal tools. The example should also support the explanation of the techniques.

2.2 Case Study

Iberia is a traditional Spanish airline based in Madrid. In the last year’s low-cost carrier such as Easy Jet and Ryan Air gain substantial market share. In the first quarter of 2006 they transport 31% of the passengers to Spain. Due to the increased competitive pressure and the high market potential Iberia will contribute in the launching of a new low cost carrier. The initial investment will be 24 million euro and Iberia will have 20% of the voting rights. The remained voting rights are distributed equally between 4 other shareholders. The new airline will be an independent company based in Barcelona. It will start to operate in October 2006 with five aircrafts expanded to 30 by 2008. The new airline should be responsible for the domestic and European point to point routes while Iberia will continue concentrating on long-haul flights to the US and Latin America which are more profitable for them. (Crawford, 2006) (Iberia Homepage, 2006)

2.3 Investment appraisal methods

The following five investment appraisal methods which are the payback method, the accounting rate of return method, the net present value method, the internal rate of return method and the discounted payback method should help to evaluate an investment (Lumby, 1994, p.39-40).

2.3.1 Payback method

The first rather traditional technique is the payback method. This method calculates in which period of time the initial investment is paid back (Lefley, 1999). Therefore, Iberia expects in the following years a series of cash inflows to cover their outlay of 24 million euro. Let’s assume that the initial investment has to be recovered in a period of four years, the annual cash flows (receipts and payments) have to be 6 million a year until the investment is paid off (Atrill & McLaney, 2002, p.194). “The advantages of this technique are that it is simple and easy to apply, and as a concept, it is straightforward to understand” (Watson & Head, 2001, p.54). Therefore, it is often used for a first screening of the investment. Moreover the method is a time- and cost saving one (Yard, 2000). It could be also stated that the Payback method is less manipulative due to the fact that it is based on cash flows and not accounting profits which could be presented in the favour for manager (Watson & Head, 2001, p.54). The two main disadvantages of the Payback method are that it does not consider the cash flows after the projects payback period and that it neglects the time value of money (Yard, 2000).

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