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University of South Wales

School of Business and Society

Capital Investment Appraisal

for AYR Co.
On Aspire and Wolf Projects

Tutor: DR Nikki Petrou

Student: Yasmine Amin Khalaf

Assignment: AF4S31 Assessment 2 (V2)

ID: 74104331

August 2019

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Table of Content
Abstract…………………………………………………………………………………………………3

Report Structure…………………………………………………………………………………………3

Chapter One: Introduction ....................................................................................................... 4

Methodology .............................................................................................................................. 5

Chapter Two: Analysis And Evaluation Of Investment ......................................................... 8

Data and Assumptions ............................................................................................................. 8
Chapter Three: Analysis And Evaluation Of Investment
& Other Factors That Might Affect The Decision ................................................................. 10
Findings & Calculations of project “Aspire” &”Wolf” ................................................................ 10
Calculations Interpretations .................................................................................................. 11
Other Factors That Might Affect the Decision ....................................................................... 12
Chapter Four: Discussion Of Two Sources Of Finance ....................................................... 14
A description of Equity & Debt .............................................................................................. 14
Cost of Equity vs Cost of Debt .............................................................................................. 16
The effect of selection on WACC .......................................................................................... 18
Impact of selection on Potential Shareholder and Lenders ................................................... 18
Conclusion ............................................................................................................................ 19

APPENDIX ONE: Aspire Calculations ................................................................................... 20

APPENDIX TWO: Wolf Calculations ..................................................................................... 21
Bibliography ........................................................................................................................... 22

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 Abstract

This report considers itself with the matter of AYR Co. venturing into a new investment
by assessing two projects “Aspire” and “Wolf”. Both projects are analysed based on
these financial methods NPV, IRR and Payback period. After calculations it has been
found that project “Aspire” is the better option for investment, if AYR Co. considers all
other variables and that if the board find itself in the need of Capital funding it should opt
for Debt Financing for the benefits it has showed in comparison with Equity Financing.

 Report Structure

This report will be structured into four chapters; The First Chapter, The introduction and
a brief explanation of calculations which are the NPV, the IRR and the Payback Period.
The Second Chapter, data assumptions on each project. The Third Chapter the analysis
and evaluation of the investment project options. Last in The Fourth Chapter, the
discussion of two sources of finance being considered by AYR Co. board and the
conclusion.

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CHAPTER ONE: AN INTRODUCTION

Investment, have been always a mean for both individuals and companies to have an
extra source to cash coming their way in the near or distant future. That is why it is crucial
for them to undergo a process called “Capital Investment Appraisal” which is in a simpler
words “a planning process which is used to facilitate the determination of the concerned
firm’s investment, both long term and short term” (Capital Investment, 2019).

During this process, a lot of tools and methods are used to determine the validity of the
investment as a winning one such as; Net Present Value (NPV), Internal Rate of Return
(IRR), Payback Period, Discounted Payback Period, Equivalent Annuity and many more.

However, in the analysis of the AYR Co. investment the report will be only including the
Net Present Value, henceforth referred to as the NPV, the Internal Rate of Return also
will be known as (IRR) and the Payback Period.

For AYR Co. two project endeavours, the aim is to increase the Market Share, which is
why the analysis will be geared towards the determination of the projects ability to
generate cash flows.

AYR Co. has already expressed interest in both projects and has already invested in their
pursuit which is evident in the 120,000$ in market research to analyse the feasibility and
the opportunity that lie in each project.

Other factors, more strategic ones, will be also included in the report to provide a more
relevant and accurate assumption to which project should be pursued taking into
consideration other factors that might affect a decision of venturing into the investment at
hand.

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1.1 Methodology

In this section, we will briefly explain the three tools of Capital investment appraisal and
their equations. We will start with:

 Net Present Value (NPV):

The NPV is described as “the difference between an investment´s market value and its
cost” (Ross, Westerfield and Jordan, 2016), this technique is very effective and meets all
the criteria, and this gives us an indication “that a project will be regarded as successful
if the present value of all expected inward cash flows is greater than, or equal to, the
capital invested at the outset. It is called net present value because, in calculation, the
capital invested is deducted from the present value of the future cash flows” (Capital
Investment Appraisal, 2010). This tool takes into consideration the time value for money,
so discounting is applied to the cash flows for more accurate representation of data,
helping investors making a more informed decision.

In our case, AYR co. should select the project that shows higher NPV or positive NPV.

Calculation of NPV:

 NPV = F / [ (1 + i)^n ] (Corporate Finance Institute, 2018)

 PV = Present Value
 F = Future payment (cash flow) (Investopedia, 2019)
 i = Discount rate (or interest rate)
 n = the number of periods in the future the cash flow is

It is important to note that if we are operating with higher interest rate it increases the discount
rate which will decrease the value of the NPV of a capital investment.

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 Internal Rate of Return (IRR):

The IRR of a project is the discount rate that would give an NPV of zero if used to discount
the projects cash flows (scicluna, 2019 or to further explain it “uses the time value of
money but results in an answer expressed in percentage form. It is a discount rate which
leads to a net present value of zero, where the present value of the cash inflows exactly
equals the cash outflows.” (Capital Investment Appraisal, 2010) the IRR measures how
efficient the utilization of capital such that if the cost of capital investment is higher than
the IRR, the project is most probably is going to be rejected.

In our case, AYR co. should select the project that shows that the IRR is higher than the
WACC.

Calculation of IRR:

(Corporate Finance Institute, 2019)

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Despite being similar to the NPV, the IRR has some drawbacks making it not 100%
accurate

 If the cash outflows are distributed over several years and not paid at the
beginning.
 If in any case the IRR and the NPV give results that contradict, we opt for the
result provided by the NPV.
 Projects may have multiple IRRs, if the cash flow alternate positive or negative
signs during the lifetime of the project calculation.

 Payback Period:

This method is often used as a first screening method, to answer one question, how long
will it take to pay back the cost? It is widely used when long-term cash flows, that is, over
a period of several years, are difficult to forecast, since no information is required beyond
the breakeven point (A Kayode Coker and Ludwig, 2014).

The Payback Period Method gives us time, usually demonstrated in years “to generate
sufficient savings to recover the initial capital outlay of the project.” (Andersson, 1992)

In our case, AYR co. should select the project that shows the shorter payback period

Calculation of Payback Period:

(Andersson, 1992)
(A Kayode Coker and Ludwig, 2014).

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Despite being favourable for its simplicity, yet the Payback Period Method has some

limitations:

 It fails to consider the time value of money, as this method simply adds up the

cash inflows without discounting, which violates the most basic principle of

financial analysis, which dictates that cash flows occurring at different points of

time can be added or subtracted only after suitable compounding/discounting

(Vikas Khare et al., 2019).

 It fails to recognize cash flows after the payback period, which leads to ignoring

projects that may have substantial cash inflows generated in more years (Vikas

Khare et al., 2019).

CHAPTER TWO: ANALYSIS AND EVALUATION OF INVESTMENT

PROJECTS
2.1 Data & assumptions about project “Aspire” and “Wolf”

This report author has gathered the data provided to formulate the calculation and
analysis with assumption made to show the value of data.

For starters, both projects “Aspire” and “Wolf” have an initial outlay of 2,250,000$ to be
paid immediately for a project timeline of 5 years. It is also provided that AYR Co. has
already showed interest by investing 120,000$ for market research, which are considered
irretrievable from both projects, that is why we will not consider this amount in our
calculations for both projects, since it is a “Sunk Cost”.

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 For Project Aspire:

- An amount of 140,000$ taken under “working Capital” from the retained profits
to be used immediately and returned by the end of the project i.e the end of five
years.
- Since project Aspire has allocated machinery a value of 375,000$ was
assigned as “Scrap Value” to be available at the year, and it will be considered
as a taxable cash inflow.
- Capital Allowance was allocated to project Aspire throughout the duration of
the project.
- This project will expand the current product range and will appeal to existing
and potential customers.

 For Project Wolf:

 75,000$ were allocated as rent income in project wolf as termed as costs, as
the project required a rented space for the project purposes.
 This project will take the company in a new direction appealing to a different
type of customer.

 Both Projects:
 Had taxes rate of 20%
 Had Weighted Average Cost of Capital (WACC) of 10%, due to the absence of
the discount rate we will make the assumption that it equals the WACC 10%,
an assumption that sometimes made by companies when budgeting for a new
project (MAJASKI, 2019).
 Depreciation rate of current asset of 20%

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CHAPTER THREE: ANALYSIS AND EVALUATION OF INVESTMENT

& OTHER FACTORS THAT MIGHT AFFECT THE DECISION

3.1 Findings & Calculations of project “Aspire” &”Wolf”

Projections for Project Aspire & Wolf

Project NPV IRR Payback Period

Aspire 1,694,600.91 27% 2 yrs, 1 month

Wolf 772,380.6 14% 2 yrs, 8 month

From the table above, it is clear that AYR Co. should pursue with project Aspire, as it
showed higher NPV, Higher IRR and less payback time of 2 years.

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3.2 Calculations Interpretations
The interpretations of the above schedule, and any other investment in general,
depends whether the investor have Limited or Unlimited funds, and in the table below
we will examine this for AYR Co.
AYR Co Limited Funds
If AYR Co. have limited
funds in this investment
then they should take the
NPV
higher NPV.
With limited funds AYR
should take the higher
IRR.
IRR
Should take up on a
Payback and
project that with the lowest
Discounted Payback
period.
With limited Funds, AYR is
Accounting rate on advised to pick an ARR
return that is the highest.
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Unlimited funds
If AYR Co. is just
interested in an investment
with no regard to funds
then they take the one that
shows NPV higher than
zero.
With unlimited funds AYR
should take the IRR that is
higher than the WACC as
this means that it
generates returns higher
than the cost.
This will depend on AYR
and how fast they wish to
receive their money back.
In this decision they simply
should pick the rate higher
than zero as it shows a
positive rate on return.
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3.3 Other Factors That Might Affect the Decision

While a company is making a decision about whether to venture into a new investment
or not, there are a lot of variables that also need to be considered by the company, be it
internal factors or external factors, systematic or unsystematic, it all has to be taken into
consideration.

That is why in this part we wills shed some light on what factors that can affect AYR Co.
decision.

 Internal:
 Organizational Change: it is in the human nature to fear, resist change and
even undermine it, so AYR Co. undertaking a new project such as Aspire, may
cause some disturbance to the operations of the company. That Is why AYR
Co. needs to adopt an Organizational Change strategy, which empowers the
employees to accept the new change and lead on with the new process not
have the change mandated from the top (Satell, 2019).

 Risk of Product Cannibalization:

“Market or Product cannibalization is a sales loss caused by a company's
introduction of a new product that displaces one of its own older products rather
than increasing the company's overall market share” (KENTON, 2019). As AYR
Co. will work on enhancing an existing product when they take on Aspire to
reach existing and potential audience, the need to bear in mind that they won’t
eat up sales portion from a product existing in their company portfolio.

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 External:
- PESTLE Analysis:

We highly recommend that AYR CO. to conduct a PESTLE Analysis in order

to be able to assess the environment surrounding them and take their effect
into consideration as well:

Political: are there any political imbalance, whether governmental or union wise
that could destabilize the business or increase taxes.

Economical: how is the country economy going, is there inflation, recession or

currency devaluation or floatation?

Social: Is this product adhere to the social etiquette and will it be accepted by
the society, is it ethical?

Technological: Is the technology to produce the product available, affordable

lasting or it will be outdated.

Legal: Is the product new or patented by another competitor?

Environmental: is the new product environmentally friendly, will it be

biodegradable, recyclable? Will it be suitable so as the environmental lobbyists
accept it if it is environmentally friendly then is the cost higher or less?

- Competitors:

It is crucial for AYR Co. should take into consideration the effect of competition
in the market, and how long will it take for other competitors either to mimic or
develop a more enhanced product that will overthrow their offering.

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CHAPTER FOUR: DISCUSSION OF TWO SOURCES OF FINANCE

4.1 A description of Equity and Debt

In this section, the author will aim to explain the two sources of finances that AYR Co. is
considering, these sources being Debt and Equity.

Equity Financing “is the process of raising capital through the sale of shares in a
company. With equity financing comes an ownership interest for shareholders.”
(MAJASKI, 2019a). This can be done either by offering existing shareholder to raise their
shares, or offer share for new potential holders. However, with equity finances comes
the risk of “Dilution”, where by selling more and more of the company’s share the
owner will lose control over the company by losing votes in the board

Debt Financing “When a firm raises money for capital by selling debt instruments
to investors, it is known as debt financing. In return for lending the money, the
individuals or institutions become creditors and receive a promise that the
principal and interest on the debt will be repaid on a regular schedule.” (MAJASKI,
2019a). With Debt financing comes banks conditioning, also the company could risk
increasing its own gearing ratio when they acquire more and more debt by turn
increasing their cost of borrowing, resulting in higher interest rates and on the long run
banks and lenders may have the right to refuse to provide AYR Co. Company with more
loans.

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 Below a table highlighting the differences between both Debt and Equity:

(Stories on Bond Street, 2017)

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4.2 Cost of Equity Vs Cost of Debt

Cost of Debt “refers to the effective rate a company pays on its current debt. In
most cases, this phrase refers to after-tax cost of debt, but it also means the
company's cost of debt before taking taxes into account.” (CHEN, 2019). It is
important to acknowledge the fact that Debt financing is simpler that the Equity
finances, that is due to the fact that the interests that are paid by the company to
the bank are deductible in taxes.

Which brings us to Cost of Equity “The cost of equity is the return a company requires
to decide if an investment meets capital return requirements. Firms often use it as a
capital budgeting threshold for the required rate of return.” (KENTON, 2019b), unlike
Debt, Equity doesn’t require to be paid, but still it is more costly that debt due to the tax
advantages that we mentioned before, However, the reason that investors prefer equity
is the fact that it provides higher rates of return, so the rule of thumb here is “the higher
the risk, higher the return” (KENTON, 2019b),

Financing sources for AYR Co.

Capital employed $million %

Equity holder funds 20 52.63

Long term debt 18 47.37

Total 38 100

After analysing the data above and calculation of the weights for both debt and equity, to
assure the correct data is gathered the author utilized the “Solver Tool” in excel to be able
to identify the cost of equity and the cost of debt.

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The objective cell was set to the WACC given in the data to be 10% and the variable cells
were changed to the cost of debt and the cost of equity, the results indicates that the Cost
of Equity equals 12.18% while the Cost of Debt equals 7.58%.

The above mentioned data and the benefits of debt financing of deductible taxes provide
more proof that the company should opt for Debt Financing, as the company has already
almost 52% of equity holders and any more shares offered for new or existing
shareholders will dilute the owners hold on the company’s decisions and ways of
business. It is up for the company now to take a more informed decision based on the
influence that it might have on the WACC.

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4.2 The effect of selection on the WACC

Even though, debt is a good option, but the interests may become a liability on the
company on the longer run and can affect the annual cash flow thus affecting the
shareholders return, but it is still a cheaper source of capital, so the cost of capital will
decrease, as for Equity, since the cost of the share will increase, this will cause the cost
of capital to increase as well, further fortifying the choice of selecting Debt Financing

4.3 Impact of selection on Potential Shareholder and Lenders

These two sources of finances either affect the control of the owner over the company
or the amount of profit. For Equity, if we further liquidate shares for existing or potential
new shareholders AYR owner risk dilution of his control over the company. As for
Equity, as mentioned before even though it is the cheapest source however interests
may become a liability on the long run, and the regular payments will surely affect the
net income.

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4.4 Conclusion

At the end, making an investment decision, for a company is not only about finances,
there are a lot of variables at play, but since this report is aimed at analysing this
investment from a financial perspective, it is in the opinion of the author to pursue
project “Aspire” as it has showed best NPV, IRR and Payback period, and it is in the
recommendation of the author that AYR Co. should utilize Debt Financing in order to
support this project as it is a cheaper source of capital and the interest rate that might
seem as a liability will be tax deductible in the end, also debt financing will chase away
any fear of board dilution of the company.

However, the author urges the company to take into consideration other factors such as
strategic and environmental before pursing this investment further to have a well
informed decision and a successful investment.

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APPENDIX ONE: ASPIRE CALCULATIONS

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Inflows 650,000.00 698,750.00 751,156.25 807,492.97 868,054.94
Variable costs/Cash
outflow (27,000.00) (28,822.50) (30,768.02) (32,844.86) (35,061.89)
Plant and Machinery (2,250,000.00)
Scrap value 375,000.00
Working capital (140,000.00) 140,000.00
Capital allowance 600,000.00 390,000.00 345,000.00 300,000.00 240,000.00
Earnings before
interest and tax (EBIT) (2,390,000.00) 1,223,000.00 1,059,927.50 1,065,388.23 1,074,648.11 1,587,993.05
Taxes (20%) 478,000.00 (244,600.00) (211,985.50) (213,077.65) (214,929.62) (317,598.61)
Net cash flow (1,912,000.00) 978,400.00 847,942.00 852,310.59 859,718.49 1,270,394.44
Discount factor 1.000 1.100 1.210 1.331 1.464 1.611
Present value (1,912,000.00) 889,454.55 700,778.51 640,353.56 587,199.29 788,815.00
NPV 1,694,600.91
IRR 27%
Payback period (85,658.00) -1
2 years, 1 month

Discounted payback
period (321,766.94) -6.029799102
2 years,6 months

Discounting rate of Aavg annual accounting

return profit 961,753.10
Avg capital investment 1312500
Acc rate of return 73%

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APPENDIX TWO: WOLF CALCULATIONS

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash inflows 955,000.00 955,000.00 955,000.00 955,000.00 955,000.00
Material cost (14,000.00) (15,050.00) (16,178.75) (17,392.16) (18,696.57)
Plant and machinery (2,250,000.00)
Other Expenses (18,000.00) (16,650.00) (15,401.25) (14,246.16) (13,177.69)
Rental (75,000.00) (75,000.00) (75,000.00) (75,000.00) (75,000.00)
Earnings before interest and tax (EBIT) (2,250,000.00) 848,000.00 848,300.00 848,420.00 848,361.69 848,125.74
Taxes (20%) 450,000.00 (169,600.00) (169,660.00) (169,684.00) (169,672.34) (169,625.15)
Net cash flow (1,800,000.00) 678,400.00 678,640.00 678,736.00 678,689.35 678,500.59
Discount factor 1.000 1.100 1.210 1.331 1.464 1.611
Present value (1,800,000.00) 616,727.27 560,859.50 509,944.40 463,553.96 421,295.48
NPV 772,380.62
IRR 14%
Payback period (442,960.00) 8
2 years, 8 month

Discounted payback period (112,468.82) 2.911475184

2 years,3 months approximately

Accounting rate of return Avg annual accounting profit 678,593.19

Avg capital investment 1125000
Acc rate of return 60%

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