Introduction
This paper evaluates the estimated returns of two investment projects; locating a production facility in Bangalore and Mumbai. The basis of evaluation is average rate of return on investment, payback period,profitability index, net present value, and internal rate of return. Further, this paper discusses other factors that need to be considered.
Average Rate of Return on Investment
This method evaluates a project using accounting profits. It is computed by dividing the average income by the average investment and then converting the result in to percentage. Normally, a project with a higher average rate of return would be preferred. Locating a production facility in Mumbai would result in a 20 % average rate of return while investing in Bangalore would result in a 31 % rate of return. Therefore, locating the production facility in Bangalore is preferable because it has a higher average rate of return.
Payback Period
This method evaluates projects on the basis of the duration it would take to recuperate the initial cost outlay. It is computed by dividing the initial outlay with the annual net cash flows. Projects will a lesser payback period would be preferred. The payback period for investing in Mumbai is 6.58 years while the payback period for investing in Bangalore is 4.9 years. Investing in Bangalore is preferable because it has a lower payback period compared to investing in Mumbai.
Net Present Value
This method evaluates projects on the basis of discounted cash flows. It is computed by subtracting the initial outlay from the discounted cash inflows. Only projects with a positive value should be accepted. When evaluating various projects, the project with the highest value should be selected. Investing in Mumbai would result in a net present value of $ 1,937,660 while investing in Bangalore would result in a net present value of $ 2,421,502. Investing in Bangalore is preferable because it has a higher net present value as compared to investing in Mumbai.
Profitability Index
This method evaluates projects on the basis of discounted cash flows. It is computed by dividingthe discounted cash inflows with the initial outlay. Only projects with a positive value should be accepted. When evaluating various projects, the project with the highest value should be selected. Investing in Mumbai would result in a profitability index of 1.388 while investing in Bangalore would result in a profitability index of 1.865. Investing in Bangalore is preferable because it has a higher profitability index as compared to investing in Mumbai.
Internal Rate of Return
Internal rate of return is the discount rate that results in a net present value of zero. When evaluating various projects, theproject with the highest value should be chosen.Investing in Mumbai would result in an IRR of 14% while investing in Bangalore would result in an IRR of 19%. Investing in Bangalore is preferable because it has a higher IRR as compared to investing in Mumbai.
Other Factors to Consider
First, the company needs to consider risk. Risk is the possibility of variations of future actual cash flows from the expected cash flows. There are various types of risks: corporate risk, market risk, international risk competitive risk, project specific risk among others. It is of importance to consider the riskiness of a project because it determines the extent to which a project returns is certain. Investment projects can be analysed for risk using sensitivity analysis, scenario analysis, risk adjusted discount rate and statistical techniques.
Secondly, there is a need to consider the availability of funds. This is important in determining which projects to invest in. For example, in this case both projects are variable since they have a positive net present value. Therefore, the company should invest in both projects. However, if there limited funds then only one project can be chosen.
Lastly, there is need to consider the opportunity cost of investing in the projects. This is important because if there are other projects that would result in higher returns, then it is only logical that they are given priority.
References
Brigham, E. F., & Houston, J. F. (2011). Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition) (7, illustrated ed.). London: Cengage Learning.
