1|Page

COMSATS Institute of Information Technology

Sahiwal
Assignment # 4

Topic:
Report on Investment appraisal of Building and Engineering
Ltd. (BLAER)

Submitted to:
Sir Shoaib Sajjad

Submitted by:
Arslan Zafar (FA16-RBA-003)
M.Zahid (FA16-RBA-009)
2|Page

Report on Investment Appraisal of

Building and Engineering Ltd.
(BLAER)
3|Page

Contents:

EXECUTIVE SUMMARY:.........................................................................................................................4
INTRODUCTION:......................................................................................................................................4
OBJECTIVE:..............................................................................................................................................5
PROBLEM:.................................................................................................................................................6
METHODOLOGY:.....................................................................................................................................6
CRITICAL ANALYSIS:..............................................................................................................................6
REQUIREMENTS:.....................................................................................................................................7
Requirement no. 1.......................................................................................................................................8
Requirement no. 2.....................................................................................................................................16
Requirement no. 3.....................................................................................................................................17
Requirement no. 4.....................................................................................................................................17
Requirement no. 5.....................................................................................................................................18
Requirement no. 6.....................................................................................................................................20
Requirement no. 7.....................................................................................................................................21
CONCLUSION:........................................................................................................................................22
REFERENCES:.........................................................................................................................................23
4|Page

EXECUTIVE SUMMARY:
Projects are very important for practical and applied perspective. BLAER’s main activity is the
construction of large industrial buildings, also provides maintenance for those buildings which it
has constructed. The company concentrate on developing its corporate image as an innovative,
technologically advanced construction firm, which secure its large competitive contracts in past.
BLAER face the problem on its investment and difficulty to evaluate it because the replacement
of old crane decision will effect on company image that’s why BLAER carefully take this
decision, either replace the existing crane with new technologically crane or keep working with
old crane which is ten year old and maintain it to fulfill the safety standards.

We evaluate the BLAER investment and critically analyze either BLAER purchase new crane or
maintain its old crane. BLAER has to make decision about replacement of old crane on the basis
of financial aspects. If we talk about financial decision making, we do some critical analysis
practically and interpret it. As our project is related to investment appraisal in which our ultimate
objective is to help the firm in this crucial situation and to provide authentic technical
information and to put practical and theoretical assumptions on the basis of our analysis that
weather old crane should be replaced with new one. To reach at productive financial decision we
use capital budgeting techniques like payback period, NPV, IRR, and PI to make the decision to
make productive decision. After the critical analysis we conclude that BLAER should purchase
new crane.

INTRODUCTION:
Building and engineering ltd (BLAER) is a medium sized private company with sales of £35
million per year and own 150 employees. BLAER has been in business for almost quarter of a
century. The nominal revenue of BLAER has been reduced at a rate of 3% per annum due to the
inflation rate of 4% per year. It pays 35% tax at the end of each year and has a system of 25%
writing down allowance on capital assets. The BLAER has large investment in construction
machinery. It is very technological oriented company and keeps pace with changing
technological aspects. BLAER old crane running cost is high plus there is a 50% probability that
it will break down during the year and also have installation charges.
5|Page

Also technological innovations are changing day by day and then they are losing the competitive
edge because of the old technology or old crane is creating a problem in running and 50% of
chances that it will break down again and the productivity will be lost. Company will go to take
its long-term planning if company buying the BL crane then BLAER have got competitive image
on its competitors because BL have technologically good image and takeover market in the next
two years. This decision will reflect on BLAER overall performance and profitability.

The construction site manager James Dean has placed a CEA application to replace old crane
with new crane i.e. Bush lift (BL). He has indicated in January budget that firm needs to spend
money on the maintenance of old crane. Original cost of old crane is £ 195,000 while that of new
crane is £345,000. Running cost of old crane is £65000 per annum. While the running cost of
new crane is £ 60000 per annum. To make a decision whether to replace old crane with new
crane or keep working with old crane, Sonia Dutta Director of financial planning and analysis
called a meeting of concerned parties to discuss the CEA application.

The information was not enough and similarly IRR was not calculated by the BLAER before
investing in any project. Therefore the members decided to also calculate the IRR to decide
whether to purchase new crane or not. This report is all about the decision of replacing crane or
not. Investment appraisal methods are used to interpret that which decision should be financially
reasonable.

OBJECTIVE:
According to given case study BLAER is having huge investment in construction machinery and
they are planning to replace the old crane with new one of latest technology or they should
continue with the old crane. So the main objective of this project is to decide whether to replace
the old crane with new crane or keep working with old crane because the maintenance cost of old
crane is high and can break down at any time during the year. Due to this reason BLEAR has
already missed out some important contracts. If they replace old crane with new crane they can
get the competitive advantage over their competitors. In case study we are provided with options
and relative data for critical analysis. It is also worthwhile to keep in mind that company has an
image of innovative, technologically advanced construction firm.
6|Page

PROBLEM:
As we know that BLAER is a construction business, they need to be active and well maintained
to survive in industry. According to case of given case study BLAER is facing problem with its
existing crane that is five year old so its technology is also old. It’s obvious that to remain
technologically competitive and outstanding BLAER needs to have latest technology. The
existing crane has high running cost and chances of its breakdown are also greater. If during
operation breakdown occurs BLAER has to face losses. BLAER can’t afford such losses as
revenue of the company has already declined 3% due to nominal inflation rate of 4%.

METHODOLOGY:
For the purpose of making decision more reliable and accurate different quantitative financial
tools and approaches have been used. Financial Tools that are used are as follows.

 Cash flows (Attachment A)

 Net present value (Attachment B and C)
 Internal rate of return (Attachment D)
 Payback period (Attachment D)
 Profitability index (Attachment D)
 Real rate of interest (Attachment E)
 Cost to cost analysis (Attachment E)
 Sensitivity analysis (Attachment F)

We have used different web pages, related journals and books to make a deep understanding of
qualitative approach we are going to use.

CRITICAL ANALYSIS:
While doing critical analysis we are available with two options

 Replacement of old crane with new one which has more capacity and advance
technology.
 Use old crane by bearing high running cost with equal chances of breakdown.

As appraisal is basically the integral part of decision making. So by using different capital
budgeting techniques we have measured risk and return regarding to our selected decision.
Appraisal is based on careful analytical evaluation because of the reason that investment
decisions are most important and critical because they can affect the whole business. So we
7|Page

focused on careful planning and strategic decisions. Other important factors that should be kept
into consideration are depreciation and tax rate.

According to given case we have to make decision about use of old crane or to purchase new by
keeping in mind respective cash flows. As BLAER has image of technologically advance firm,
so now they are ambiguous about choice between new and old crane. So here we made step by
step analysis by use of appraisal methods. After the critical analysis we will be able to make
suggestion to BLAER that what should be their decision regarding cranes.

COST ANALYSIS:

Cost analysis for both the cranes is given as follow.

NEW CRANE OLD CRANE

Initial investment £345000 Initial investment £195000
Cost per annum £60000 Maintenance £40000
Installation cost £10000
Loss due to breakage, Cost per annum £65000

REQUIREMENTS:
Now we can present the work that we have adopted to reach at the end point. By calculating
following financial accounting terms we can determine that choice of which crane will be
worthwhile. Present values (PV) and Net Present Values (NPV) for both options have been
calculated separately at different discount rates and payback periods, internal rate of returns
(IRR) were also calculated and were compared with each other and then the most suitable option
was chosen.

Requirement no. 1
Present the financial analysis required by blear capital expender manual, as they have
traditionally been calculated. Explain any assumptions’ you make. According to BLEAR’s
usual decision criteria, would the BL be purchased now?

FINANCIAL ANALYSIS:

Financial analysis as per BLAER capital expenditure manual:

8|Page

NEW CRANE OLD CRANE

Initial investment £345000 £195000
Cash flow £66000 £39000
Payback period 2.8 years 5 years
IRR 14% 15%
PI 1.03 1.00
Discount rate 13% 15%
NPV 13132.06 731.97
Standard Deviation 1.53% 2.61%

According to BLAER’s usual decision criteria BL can be purchased as now as it falls under
category 1 of decision making. Although financial projections for the year are designed in the
start of January but this decision falls under category 1 i.e. essential replacement of existing
asset.

Net Present Value:

The NPV is basically represents the sum of PV of all future cash flows minus the initial
investment. This technique is significantly comes from the time value of money and it considers
the total benefits arising out of proposal over its life time. To calculate NPV first of all we
calculate the NPV of cash flows at different discount rates. Net present value of both the crane
has been calculated on excel sheet. Here we are only depicting the values and interpretations.

Table no.1

At discount rate 26%

New crane Old crane

Discount rate 0.26 0.26
NPV -168703.75 -59872.56
Interpretation:
From the above given table, we can interpret that 26% rate is too risky and high. We cannot think
of purchasing new crane at this rate. For old crane it is also risky.

Table no.2
At discount rate 25%
New crane Old crane
9|Page

Discount rate 0.25 0.25

NPV -109346.78 -55750.37
Interpretation:
Table 2 also gave interpretation that 25% rate is also very high and risky as it is given negative
NPVs for both cranes.

Table no.3
At discount rate 24%
New crane Old crane
Discount rate 0.24 0.24
NPV -101997.48 -51407.60
Interpretation:
From above given table we can understand that 24% is also very high rate, giving negative
NPVs.

Table no.4
At discount rate 23%
New crane Old crane
Discount rate 0.23 0.23
NPV -94248.18 -46828.47
Interpretation:
23% rate is also risky and high as giving negative NPV.

Table no.5
At discount rate 22%
New crane Old crane
Discount rate 0.22 0.22
NPV -86069.83 -41995.81
Interpretation:
From the above table we can also interpret that 22% rate is not reasonable as giving negative
NPVs. New crane cannot be purchased if we kept 22% as discount rate.
10 | P a g e

Table no.6
At discount rate 21%
New crane Old crane
Discount rate 0.21 0.21
NPV -77430.85 -36890.95
Interpretation:
Due to negative NPVs we cannot consider 21% as discount rate.

Table no.7
At discount rate 20%
New crane Old crane
Discount rate 0.20 0.20
NPV -68296.84 -31493.58
Interpretation:
20% rate is also giving negative NPVs when subtract PV from initial investment.

Table no.8
At discount rate 19%
New crane Old crane
Discount rate 0.19 0.19
NPV -58630.29 -25781.54
Interpretation:
19% discount rate is also risky and high. We cannot consider it as it is giving Negative NPV. If
we purchase new crane at this rate, we will be in loss.

Table no.9
At discount rate 18%
New crane Old crane
Discount rate 0.18 0.18
NPV -48390.30 -19730.63
11 | P a g e

Interpretation:-
We can see that the above table is giving negative NPVs in case of both cranes. So this rate is too
high and risky.

Table no.10
At discount rate 17%
New crane Old crane
Discount rate 0.17 0.17
NPV -37532.16 -13314.45
Interpretation:
17% is also high rate. We cannot consider it as our discount rate.

Table no.11
At discount rate 16%
New crane Old crane
Discount rate 0.16 0.16
NPV -26006.98 -6504.12
Interpretation:
16% is also high discount rate giving negative NPVs.

Table no.12
At discount rate 15%
New crane Old crane
Discount rate 0.15 0.15
NPV -13761.27 731.97
Interpretation:
The net present value of old crane is positive at 15% discount rate so for old crane this rate will
be appropriate.
12 | P a g e

Table no. 13
At discount rate 14%
New crane
Discount rate 0.14
NPV -736.36
Interpretation:
From above table we can interpret that at 14% NPV of new crane is negative so we cannot
consider this rate as discount rate.

Table no.14
At discount rate 13%
New crane
Discount rate 0.13
NPV 13132.06
Interpretation:
For new crane 13% rate will be appropriate. We can consider this rate appropriate as NPV is
positive at this rate. It can also be interpreted that purchase of new crane is more appropriate
decision as it is giving low discount rate.

Decision Criteria:
At 26% NPV is negative -£168703.75 by this way we calculate NPV at different interest rates by
moving downward and it will become positive at 13% and which is £13132.06.

And in the case of the old crane when we calculated NPV at 26% it is negative -£59872.56 and
we calculated its NPV at different interest rates and it becomes positive at 15% that is £731.97.
On NPV basis we select new crane.

Internal rate of return:

Internal rate of return is also known as the discount rate. It is the rate where net present value
becomes zero. The internal rate of return is rates that are used in capital budgeting to measure
13 | P a g e

and compare the profitability of investment. It is also known as discounted cash flow rate of
return. The project having more IRR is more favorable.

Calculation of IRR is given as under:

IRR= R1+ N1 (R2-R1)/N1+N2

Where

R1= lower rate of interest

R2= highest rate of interest

N1=positive NPV

N2=negative NPV

New crane:

IRR=13%+13132.07(14%-13%)/13132.07+736.367 = 13.95 or 14%

Old crane:

IRR= 15%+731.9764(16%-15%)/731.9764+6504.13 = 15.10%

Decision Criteria

The IRR in purchasing the new crane is 14% which is greater than the cost of capital (13%) and
the IRR for the old crane is 15.10% which is almost equal to the cost of capital (15%). On the
basis of IRR and our analysis we select the new crane because it provides greater return to the
firm at 14%.

Payback period:

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest appraisal
techniques.
14 | P a g e

New crane Old crane

Initial investment= 345000 Initial investment=195000
Cash flows= 126000 Cash flows=39000
Payback period= Initial investment/cash flows Payback period= Initial investment/cash flows
345000/126000= 2.8years 195000/39000= 5 years

Decision Criteria:

The payback period in using the old crane is 5 years and new crane is 2.8 years. We conclude
that the new crane payback period is beneficial than the old crane. Because we always select
those payback periods whose payback period is small. The new crane payback period is
beneficial than the old crane we select the new crane rather than the old one.

Profitability index:

It allows the comparison of cost and the different projects to be assessed and thus allows decision
making to be carried out. It is regulation of evaluating whether to proceed with a project or
investment. PI should be 1 or greater than one for project to be successful.

PI= PV of cash inflows/PV of cash outflows

New crane:

PI = 358132/345000 = 1.03
Old crane:

PI= 195732/195000 = 1.00

Decision Criteria

As in the case of BLAER the profitability index of new crane is 1.03 while profitability index of
old crane is 1.00. We selected the new one because it has a high profitability index.

So from above comparison we can conclude that it will be more beneficial for BLAER to
purchase a new crane.
15 | P a g e

Requirement no. 2
Explain the difference between real and nominal rates. What adjustment to SD’s suggested
discount rate would be needed in order to match the discount rate with the cash flows
used? What do you think of comment that 21% may be too risky?

Real interest rate:

 Real interest rate is the real discount rate that is adjusted to eliminate the effect of
expected inflations.
 It should be used to discount constant dollar or real benefit and costs.
 It is determined by subtracting expected inflation from nominal interest rate.

Nominal interest rate:

 A nominal discount rate that reflects the expected inflation should be used to discount
nominal benefits and costs.
 Market interest rates are nominal interest rates [ CITATION Nom15 \l 2057 ]

For this project:

Nominal interest rate = 21%

Real interest rate = (1+21%)/ (1+4%) -1= 16.35%

Sonia Dutta who is director of financial planning and analysis suggested that new crane can be
purchased at 26% rate. It yields negative NPV so it is not reasonable rate to calculate NPV.

Other rate that is suggested by Sonia Dutta is 21% that is also giving negative NPV so it is not
appropriate to use this rate also. Means 21% rate is also too risky. For new crane NPV is positive
at 13% rate. So purchasing new crane will be profitable only if 13% rate is used.

Requirement no. 3
Re calculated the NPV of BL purchase proposal, using what SD would consider to be
appropriate discount rate. Do these revised NPV results suggest that the BL should be
purchased?

In the start of this report we have given the discount rates and NPVs of both cranes. New crane
has discount rate of 13% with NPV of 13132.06 while old crane has discount rate of 15% with
16 | P a g e

NPV of 731.97. So here discount rate of new crane is lower as compared to old crane. So we can
conclude that new crane should be purchased.

At discount rate 13%

New crane
Discount rate 0.13
NPV 13132.069

Requirement no. 4
In light of your calculations for BL purchase proposal, what would be your response to
XL’S comment that the IRR of the projects should be calculated? Discuss both the
theoretical and practical adjustments.

XILU who is M.D of BLAER suggested that IRR of the project should be calculated to reach at
ultimate decision. IRR is calculated at positive NPV. We have positive NPV at 13%. Here we
also calculate IRR of new crane that fulfill the criteria when compared with old crane.

IRR= R1+ N1 (R2-R1)/N1+N2

Where

R1= lower rate of interest

R2= highest rate of interest

N1=positive NPV

N2=negative NPV

New crane:

IRR=13%+ 13132.07*(14%-13%)/1313.07+736.367 =13.95% or 14 %

Old crane:

IRR= 15%+731.9764(16%-15%)/731.9764+6504.13 = 15.10%

17 | P a g e

Here IRR of new crane exceeds the discount rate so purchase of new crane will be more
profitable.

 Theoretical argument:

On theoretical basis NPV is better approach to investment decision. So on this base BLAER
should select purchase of new crane as it has greater positive NPV when compared with old
crane that is 13132.06 as compared to 731.97.

 Practical argument:

When we talk about practical approach, IRR calculation will be most beneficial criteria for
choice of any project. It is because of the reason that investor has more interest in IRR return
than rupee return. For new crane the IRR is greater than its discount rate i.e. 14%, so it also
suggest that new crane should be bought.

Requirement no. 5
Discuss the several methods of analyzing risk and uncertainty of project. Where possible,
support your descriptions with calculations.

Risk and uncertainty:

Risk is probability in which investor actual return might be different than expected return.
Uncertainty is the condition in which unpredictability of calculated possible outcome occur.
Company should be trying to manage their exposure of risk in an appropriate way. The company
can face different types of risks while making the investment decision for the purchase of new
crane which are discussed below:

 Inflation rate risk

 Tax rate risk
 Interest rate risk.
BLAER must keep into consideration other factors while making the investment appraisal before
purchasing the new crane like interest rate, tax rate and inflation rate risk.
18 | P a g e

Interest rate:

Interest factor influences the investment decision for any firm. When interest rate increases,
chances of loss will also increases because of the reason that uncertainty is also linked with
interest rate. Overall cost of machine also increases. Example of BLAER can be taken where
26% rate is high and uncertain.

After calculations we reach a conclusion that discount rate for new crane is 13% while for old
crane is 15%. So we can say that it is more appropriate to purchase new crane where discount
rate is lower that will also lower cost of machine. If we talk about real interest rate and nominal
interest rates, they also prove that when these interest rates increase our cost will also high.

Nominal interest rate=21%

Real interest rate=16.35%

Inflation rate:

Inflation causes increase in prices, that causes increase in risk as interest will also be high in that
case that effect badly overall cost of company. In this case study this is mention due to increase
in inflation rate by 4%, revenues decreased to 3%.

Tax rate:

Besides interest rate and inflation, tax rate also influence the investment assessment. By
company point of view, increase in tax rate can affect the overall profitability of the firm and cost
will also increase. Tax rate is the unexpected factor and it can be analyzed through sensitivity
analysis and standard deviation.

There are different techniques are used to determine the value of risk and uncertainty as
followings:

 Sensitivity Analysis

An approach to measure the risk that uses different possible return estimates to determine the
variance among the possible outcomes. Sensitivity analysis is simply the method for determining
how sensitive our NPV analysis is to changes in our variable assumptions.

 The Standard Deviation

19 | P a g e

It is a statistical measurement that is used to determine the assets risk and deviation/error from
the expected mean. The standard deviation of new crane is 1.53% and old crane is 2.61%. By
assessing the amount of risk we calculate and analyze that there is the less risk involved in the
purchasing of new crane [ CITATION Ris \l 2057 ]

Therefore, Risk and uncertainty of a project can be analyzed by these methods.

Requirement no. 6
Discuss the key variables in the BL investment which will affect its viability.

Viability:

The viability of a business is measured by its long-term survival, and its ability to have
sustainable profits over a period of time. If a business is viable, it is able to survive for many
years, because it continues to make a profit year after year. The longer a company can stay
profitable, the better its viability.

There are different variables that affect the BL investment which are as. These factors can be
given as follow.

 Technology:

BLAER will need to have new crane with latest technology and more capacity. Old crane are
lagging in technology and capacity. BLAER will change the technology there will be greater
chance to win the project by using BL crane while it will not be the case of old crane So, new
crane will help them to make operations more appropriately.

 Quality:

From case study we came to know that old crane has quality problem with 50% chances of
breakdown and in that way may increasing project timing. By purchasing new crane BLAER can
overcome this issue.

 Time Overrun:
20 | P a g e

Every project has specified timing for its completion so BLAER should have efficient crane to
make timely operations. BLAER has to be delivered the product within a certain time frame to
deliver benefits. If it use new crane then the productivity will increase. So, new crane should be
purchased.

Requirement no. 7
Discuss any further information that would be useful in analyzing the BL proposal.

As we know that BLAER is innovative and technologically advanced construction firm, so there
is need to analyze that weather BLAER is up to corporate image or not. There is also need to
analyze that weather purchase of new crane will attract more investors or not and analysis of
winning new contracts is possible or not as mention in case study that chances of winning new
contract is 60%.

 Cost to cost comparison:

While making cost to cost comparison the old and new crane costs should be kept into
consideration. It is possible that mew crane is more cost effective and increase productivity of
firm. According to our calculations the cost of new crane is £60000 while old crane has cost of
£65000. So new crane purchase will be more beneficial.

 Profitability index approach:

This approach is used to measure the present value of returns invested while NPV is based on the
difference between present value of future cash inflows and the present value of cash outlays. As
per our calculations the profitability index of new crane is 1.03 while PI of old crane is 1.00 so
purchase of new crane will be more beneficial.

 Pretax profit calculation:

We also use the assumption as mention in the project of pretax profit of pretax profit of
£80000.by using this value as our cash flows we calculate the payback period, NPV and IRR and
we determined according to these calculations and analysis. So at end we can conclude that
BLEAR should purchase new crane. [ CITATION Bui \l 2057 ]
21 | P a g e

CONCLUSION:
BLAER has been in business for almost quarter of a century and is well established in the market
place. BLAER has a large investment in construction machinery, and has always kept up with the
latest technology in the industry. Therefore BLAER needs to have a new crane latest and new
technology with more capacity. As we know that before selecting the crane we must have to take
in account the proper figures and calculations which are clearly mentioned in the project. We
have calculated NPV of new crane at 13%, IRR at 14%, Profitability index at 1.03, payback
period at 2.8 years, Standard deviation at 1.53% which is better and profitable than old crane So,
after all calculations and accordance we reach at the point that BLAER must choose the new
crane because it will increase the productivity and efficiency of the firm.

.
22 | P a g e

REFERENCES:

(n.d.). Retrieved 05 10, 2015, from Nominal and real interest:

http://www.investopedia.com/terms/n/nominalinterestrate.asp#ixzz3aEEKfxQm

(n.d.). Retrieved from Risk and Management: • https://success.clarizen.com/entries/24127786-Risk-

Management-Useful-Tools-and-Techniques

Building and Engineering LTD (BLAER).