Executive Report for Peaches plc. about Strategic Option Choosing
Recommendations
Before presenting the analysis of the comparison and giving the suggestion, to compare the method outcomes better, the results will be put into one table which can reflect the comparison more directness.
Table 14: Comparison among Three Options
Strategic Option 1A

Strategic Option 1B

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Strategic Option 1C

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ARR

30.93%

42.79%

47.12%

Payback Period

3.75 years

3.68 years

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1.68 years

NPV

£19.614

£17.865

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£12.095

IRR

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32.1%

33.1%

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67.3%

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Strategic Option 1A

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Strategic Option 1B

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Strategic Option 1C

ARR

30.93%

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42.79%

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47.12%

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Payback Period

3.75 years

3.68 years

1.68 years

NPV

£19.614

£17.865

£12.095

IRR

32.1%

33.1%

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67.3%

First and foremost, when considered the ARR and payback period, company should choose strategic option 1C to compete with Apple’s IPhone since it achieve the highest ARR (47.12%) and lowest payback period (1.68 years). Theoretically, the one with the highest ARR should be selected and in payback period method, the one with the shortest payback period also the best choice (Mclaney and Atrill, 2012).
However, there are several disadvantages of these methods force people think twice before making decision. Firstly, ARR based on the use of accounting profit instead of cash flows which is also important for the reason that cash is the ultimate measure of the economic wealth generated by an investment (Lumby, 1994). According to Mclaney and Atrill (2012), it also can create problems when considering competing investments of different size which is exactly the situation of three strategic options. What is more, using the average investment to do the calculation can make the deviation to the results (Mott, 1997).
In payback period method, it is simply concerned with how quickly the initial investment can be recovered. Cash flows arising beyond the payback period are ignored and not all relevant information may be taken into account (Pike and Neale, 2009). It also do not considered with maximizing the wealth of the business owners but look for the quickly project to pay for them (Atrill, 2006). Besides, the major problem for both methods is that they lack of thinking about the time value of money (Bhat, 2008). In the option, even option 1C reach the highest ARR but it does not mean that it can bring the biggest fortune to the company in the future. So does payback period. Moreover, with different cash flows, payback period will be different even though the project brings same revenue to the shareholder. Hence, compare the NPV and IRR are more important to decision making.
Maximize the shareholder’s wealth is the ultimate target in each company (Levy and Sarnat, 1986). Since all three strategic options are not independent projects, thus, the rule for NPV is accepting the projects that offer the greatest NPV when discounted at the required rate of return for each investment (Pike and Neale, 2009). According to the NPV results, strategic option 1A should be selected since it achieves the biggest figure. Beside, NPV offers a better approach investment opportunity than ARR or payback period which make it more convinced. The most significant issue it concerned about is the time value of money (Mott, 1997). As the discounting process incorporates the opportunity cost of capital, the net benefit after financing costs have been met is identified (Mclaney and Atrill, 2012). NPV method also takes the whole of the relevant cash flows into account which means they all have an influence on the decision (Mott, 1997). It is also the only method of appraisal in which the output of the analysis has a directing bearing on the wealth of the owners of the business (Bhat, 2008). All the advantages make NPV superior than other two methods (ARR and payback period).
IRR is the last of the four major investment appraisal methods and it is closely related to the NPV method since that both involve discounting future cash flows. The discount rate of IRR will produce precisely zero NPV when it applied to its future cash flows (Mclaney and Atrill, 2012). In the case, all option’s IRR are greater than the cost of capital but since strategic option 1C achieves the highest IRR, it should be chose in terms of rules. Despite IRR considered all cash flows, the main problem of IRR is that it does not directly address the question of wealth generation (Lumby, 1994). Obviously, it also can be reflected from the case where the strategic option 1A has the highest NPV but strategic option 1C has the greatest IRR. According to Levy and Sarnat (1986), this is because IRR completely ignores the scale of investment, for instance, the initial outlay of 1A and 1C is 17.2 million and 5.2 million, respectively.
Furthermore, in this case, each option is mutually exclusive project, the conflict between NPV and IRR lead to a further discussed about it. The project with a higher NPV should be chosen which means company should select strategic option 1A because there is an intrinsic reinvestment assumption (Pike and Neale, 2009). Specifically, in the calculation, there is an assumption that the cash flow will be reinvested at the same discount rate while they are discounted. In the NPV calculation, the implicit assumption for reinvestment within ten years is 12.5%. The implicit reinvestment rate assumption of IRR is of 32.1%, 33.1% or 67.3% which are quite unrealistic compared to NPV. IRR of strategic option 1C is way higher than the other two make it more idealistic. This makes the NPV results superior to the IRR results.
In addition, the conflict results also occur because of the size and investment of the project. In three option (1A, 1B and 1C), the initial outlays are 17.2 million, 13.6 million and 5.2 million separately. Taking all corresponding NPV and IRR into account which can be concluded that a small project may have low NPV but higher IRR and larger project has the larger NPV. This theory support than strategic option 1A is better than strategic option 1C. When it comes to strategic option 1B, the NPV between strategic option 1A and strategic option 1B have a slightly different, however, since the units of figures are million which contribute a huge difference despite of 0.1 changes (Mclaney and Atrill, 2012).
To make the decision more convinced, here is another investment appraisal, profitability index (PI), calculate a percentage which represents the present value per pound of finance is obtained (Atrill, 2006). The equation is:
Profitability index=
Based on the formulation, here is a table which list the PI of each option and ranking it.
Table 15: Comparison and Ranking of NPV and PI
Strategic Option 1A

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Strategic Option 1B

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Strategic Option 1C

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Outlay

£17.2 m

£13.6 m

£5.2 m

NPV

£19.614m

£17.865 m

£12.095 m

PI

1.14

1.31

2.33

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Ranking by NPV

1

2

3

Ranking by PI

3

2

1

Table 15 still reflect a conflict between NPV and PI and the reason for this phenomenon is PI does not reflect differences in investment scale because it ignores the size of the project (Baker and Powell, 2005). According to Backer and Powell (2005), NPV measures the total present value of pound return while PI measures the present value of the return for each pound of initial investment. Specifically, strategic Option 1A with the higher positive NPV will generate more pounds to shareholder wealth than the larger PI. Due to the potential misleading may occurs by PI method for projects of differing size. Hence, NPV method is preferred because it always selects the project that will add the most value to the firm.
To sum up, after a solid consideration, unless the firm is experiencing severe capital rationing problems, strategic option 1A should be accepted.
(1,250 words)