the method of investment appraisal which may be applied to evaluated and rank potential investment opportunities and their relative merits and limitations

Table content
Introduction………………………………………………………………………………2
I-Analysis of the reasons behind takeovers and the methods by which such takeovers may
have take place together with the potential effects of a takeover……………………… 3
II- The method of investment appraisal which may be applied to evaluated and rank
potential investment opportunities and their relative merits and limitations…………… 7
1-Payback period………………………………………………………………………….7
2-Accounting rate of return……………………………………………………………….8
3-Net present value……………………………………………………………………… 9
4- Internal rate of return………………………………………………………………….10
III- The nature of gearing and the potential effects of high gearing on perceived risk and
cost of capital…………………………………………………………………………….12
IV- Conclusion………………………………………………………………………… 13
Appendix…………………………………………………………………………………14
Reference……………………………………………………………………………… 17
Word account: 3,625
1
Introdcution:
Jebb Plc wants to takeover a rival company in which they believe will be successful
in increasing the wealth of shareholders. Due to understanding of limited fund, managers
of Jebb PLC are going to raise money through increasing debts in order to acquire target’
firm. As a senior financial manager in Jebb PLC, I have to prepare a report to analysis
reasons behind takeovers and the methods by which such takeovers may take places
together with the potential effects of a takeover. Then, I will give four method of
investment appraisal to evaluated and rank potential investment opportunities and their
merits and limitation. Moreover, the nature of gearing and potential effected of high
gearing on perceived risk and cost of capital.
2
I-Analysis of the reasons behind takeovers and the methods by which such takeovers
may have take place together with the potential effects of a takeover.
‘Takeover’ is referring to transfer of control of a firm from one group of shareholders

to another group of shareholders. It is a change in the controlling interest of corporation,
either through a friendly acquisition or unfriendly, hostile, bid. A hostile takeover with
the aim of replacing current existing management is usually attempted through a public
tender offer. (asia.advfn.com)
Next following below I will give reasons for takeover company.
• Defensive. Some acquisitions take place because the buyer is itself the target of
another company, and simply wants to make itself less attractive through acquisition.
• Intellectual property includes patents, trademarks, production processes, and
databases. This is defensible knowledge base that gives a company a competitive
advantage, and is one of the best reasons to acquire a company.
• International alternative. A company may have an extremely difficult time creating
new products. And so looks elsewhere to find replacement products. This issue is
especially likely to trigger an acquisition of a company has just decided to cancel an
in-house development project, and needs a replacement immediately.
• Market growth. Buyer can not grow revenues quickly in a slow-growth market,
because there have few sales to be made. In contrast, a target company may be
suitable in a market that is growing faster than the buyer itself. Hence, the buyer can
see rapid growth when acquire target Company.
• Market share. In general, companies all look toward a high market share, because it
allows them to have advantage in price competitive. The acquisition of a large
competitor is a reasonable way to quickly attain significant market share.
• Production capacity. The buyer may have excess production capacity available, from
which it can readily manufacture the target’s products. Moreover, the target company
may have an excellent product that the buyer can use to fill a hold in its own product
line. This is an especially important reason when the market is expanding rapidly, and
the buyer does not have time to develop its product before others compete and take
over the market.
3
• Sales channels. A target company may have an effective sales channel that buyer
think can use to distribute its products. Besides, the target sales staff might be

effective so that it may be the prime reason for an acquisition offer.
• Vertical integration. This is use in security term. The buyer may want to secure its
supply lines by acquiring selected suppliers. It is important when supplier has to
control over a large proportion of demands. In addition to backward integration,
company can engage in forward integration by acquiring a distributor or customer.
This most commonly occurs with distributors, especially when they have good
relationship with customers (Accountingtool)
Thirdly, I will give some method to takeover the target’s company. There are 4 methods
to takeover a company: cash offers, share-for-share offers, mixed bids and security
package.
• Cash offers. Public offering of security issue to every interested investor, with or
without involving an underwriter. In contrast, a right issue is offered only to the
current stockholders. General cash offer is the most common method of selling debt
(bond) and equity (stock) issues. According to the SEC Rule 415 (1982), a large firm
can file a single new issue registration statement that is valid for two years. Within
this period the firm can make general cash offer as and when it wants.
(investorword.com)
Cash-offer attracts a target company shareholder because it provides shareholders
with significant, immediate and certain value for the buyer’s existing assets, as well as its
future growth potential. Besides, cash-offer adjusts company’s portfolios, its operation
and development capabilities and strong balance sheet. (transalta.com)
Advantage of using cash-offer is that company can determine the outcome. However, its
disadvantage that cash offer to acquire target’s company may insufficient and in case
company borrows money from bank, the interest rate changes must be considered.
• Share-for-share offers. Takeover bid in which the acquiring firm offers its shares for
an equal number of shares in the target firm. It accepted. Shareholders of the both
pre-merger firms become owners of the resulting firm (Businessdictionary.com)
A shareholder must take an offer when its shareholding, including that of parties acting
reaches 30% of the target. Information relating to the bid must not be released except by
4

announcements regulated by the Code. The bidder must make an announcement if rumor
speculation has affected a company’s share price. If shares are bought during the offer
period at a price higher than the offer price, the offer must be increased to that price.
(Business&Financemarket.)
• Mixed bids are where share for share offer is supported by a cash alternative. This
method is being acceptable to company’s targeted shareholder.
• Security packages. Projects involve risks for all parties. The ability of the parties to
agree on how risks will be shared is often the key to initiating a successful project. In
order to reduce the risk particularly for all parties, a security package is established
through the various agreements, contractors, undertaking and the guarantees. Buyer
looks to the security package agreement in order to provide security for money the
investment and target’s company assets. There preparation of the key agreement must
be coordinated in order to avoid conflicts and provision of interlocking among these
agreements should be made.(assessmylibrary.com)
Fourthly, I will analysis and explain impacts that effect when Jebb PLC takeover rivals.
When a company wants to takeover a target firm, there are some influences affect
management, employees, financial, stockholder and economy of scale.
• Management. When a change in company control takeover often the corporation who
becomes in charge often prefers to bring in their own staff members to assimilate and
become the decision makers of their newly acquired business. As a result of the
acquisition the original management may be dismissed or given notice. In case, the
current management is allowed to stay there is a good possibility things may not
continue per the norm and managers may find themselves having to adjust to new
policies, practices and an overall different way of doing things; the transition that
occurs with a change of control can be difficult.(helium.com)
• Employees. They are people who also go through a lot when takeover occurs. With a
shift of control/ownership comes lots of organizational change, sometimes new
bosses, loss of job and an over attitude of ‘out with the old. In with the new’.
Sometimes the change entails letting easy on everyone. Other times the new
corporation maintains some employees for good or to train their own people.

5
Whatever the decision on employees, this can have a serious impact on employee
morale. (helium.com)
• Financial. Ansof (1971) found that after an acquisition, low sales growth companies
showed significantly higher rates of growth, whereas, high sales growth companies
showed lower rates of growth. However, even though low sales growth companies
showed higher rates of growth after acquisitions, they actually suffered decreases in
their mean P/E ratios, mean EPS and mean dividend payouts. The similar pattern of
inconsistency found in the high sales growth companies whereby their performance
levels for EPS, PE ratio, earning and dividend payouts were greater. Low sales
growth companies financed their acquisitions through decreased dividend payouts
and the use of new debts. In contrast, high sales growth companies with other
strategies tended to decrease debts but increase dividend payouts. (international
business and management)
• Stockholders have such a vested financial stake in the corporations they own stock in
that a takeover affection. The company may falter or thrive and either way this affects
the bottom line of their investment.
• Economy of scale. According to Ansof (1971), acquisitions were in general
unprofitable, as they did not contribute to increase in all of the variables of
companies’ growth. However, follow Ajit Singh, after a two-year period of takeover,
there was deterioration in relative profitability record. He added that as in relation to
EPS, the biggest potential losers are shareholders in biding companies who were
sacrificing profits for future growth. Those acquiring firms could have maintained
their profitability records if they were not involved in takeovers and large companies
tended to engage in higher gearing and this led to higher retention ratio and
eventually higher growth is attained. (international business and management)
6
II- The method of investment appraisal which may be applied to evaluated and rank
potential investment opportunities and their relative merits and limitations.
In this report, I will give 4 methods to evaluate and rank potential investment

opportunities. They are: payback period, ARR, NPV, and IRR
1-Payback period (PP)
The payback method focuses on the payback period. The payback period is the length of
time that it takes for a project to recoup its initial cost out of the cash receipts that it
generates. This period is sometimes referred to as ‘the time that it takes for an investment
to pay for itself’. The basic premise of the payback method is that the more quickly the
cost of an investment can be recovered, the more desirable is the investment. The
payback period is expressed in years. When the net annual cash inflow is the same every
year, the following formula can be used to calculate the payback period.
(accountingformanagement.com)
*Formula:
Payback period = Cash outlay (investment)/ annual cash inflow
• Merit
It is very easy to calculate and allow managers and stakeholders an easy understanding
when the initial investment will be recouped. This allows information to decision making
based on simple cutoff date rules. It recommends to quick return of the invested fund so
that may be put to use in other places or in meeting other needs. Besides, it is easy to
apply. (nettle@Africa)
• Limitation
When PP’ merit is easy to calculate but its limitation is also can lead to wrong decision.
Discounted cash flow should be the preferred way to evaluate payback since it does
recognize the time value of money. This is cash in the future is not worth as much as cash
today. PP also ignores all cash flow that occurs after the payback period is reached or in
other word, PP does not consider post-payback cash flows and time value of money. In
addition, it does not explicitly consider risk. (nettle@Africa)
Evaluation the PP. it is not a true measure of the profitability of an investment. Rather, it
simply tells the manager how many years will be required to recover the original
7
investment. Unfortunately, a shorter payback period does not always mean that one
investment is more desirable than other.

2- Accounting rate of return (ARR)
‘The rate of return on an investment that is calculated by taking the total cash inflow
over the life of the investment and dividing it by the number of years in the life of the
investment. The ARR does not guarantee that the cash inflows are the same in a given
year. It simply guarantees that the return averages out to the average of return’.
(thefreedictionary.com)
ARR uses the data from the income statement. This is a non-discounting cash flow
project appraisal model. This is computed by using the following formulas:
ARR = Average net profit / Average Annual Investment
Or
ARR = − (Increase in expected average operating income/ Initial increase in investment)
ARR is related with conventional accounting models of calculating income and required
investment. It shows the effect of an investment on project’s financial statement.
• Merits:
It is simple to calculate using accounting data. ARR formula is easy to apply and familiar
concept to managers which they refer to as ‘returns on investment’ or ‘return on capital
employed’. ARR helps manager to calculate earning of each year which includes the
profitability of the project.
• Limitations:
It is no account of time value of money like PP, i.e. company expected future dollars are
erroneously regarded as equal to present dollars. ARR is inconsistency with wealth
maximization as the objective of the firm. It uses the accounting data it includes the
amount of accruals in accounting the earnings ‘net profit’. Moreover, it can be
manipulated by changing accounting method like depreciation rates and methods which
have nothing to do with the underlying investment.
3- Net present value (NPV)
Definition: it is the method of evaluating project that recognizes that the dollar received
immediately is preferable to a dollar received at some future date. It discounts the cash
flow to take into the account the time value of money.
8

This approach finds the present value (PV) of expected net cash flows of an investment,
discount at cost of capital and subtract from it the initial cash outlay of the project. In
case the PV is positive, the project will be accepted. If it is negative, it should be rejected.
When the projects under consideration are mutually exclusive, the one with the highest
NPV should be chosen. The next following I will show the NPV formula.
(source:netel@africa)
• Merits:
NPV’s method measure directly the dollar contribution to the stockholders. It recognizes
the risk associated with future cash flow. NPV consistent with shareholder wealth
maximization: added NPV generated by investments are represented in higher stock
prices. Besides, NPV consider both magnitude and timing of cash flows. Moreover, it
indicates whether a proposed project wills yield the investor’s required rate of return.
9
• Limitation:
Many people find it difficult to work with a dollar return rather than a percentage return
4- Internal rate of return: (IRR)
Definition: IRR is the investor’s required rate of return which equates the Initial Costt
outlay with the present value of series of expected cash flows.
• Merits
It considers both the magnitude and the timing of cash flows.
• Limitations
It does not distinguish between a lending (investing) or borrowing (borrow and invest)
situation, whereas the NPV clearly points out the negative aspects of the borrowing
strategy. IRR can affect the scale (size) of business.
There has conflict between NPV and IRR method (possible decision conflicts). An
accept/reject ‘conflict’ occurs when NPV says ‘accept’ and IRR says ‘reject’ or NPV
says ‘ reject’ and IRR says ‘accept’. When projects are independent, there is no accept or
reject conflict arise. A raking conflict occurs when one project has a higher NPV than
another while the lower NPV project has a higher IRR. Ranking conflict is usual but can
occur. These conflicts are relevant only when there are multiple acceptable mutually

exclusive projects. The ranking conflicts arise because of: timing differences in
incremental cash flows and magnitude differences in incremental cash flow. When a
conflict arise among mutually exclusive project, it would be better to pick the one with
the highest NPV.
Company A Company B Company C
PP 4.38 years 3 years 2.96 years
ARR 6% 12% 18%
NPV -$20,950 @ 10% $57,500. @ 10% $103,250 @ 10%
IRR 12.05% 18.46% 21.86%
The table above shows the result of PP, ARR, NPV and IRR. The 4 method has it
own strength and weakness. Looking at the PP’s result, the shortest time for the company
to payback its investment is C which PP is lowest in the three-project. ARR of company
A is lowest of 6% compare to project B, 12% and project C, 18%. The NPV of company
A also is the lowest with - $ 20,950 at 10%. The highest NPV is company C is $103,250
10
at 10% and the second one is company B with NPV of $ 57,500. IRR of company C is
the highest of 21.86 %, then the second higher is company B with IRR of 18.46% and the
lowest has 12.95 %.
Each project has it own attraction. However, while analyzing data, it usually has
conflict. A raking conflict occurs when one project has a higher NPV than another while
the lower NPV project has a higher IRR.
Based on the information analysis above, we know how to calculate the four-method.
Hence, the most suitable method is NPV, then the second one is IRR, third one is PP and
ARR is the last one. It seems that most suitable method which is the more accurate
measure of telling which project is a good investment and which one is better is NPV
method. There are 3 main reasons:
• NPV measures project value more directly than IRR because NPV actually calculates
the project’s value. In this case it has more than one project lined up, then manager
can simply add the values together to get a total.
• NPV assumes that project cash flows are reinvested at the company’s required rate of

return, IRR assumes that they are reinvested at the IRR. Since IRR is higher than the
required rate of return, in order for the IRR to be accurate, the company would have
to keep finding projects that would reinvest the cash flow at this higher rate. It would
be difficult for a company to keep this up forever, thus NPV is more accurate.
• PP and ARR ignored the time value of money and it will lead to wrong decision in
long-term. During the life of project, cash flow must be reinvested to cover
depreciation. This will give a negative cash flow for that period, thus leading to more
than one IRR. If there is more than one IRR, calculating only 1 IRR for the project is
not reliable. NPV must be used for this type of project.
III- The nature of gearing and the potential effects of high gearing on perceived risk
and cost of capital.
11
There are some ways to increase company fund:
• Bank
Company can raise funds by taking out a loan from bank. Some banks are more flexible
in their loan requirements than other. Generally, banks prefer property to inventory. It is
important to submit copies of company previous tax return, as well as details of the new
projects that company wants financing for. If company’s taxation returns indicate that it
made a healthy profit in previous years, it will be easier to secure a loan, since banks also
look at company ability to pay back the loan then considering its application.
• Venture Capital
In case company can not get funds from bank, then it should try sourcing funds from
venture capitalists. To get venture capitalist funding, company will have to convince
them that they are making the right choice by funding company project. The problem is
that they might become part-owner of the project. Once company starts earning money
from its project, it is good idea to pay back the money as soon as possible and exist from
venture capitalist agreement.
• Friends and relatives.
A good relationship help company can lend money from friends or relative. It may be
viable option and you will still have to pay interest rate on the loan amount. However, it

may not be wise to mix business with personal life. Hence, be careful and make sure
terms are clear and documented before proceeding with borrowing from friends and
relatives.
• Bonds and debentures.
Bonds are debt security which is issued by the authorized issuer to the masses. They
generally have a fix term of maturity, which is more than 10 years. The company has
authority to give limited powers to the bond holders with respect voting rights,
information related to company,etc.
Debenture are long term debt instrument used by large companies and governments to
raise finance from the generate people. Debentures are different from bonds because of
securitization conditions. They are usually unsecured debt instruments. If the company
gets liquidated, the debenture holders would be considered at par with general creditors.
Debenture can be pledged against the amount received, only if state in the terms and
12
conditions of the issue. Debentures are freely transferable instruments.
(firewordzone.com)
• New share issues, for example, by companies acquiring a stock market listing for the
first time
• Rights issues: Loan stock; Retained earnings, etc.
Jebb plc understands that to carry out any of the proposed projects will require them
to raise a substantial amount of money through increased debt and this will increase the
gearing of Jebb plc to a high level
Gearing ratio is a term describe a financial ratio that compare some form of owner’s
equity (or capital) to borrowed funds, Gearing is a measure of financial leverages,
demonstrating the degree to which a firm’s activities are fund by owner’s funds versus
creditor’s funds. (accoutingformanagement.com)
There are three effects arising directly from an increase in corporate gearing. Two of
these, the advantage of debt being ‘cheaper’ than equity and the disadvantage of the cost
of equity rising because of increase financial risk, exactly offset each other. This leaves
one net advantages: the tax relief on debt interest. Behind the use of WACC (the average

of the costs of these sources of financing) as the NPV discount rate is the assumption of
an unchanging capital structure. In using the WACC, the net advantage of debt capital is
taken into account by using the after-tax cost of debt capital.
Gearing ratio measures the percentage of capital employed that is financed by debt
and long-term finance. The higher level of gearing leads the higher lever of financial risk
due to increase volatility of profit. Capital gearing ratio is important to the company and
the prospective investors, it must be carefully planned as it affects the company’s
capacity to maintain a uniform dividend policy during difficult trading periods. It reveals
the suitability of company’s capitalization. (bizcovery.com)
IV-Conclusion:
In conclusion, following the information above, acquiring is not always good for
company. However, by knowing its situation of weakness, Jebb has prepared for its own
consider the risks. Company is now ready to takeover target’firm
Appendix
Investment: $ 250,000,000
13
Cost of capital = 10% calculating unit: USD’000
Net cash flow:
Year Company A Company B Company C
0 ($ 250,000) ($250,000) ($250,000)
1 $ 35,000 $ 100,000 $ 65,000
2 $ 20,000 $ 50,000 $ 70,000
3 $ 60,000 $ 100,000 $ 120,000
4 $ 90,000 $ 50,000 $ 80,000
5 $ 120,000 $ 100,000 $ 140,000
a) Payback period (PP)
Payback period of project A = 4 years +
000,120
000,205$000,250$ −
= 4.38 years

Payback period of project B = 3 years.
Looking at the table above, after 3 years the company’s cash = $100,000+$50,000+
$100,000=$250,000. Then, after 3 years company can pay-back its investment.
Payback period of project C = 2 years +
000,120$
000,135$000,250$ −
= 2.96 years
b) Accounting rate of return (ARR)
ARR (A) =
%6%100
000,250$
5
000,120$000,90$000,60$000,20$000,35$
=∗
++++
ARR (B) =
%12%100
000,250$
5
000,100$000,50$000,100$000,50$000,100$
=∗
++++
14
ARR (C) =
%18%100
000,250$
5
000,140$000,80$000,120$000,70$000,65$
=∗
++++

c) Net present value (NPV) cost of capital = 10%
NPV (A) = ($35,000*0.91 + $20,000*0.83+ $60,000*0.75 + $90,000*0.68 +
$120,000*0.62) – $250,000 = -$20,950.
NPV (B) = ($100,000*0.91 + $50,000*0.83 + $100,000*0.75 + $50,000*0.68 +
$100,000*0.62) - $250,000 = $57,500.
NPV (C) = ($65,000*0.91 + $70,000*0.83 + $120,000*0.75 + $80,000*0.68 +
$140,000*0.62) – $250,000 = $103,250.
d) Internal rate of return (IRR)
Company A Company B Company C
Year Cash flow PV rate
@ 20%
PV per
year
Cash flow PV rate
@ 20%
PV per
year
Cash flow PV rate
@ 20%
PV per
year
USD’000 USD’000 USD’000 USD’000 USD’000 USD’000
0 (250,000) 1.00 (250,000) (250,000) 1.000 (250,000) (250,000) 1.000 (250,000)
1 35,000 0.83 29,050 100,000 0.83 83,000 65,000 0.83 53,900
2 20,000 0.69 13,800 50,000 0.69 34,000 70,000 0.69 48,300
3 60,000 0.58 34,800 100,000 0.58 58,000 120,000 0.58 69,600
4 90,000 0.48 43,200 50,000 0.48 24,000 80,000 0.48 38,400
5 120,000 0.40 48,000 100,000 0.40 40,000 140,000 0.40 56,000
NPV (81,150) (10,500) 16,200
15

IRR (A) =10%+
%05.12
150,81$950,20$
%)10%20(*250,20$
=
−−
−−
IRR (B) = 10% +
%46.18
)500,10500,57($
%)10%20(*500,57$
=
+
−−
IRR (C) = 10% +
%86.21
)200,16$250,103($
%)10%20(*250,103$
=
−
−
Reference:
Accounting tool, assessed 8 April 2010,< />words_term_4868_takeover.html assessed 7 April 2010>
[Internet], assessed 8 April 2010,
<
[Internet], assessed 8 April 2010
< >
16
[Internet], assessed 8 April 2010, < />releases/2009-07-20/transalta-proposes-all-cash-offer-acquire-canadian-hydro-
developer>

[Internet], assessed 8 April 2010, < />for-share-offer.html>
[Internet], assessed 8 April, 2010
[Internet], assessed 8 April 2010,< />19769155/security-package-ipps-international.html>
[Internet], assessed 9
April,< >
[Internet], assessed 9 April,
2010,< />ng_decisions.htm>
Project Evaluation and Selection Analysis Techniques, assessed 9 April, 2010
< >
[Internet], assessed 9 April 2010, < />[Internet], assessed 9 April, < />[Internet], assessed 9 April,
< >
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