ASSIGNMENT

You are required to provide an evaluation of two proposed projects, both with five
year expected lives and identical initial outlays of £125,000. Both projects involve
additions to AP Ltd.’s highly successful product range and as a result, the cost of
capital on both projects has been set at 12%. The expected cash flows from each
project are shown below.

Table 1: EXPECTED CASH FLOWS

YEAR PROJECT A PROJECT B

(£000) (£000)
0 125 125
1 22 43
2 31 43
3 43 43
4 52 43
5 71 43

In evaluating the projects please respond to the following questions:

(a) Investment appraisal should add value to the business entity. Do you agree?

Capital budgetary (or investment appraisal) is the planning process used to determine
whether a firm's long term investments such as new machinery, replacement machinery,
new plants, new products, and research development projects are worth pursuing. It is
budget for major capital, or investment, expenditures.

The efficient allocation of capital resources is a most crucial function of an organisation.

This function involves organization’s decision to invest its resources in long-term assets
like land, building facilities, equipment, vehicles, etc. All these assets are extremely
important to the firm because, in general, all the organizational profits are derived from
the use of its capital in investment in assets which represent a very large commitment of
financial resources, and these funds usually remain invested over a long period of time.
The future development of a firm hinges on the capital investment projects, the
replacement of existing capital assets, and/or the decision to abandon previously accepted
undertakings which turns out to be less attractive to the organization than was originally
thought, and divesting the resources to the contemplation of new ideas and planning. For
new projects such as investment decisions of a firm fall within the definition of capital
budgeting or capital expenditure decisions.

So, we can say that investment appraisal should be made in such a manner that it adds
value to the business otherwise the very existence of the firm is put into question.

(b) What is the payback period of each project? If AP Ltd imposes a 3 year
maximum payback period which of these projects should be accepted?

CALCULATION OF PBP
YEAR PROJECT A PROJECT B
(£000) (£000)
0 125 125
1 22 43
2 31 43
3 43 43
4 52 43
5 71 43

PAYBACK PERIOD OF PROJECT A

YEAR NET CASH FLOW CUMULATIVE NET CASH

(£000) FLOW
(£000)
1 22 22
2 31 53
3 43 96
4 52 148
5 71 219

Payback = 3 + [(125 ¬ 96) / 52]

= 3 + (29 / 52)
 = 3.6 years = 3 years 7 months

PAYBACK PERIOD OF PROJECT B

Payback = INITIAL OUTLAY / CASH FLOW

= 125,000 / 43,000
= 2.91 years = 2 years 10 months

Here in Project B initial investment recover in 2 years and 10 months whereas Project A
takes 3 years and 7 months. If AP Ltd imposes a three year maximum payback period
then Project B should be accepted.

(c) What are the criticisms of the payback period?

The main limitations of pay back method are:

• This method does not take into consideration the cash inflows beyond the
payback period.
• It does not take into consideration the time value of money. It considers the same
amount received in the second year and third year as equal.
• It gives over emphasis of liquidity.
• It ignores cost of capital

(d) Determine the NPV for each of these projects? Should they be accepted –
explain why?

CALCULATION OF NPV
Here the required rate of return on both projects has been set at 12%. For both Projects
discount rate is @12%. We use this discount rate and we find NPV. Initial cost £125,000
is given

NPV FOR PROJECT A

 YEAR NET CASH FLOW DISCOUNT RATE PRESENT VALUE
(£000) @ 12% (£000)
1 22 0.893 19.65
2 31 0.797 24.71
3 43 0.712 30.62
4 52 0.636 33.07
5 71 0.567 40.26

Total Present Value = £ 148,298

Net Present Value (NPV) = Total Present value - Initial Cost.

= 148,298 – 125,000

= £ 23,298

Therefore,
NPV @ Discount Rate 12% = £ 23,298

NPV FOR PROJECT B

In Project B Net Cash Flow is same for every year so use Annuity table

NPV @ interest rate 12% for 5 years = 3.605

Total Present Value = (Net Cash Flow) × interest rate

= £ 43,000 × 3.605

= £ 155,015

Net Present Value (NPV) = 155,015-125,000

= £ 30,015

NPV @ Discount Rate 12% = £ 30,015

Both Projects have positive NPV so both are accepted. But Project B will probably be
chosen in preference to project A because it has a higher NPV.

(e) Describe the logic behind the NPV approach

The net present value (NPV) or net present worth of a time series of cash flows, both
incoming and outgoing, is defined as the sum of the present values (PVs) of the
individual cash flows. In case when all future cash flows are incoming (such as coupons
and principal of a bond) and the only outflow of cash is the purchase price, the NPV is
simply the PV of future cash flows minus the purchase price (which is its own PV). NPV
is a central tool in discounted cash flow (DCF) analysis, and is a standard method for
using the time value of money to appraise long-term projects.

The net present value method (NPV) gives consideration to the time value of money. It
views that the cash flows of different years differ in value and they become comparable
only when the present equivalent value of these cash flows of different periods are
ascertained. For this the net cash inflows of various periods are discounted using the
required rate of return, which is a pre determined rate. Scrap value is also considered as
cash inflow at the end of the life of the project. If the present value of expected cash
inflows exceeds the initial cost of the project, the project is accepted. If there are two
project proposals, the project with the higher net present value will be selected.

(f) What would happen to the NPV if:

(1) The cost of capital increased?
(2) The cost of capital decreased?

If the Cost of Capital is increased then it will have a negative effect on Net Present Value
i.e. NPV will decrease.
On the other hand if the cost of capital is decreased then the Net Present value will
automatically increase.

(g) Determine the IRR for each project. Should they be accepted?
CALCULATION OF IRR
First step is to select two discount factors and then calculate the NPV of the project using
both factors.

IRR FOR PEOJECT A

YEAR NET CASH DISCOUNT PRESENT DISCOUNT PRESENT

FLOW RATE @ 15% VALUE RATE @ 20% VALUE
(£000) (£000) (£000)
1 22 0.870 19.14 0.833 18.33
2 31 0.756 23.44 0.694 21.51
3 43 0.658 28.29 0.579 24.90
4 52 0.572 29.74 0.482 25.06
5 71 0.497 35.29 0.402 28.54

Total Present Value @ Discount rate 15 % = £ 135,901.

Net Present Value (NPV) = 135,901-125,000

= £ 10,901

Total Present Value @ Discount rate 20 % = £ 118,343.

Net Present Value (NPV) = 118,343 -125,000

= £ (6,657)

INTERNAL RATE OF RETURN (IRR)

= Positive rate + [{Positive NPV÷ (positive NPV+ negative NPV*)} × range of rates]

= 15% + [{10,901÷ (10,901+6,657)} × (20%-15%)]

= 15% + 3.104 %

= 18.104%

Therefore,
IIR for Project A= 18.104%

* = Negative sign neglect.

IRR FOR PROJECT B

YEAR NET CASH DISCOUNT PRESENT DISCOUNT PRESENT

FLOW RATE @ 20% VALUE RATE @ 24% VALUE
(£000) (£000) (£000)
1 43 0.833 35.82 0.806 34.66
2 43 0.694 29.84 0.650 27.95
3 43 0.579 24.90 0.524 22.53
4 43 0.482 20.73 0.423 18.19
5 43 0.402 17.29 0.341 14.66

Total Present Value @ Discount rate 20 % = £ 128,570.

Net Present Value (NPV) = 128,570 -125,000

= £ 3,570

Total Present Value @ Discount rate 25% = £ 117,992.

Net Present Value (NPV) = 117,992-125,000

= £ (7,008)

INTERNAL RATE OF RETURN (IRR)

= Positive rate + [{Positive NPV÷ (positive NPV+ negative NPV*)} × range of rates]

= 20% + [{3,570÷ (3,570+7,008)} × (24%-20%)]

= 20% + 1.350%

= 21.350%

Therefore,
IIR for Project B= 21.350%

* = Negative sign neglect.

Here both projects IRR > cost of capital so both projects are accepted. If here we take
ranking decision then project B’s IRR > project A’s IRR. At that type Project B is more
acceptable than project A.
(h) How does a change in the cost of capital affect the project’s IRR?

Traditional cash flow analysis (payback) and the accounting rate of return (ROI) fail to
consider the time value of money. The internal rate of return (IRR) considers the time
value of money and is frequently referred to as the time adjusted rate of return. The IRR
is defined as the discount rate that makes the present value of the cash inflows equal to
the present value of the cash outflows in a capital budgeting analysis, where all future
cash flows are discounted to determine their present values. The relationships are
presented below. The cost of capital represents the minimum desired rate of return (i.e., a
weighted average cost of debt and equity capital).

If IRR<Cost of Capital then, reject the investment from the cash flow perspective.

If IRR = Cost of Capital then, the project provides the minimum return. Probably reject
the cash flow perspective.

If IRR > Cost of Capital then, screen in for further analysis. Other investments may
provide better returns and capital should be rationed.

(i) Compare the effectiveness of the NPV method with that of the IRR method

In IRR calculation, the implied interest rate of reinvestment of cash flows is IRR itself. In
NPV calculation, it is the discount rate. Which of the two methods is correct depends on
the choice of what is a more realistic rate of reinvestment of cash flows: IRR or discount
rate. Most often the reinvestment opportunities that a company has are those that can earn
its weighted average cost of capital, because it is what its projects earn on average.
Relying on an assumption of weight average cost of capital as the reinvestment
opportunity is also more conservative. Thus, NPV is most often the safest basis for
decision.

But that may not be always the case. For instance, choosing projects that have positive
NPV implies that they earn a higher return than risk adjusted cost of capital. This implies
that we expect opportunities for reinvestment of cash flows at higher rates. Higher rates
of return can also be required when future inflation is anticipated. To investigate the
impact of cash flow reinvestment opportunity, advanced textbooks in financial
management recommend calculating an adjusted NPV and an adjusted IRR. These are
obtained by first calculating a terminal value which is the future value of cash flows
compounded at the opportunity rate of reinvestment. Then the terminal value is
discounted to the present using the weighted average cost of capital.

All other things being equal, using internal rate of return (IRR) and net present value
(NPV) measurements to evaluate projects often results in the same findings. However,
there are a number of projects for which using IRR is not as effective as using NPV to
discount cash flows. IRR's major limitation is also its greatest strength: it uses one single
discount rate to evaluate every investment.

Although using one discount rate simplifies matters, there are a number of situations that
cause problems for IRR. If an analyst is evaluating two projects, both of which share a
common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR
will probably work. The catch is that discount rates usually change substantially over
time

REFERANCES

Principles of Business Decisions, Dr. P.C. Thomas

http://forex-management-online.blogspot.com/2009/04/what-is-capital-budgeting.html

www.wikipedia.com

http://maaw.info/IRRNPVandCostofCapital.htm
http://www.peoi.org/Courses/finanal/ch/ch10e5.html
http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp