The Concept of Net Present Value Method - Essay Example

1. Methodology The analysis has been performed using Net Present Value (NPV) method. In this method, the Net Present Value of cash flows for each period is calculated. If this value comes out as positive, it makes business sense to go for the project or the plan. In this method, all the sources of income are listed down which are basically the cash inflows for the company/boutique. Similarly all costs or expenditures are listed down which are cash outflows (negative cash flows) for the boutique. Subtracting the cash outflows from cash inflows gives the net cash flows for a quarter (Johnson, Derek). The cash flow for a particular period reflects the flow of cash in future for that period. But due to a loss in the time value of money, the present value of the cash flow is actually less than the actual value. To have a realistic view of the cash flows the actual values need to be converted into what are called as the Present Values. The factor by which the actual value is multiplied to calculate the present value is called the Discount Factor. Discount factor lies between 0 and 1. It is determined by the rate of return on capital during a given period and can be calculated using compounding (Johnson, Derek). 2. Initial Conclusion Using the net present value approach, it can be found out that the net cash flows are positive in all quarters and the initial investment is also recovered within a quarter. The Net present value is hence positive and comes out as £5,030,687. The NPV (Net Figure 2.1: NPV and Net Cash Flow Analysis Present value) calculations can be done using an excel spread sheet. An extract of the same is shown in Figure 2.1. Thus, it can be concluded from this that, the boutique must go with the development plan. 3. Sensitivity Analysis There are several key factors that can affect the cash flows. One of them is the Build-up factor. If the build-up factor becomes negative i.e. there is a decrease in income in the following quarters due to some reason, the NPV decreases. The NPV turns negative at -57% build-up factor for each quarter as shown in Figure 3.1. This is where the decision gets reversed. This could happen in case of adverse external circumstances. The second factor which can affect cash flow is Cost of Sales. If due to an increase in raw material costs or due to some other factors, Cost of Sales rise as much as 89% of the sales, the NPV becomes negative and the decision has to be reversed. This is shown in Figure 3.2. Thirdly, the increase in rent can have an impact on net cash flows especially in wake of continuously rising real estate prices. If the rent increases to £1427 per sq. m., the NPV becomes negative as shown in Figure 3.3 and the decision will be reversed. This has a fairly good likelihood of occurring. Similarly, if the number of takings per hour reduces from 2.5 to .66, the NPV turns negative as shown in Figure 3.4. This reduction may be due to more demanding work in the future or less efficiency of workers than what was initially expected. The probability of this happening is quite low. Figure 3.1: Sensitivity Analysis for Build-up factor Figure 3.2: Sensitivity Analysis for Cost of Sales Figure 3.3: Sensitivity Analysis for Rent Figure 3.4: Sensitivity Analysis for Takings 4. Market Intelligence Market research of designer clothing market reveals that the inputs used for analysis by Bristol are fairly consistent. However, the company has not considered the impact of competition and the importance of brand-building on its business. Designer clothing has a niche market and is not affordable by all. Therefore, any false step in the beginning may be a recipe for disaster. The risk factor for the same has not been taken into account for NPV analysis. 5. Final Conclusion From all the facts stated, the sensitivity analysis and the market intelligence, it can be said that the Net Present value analysis is quite exaggerated and the actual cash flows may be significantly lower than that projected by NPV analysis. Having said that, unless Bristol goofs up big time in its marketing and manufacturing or there are some extremely adverse environmental conditions, the development plan would reap sizeable benefits for the company. Therefore, it is recommended that Bristol goes with the development plan. 6. References Johnson, Derek. NPV analysis and applications for Competitive intelligence. Aurora WDC. Competitive Intelligence Magazine Read More