Perils of the Internal Rate of Return - Essay Example

PART There are two common measures applied in investment evaluation and which include International Rate ofReturn (IRR) and Net Present Value (NPV). The assumption under both measures is that the higher it is the better. Projects with bigger IRR are taken to be more profitable. This is not always the case, though. NPV on the other hand is the total amount of incomes present value. All the amounts to be received or expended in future are discounted. It simply shows the opportunity cost of not carrying out the project. For projects that are considered as mutually exclusive, that project that reflects the higher NPV, which has been applied in this case is the most appropriate to pick. The assumption under NPV is that cash inflows after every period are usually reinvested. It calculates the absolute proportionality of two projects. (Heitger, 2007 p525) Therefore, it is going to be applied in this study. Managers are in a position to make an evaluation of a project cash flow. One of the renown methods of projects’ analysis and choice is NPV; NPV= Present Value cash inflows – Present Value cash outflows. If the result is positive, then it gives a go ahead to take up the project. (Harvey, 1995) In this case presented below, there is no project with a positive NPV and thus rationality call for the avoidance of both. However, if the company has to undertake a project, then it should undertake Titan project since it has the higher NPV. Figure 1: PROJECT TITAN PROJECT TITAN Year 0 1 2 3 4 5 6 EXPENSES initial costs 48000000 0 0 0 0 0 0 infrastructure costs 15000000 0 0 0 0 0 0 depreciation equipment 0 7200000 7200000 7200000 7200000 7200000 7200000 working capital 0 5500000 6050000 6655000 7320500 8052550 8857805 operation expenses 0 16000000 17120000 18318400 19600688 20972736 22440828 Royalties 0 0 2200000 2464000 2759680 3090842 3461743 interest on loan 0 4178351 3572568 2908313 2179941 1381263 505494 TOTAL OUTFLOWS 63000000 32878351 36142568 37545713 39060809 40697391 42465870 REVENUES 0 0 44000000 49280000 55193600 61816832 69234852 NET CASH INFLOWS BEFORE TAX 63000000 32878351 7857432 11734287 16132791 21119441 26768982 TAX ON NET REVENUE 0 0 2357230 3520286 4839837 6335832 8030695 NET CASH INFLOWS -63000000 -32878351 5500202 8214001 11292954 14783609 18738287 PRESENT VALUE (17%) 1 0.8547 0.7305 0.6244 0.5337 0.4561 0.3898 -63000000 -28101126.6 4017897.561 5128822.224 6027049.55 6742804.065 7304184.273 NPV= -61880368.93 PROJECT OLYMPUS PROJECT OLYMPUS YEAR 0 1 2 3 4 5 6 7 8 EXPENSES initial costs 66000000 0 0 0 0 0 0 0 0 infrastracture costs 20000000 0 0 0 0 0 0 0 0 depreciation equipment 0 9900000 9900000 9900000 9900000 9900000 9900000 6600000 0 working capital 0 14000000 12880000 11849600 10901632 10029501 9227141 8488970 7809852 operation expenses 0 31000000 32240000 33529600 34870784 36265615 37716240 39224890 40793885 Royalties 0 0 2725000 3079250 3479553 3931894 4403722 4976205 5623112 interest on loan 0 5668303 5116727 4513708 3854450 3133706 2345743 1484291 542497 Lease costs 0 3000000 3000000 3000000 3000000 3000000 3000000 3000000 3000000 TOTAL OUTFLOWS 86000000 63568303 65861727 65872158 66006419 66260716 66592846 63774356 57769346 REVENUES 0 0 54500000 61585000 69591050 78637887 88074433 99524109 112462243 NET CASH INFLOWS BEFORE TAX -86000000 63568303 -11361727 -4287158 3584631 12377171 21481587 35749753 54692897 TAX ON NET REVENUE 0 0 0 0 1075389.3 3713151.3 6444476.1 10724925.9 16407869.1 NET CASH INFLOWS -86000000 -63568303 -11361727 -4287158 2509241.7 8664019.7 15037110.9 25024827.1 38285027.9 PRESENT VALUE (17%) 1 0.8547 0.7305 0.6244 0.5337 0.4561 0.3898 0.3332 0.2848 -86000000 -54331828.57 -8299741.574 -2676901.455 1339182.295 3951659.385 5861465.829 8338272.39 10903575.95 NPV= -118237414.3 PART 2 Beta shows the relationship existing between the premium rate of the market and a firm’s rate of return. Beta is the value reflecting the slope when these two components mentioned are graphed. The process of finding beta is to be explained as follows: (note that what is needed is the required return rate, risk free rate as well as the premium rate of the market) The procedure is as below:- 1. Ensure that each of the three components percentage is obtained. Then, determine their decimal points. For example; if the risk free rate is 6%, then the decimal is 0.06. 2. Apply the decimals from procedure 1 into the CAPM model (Capital Asset Pricing Model). Its formula is, Required rate of return = Rf +(?*Rm) Where; Rf = Risk free rate of return Rm = Risk premium of the market ? = Relationship between market premium rate and the firm’s rate of return 3. Minus the Rf rate of return from both sides of the equation 4. Divide both of the equation’s sides by Rm (Hessong, 2011) The proxy company to be used in this case is ICON ENERGY LTD. This company is listed in the Australian stock exchange. The data from the company is going to be applied in the determination of the levered beta. Figure 2: Market interest rate Premium Year Debt/Equity Ratio Weighted Average Risk in %(Rm) 2005 2/100 7.95 2006 0/1 7.95 2007 0/1 8.10 2008 0/1 9.76 2009 6/100 10.49 (iconenergy.com, 2011) Figure 3: Risk free rate of interest Year Risk free rate %(Rf) 2005 5.25 2006 5.5 2007 6.25 2008 6.75 2009 4.25 (tradingeconomics.com, 2011) Figure 4: Computation of average and Beta amounts Year Required rate of return(R) Rf Rm ? 2005 .17 .0525 .0795 1.48 2006 .17 .055 .0795 1.45 2007 .17 .0625 .0810 1.33 2008 .17 .0675 .976 1.05 2009 .17 .0425 .1049 1.22 Average= 5.6 Average= 8.85 ?=1.31 With other things held constant, the amount of financial leverage applied will always raise the equity beta of any typical company. The debt raises the variance in the amount of net revenues and thus, the higher the levels of debt, the digger the levered beta. Therefore ?l= ?e (1+ (1-t)(D/E)) Where; ?l = levered beta ?e = unlevered beta t= corporate rate of tax D/E= debt equity ratio (Kapil, 2011 pp186,187) Taking that the 2009’s D/E ratio is the one to be applied in this scenario, therefore; ?l = 1.31 (1+ 0.7(6/100)) ?l =1.37 CAPM (R) = Rf + (?*Rm) R = 5.6 + (1.37 *8.85) R = 17.75% Assumptions At the given amounts of cost of infrastructure as well as equipment to be applied in the project to be carried out by Montrose and which is taken to be Project Titan, it was not possible to apply linear interpolation to determine the amount of the required rate of return. They were too high to apply any discounted amounts that would lead to an NPV of positive amounts. The proxy company is also experiencing losses. PART 3 To explain this part, one can apply the already used computation to analyze the implications of the various amounts of beta. It is a scenario covering five years of data and the implication of this data analysis and evaluation will be expounded. Figure 4: Computation of average and Beta amounts Year Required rate of return(R) Rf Rm ? 2005 .17 .0525 .0795 1.48 2006 .17 .055 .0795 1.45 2007 .17 .0625 .0810 1.33 2008 .17 .0675 .976 1.05 2009 .17 .0425 .1049 1.22 Average= 5.6 Average= 8.85 ?=1.31 Beta simply shows the magnitude of risk a single stock adds to the diversified portfolio. A bench mark is usually chosen from a market portfolio that includes stocks in entirety. ? is also computed as ?= (?i/?m) ?m Where; if ?i is high and which refers to the stock’s standard deviation, then the resultant beta is also huge. This implies that as stock with a very huge amount of risk individually will have a high risk as well. An addition of this stock to a portfolio means more risk to this portfolio of stock eventually. A portfolio with a beta of 1.0 implicates, simply, that the behavior of the stock is dependent upon the market. That is, if the stocks move up and down so will this particular stock behave. On the other scenario, a stock portfolio with a beta of 0.5 means that it (the stock) is half as risky as the market portfolio. A beta of 2.0 following the same argument would, thus mean that this portfolio of stock is highly risky and in fact it is as twice as risky as the whole market portfolio. A rational investor would therefore invest in stocks with the lowest beta amounts. (Brigham and Daves, 2007, p52) Since beta in a given market involves a big number of stocks, it is computed by way of applying a regression analysis. For instance; the S&P 500 of the USA. (Little, 2011) The risk upon any given security is usually subdivided into specific stock risk and market risk. Specific risk is that stock’s risk and that is the risk to be put under check. A market risk on the other hand is the entire market’s risk and it cannot be changed in any given situation. A market risk cannot be diversified while a specific stock risk can. (Boston Institute of Finance, 2005 p234) A stock belonging to a firm is impacted upon by the debt-equity ratio and this brings about levered beta. If a firm does not apply debt in its operations, then its beta and unlevered beta are supposed to be equal. A levered beta is also expected to be higher than a normal beta. (Damodaran, 2010 p135) This case’s beta is 1.31 and, therefore, this implies that the firm is more risky compared to the entire market. Reference list: Baker, Samuel L. Perils of the Internal Rate of Return. (2000). Retrieved 30th April 2011 http://hspm.sph.sc.edu/Courses/Econ/invest/invest.html Boston Institute of Finance. Boston Institute of Finance stockbroker course: series 7 and series 63 test preparation. Edition illustrated. John Wiley and Sons (2005). p234. Brigham, Eugene F and Phillip R Daves. Intermediate Financial Management. ninth edition. Cengage Learning. (2007). p52. Damodaran, Aswath. Applied Corporate Finance. Edition 3, illustrated. John Wiley and Sons. (2010). p135. Harvey, Campbell R. Project Evaluation. (1995). Retrieved 30th April 2011 http://www.duke.edu/~charvey/Classes/ba350/project/project.htm Heitger, Dan L. et al. Fundamental Cornerstones of Managerial Accounting. Edition Illustrated. Cengage Learning.  (2007). p525. Hessong, Athena. How to Calculate Beta. (2011). Retrieved 30th April 2011 http://www.ehow.com/how_4910972_calculate-beta.html#ixzz1L78ZiJ2G iconenergy.com. Annual Reports. (2011). Retrieved 30th April 2011 http://www.iconenergy.com/investor-information/annual-reports.html Little, Ken. Using and Misusing the Beta Ratio. (2010). Retrieved 30th April 2011 http://stocks.about.com/od/evaluatingstocks/a/beta120904.htm Kapil, Sheeba. Financial Management. (2011). Pearson Education India. pp186,187. tradingeconomics.com. Australian Interest Rate. (2011). Retrieved 30th April 2011 http://www.tradingeconomics.com/australia/interest-rate Read More