Capital Budgeting and Pros and Cons of IRR and NPV - Essay Example

Estimate the NPV of the project Net Present Value Net Cash Flow Net Cash Flow Net Cash Flow Particulars Initial Outlay Year Year 2 Year 3 ? Initial Capital Expenditure (12,000,000) Sales 8,000,000 12,000,000 16,000,000 Variable Costs (2,400,000) (3,600,000) (4,800,000) Fixed Costs (2,000,000) (2,000,000) (2,000,000) Depreciation (4,000,000) (4,000,000) (4,000,000) Taxable Profit (12,000,000) (400,000) 2,400,000 5,200,000 Tax @ 30% 3,600,000 120,000 (720,000) (1,560,000) Amount after tax (8,400,000) (280,000) 1,680,000 3,640,000 Add back Depreciation (Non cash item) 4,000,000 4,000,000 4,000,000 Net Cash Flow (8,400,000) 3,720,000 5,680,000 7,640,000 Discounting Factor @ 8% 1 0.93 0.86 0.79 Present Value (8,400,000) 3,444,444 4,869,684 6,064,878 Net Present Value (i) 5,979,007 Hi-Tech Industries is considering installing a production facility for upgrading a standard component. The initial investment layout is estimated to be ? 12 million, which is the entire cost of installing the component. Sales increase from year 1 to year 2 by 1.5 times, but in the 3rd year it appears that the sales only increase by 1.33 times, which shows a decline as compared to the previous financial year. Variable cost is included as a percentage of the sales for the month, which is 30% of the sales for the year. All the fixed costs are assumed to be directly attributable to the project and thus are included in the cash flows. As mentioned in the project, the useful life of the facility will be three years, thus it will be depreciated on a straight line basis over three years. Depreciation is a non-cash item, but it is included in the cash flow forecasting because of the tax shield, since depreciation is also tax deductible. In first year, the company will have taxable loss, so it is assumed that the company will have taxable profit in the future, against which this taxable loss will be utilized, resulting in tax savings. Depreciation is added back and the net cash flow is discounted through the use of the required rate of return in order to calculate the Net Present Value. 2. The principal risk of the project There are several principal risks that surround the project. Hi-Tech Industries operates in the technology industry, which is subject to rapid changes in many fields such as standard equipment, operating procedures, and laws and regulation. The project under consideration requires a careful estimation of all the relevant costs and revenues; a misjudgment in the forecast will cause an error in the project net present value, which might result in the acceptance of a project which is not financially viable. The initial capital expenditure must be carefully projected. In order to do so, it is of prime importance that the company obtains quotations from several companies in order to project the current market value of component. An artificially higher price will put a declining effect on the net present value of the project, and an artificially lower price will cause the opposite. Another risk that is present in the financial appraisal of the project is that the company might not have estimated the correct useful life of the equipment. The IT related hardware and equipment are subject to becoming obsolete at a greater pace as compared to the other kinds, so this risk is present. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The information provided does not include any relevant information about the price inflation over the three year period, which can significantly impact the expected NPV. The director of the company must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant, as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flow in the future for the payment of these finance charge. In order to commence any investment venture, the director must receive the approval of the shareholders. Although certain investments might appear to be rewarding and worthwhile to do, they do not receive shareholders’ attention that easily. Shareholders, who are often short-sighted and tend to ignore the long-term feasibility, disapprove the decision of the board based on the fact that the cost of the investment will weaken the financial outlook of the organization in the year of the investment. The directors, while making the investment decision, must consider whether it is of a capital nature or will be reflected in the profit and loss of the company as an expense. Moreover, it is apparent that the company has included variable cost as an estimation of the sales in the cash flow forecast, whereas the actual variable cost might turn out to be different than the estimated, thus distorting the Net Present Value of the project. It is of prime importance that the company includes only the relevant fixed cost in the financial appraisal of the project. The project is discounted through the use of the rate of return of the company, which is actually the WACC of the company. WACC, or the weighted average cost of capital, is the weighted average cost of the company’s equity and long-term debt. WACC is calculated by multiplying the cost of equity with the market value of the equity and cost of debt with the market value of the debt. Cost of debt is usually the interest rate that the company’s pay on its long-term and short-term financial borrowings. However, an analysis of the company’s financial statements will show that the company does have any financial debts bearing long-term or short-term interest. All of its debts comprise of trading nature, and the company does have to pay any interest on such securities. Therefore, taking the other factors into consideration, it is quite necessary that the accurate required rate of return is calculated in order to accurately estimate the required return of the project. 3. Recommendation The company can use either IRR or NPV method for the financial appraisal of the project. The NPV method comes with several attributes, which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several times over the period. The IRR method does not incorporate this fact into calculation, and thus is not suitable for long term investment appraisal. In NPV method, the discount rate is known and is singular, which makes it easier to evaluate the feasibility of the investment. An investment with a negative value represents an unattractive investment, whereas a positive value represents otherwise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. Based on the discussed facts, NPV method of appraising investment is more practical and precise. Since the NPV of the project is in positive (? 5,979,007), it is financially viable for the company to accept the project, provided the above mentioned risk is taken into account. Question 2 a) The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flows, over the time span of the project, are discounted based on the expected discount rate in the economy. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0, i.e. at the time of making of the investment. An investment the NPV of which is positive is considered to be a rewarding one, whereas an entity does not venture an investment where the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating the Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflows, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Investment appraisal through NPV method and IRR method are both very useful. A good financial analysis is based on the trade-off between these two methods. Practically, however, the IRR method is more widely used in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is that it is comparatively straightforward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates, because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rates for different investment proposals, whereas IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts (Financial Modeling Guide, 2010). b) The primary reason why the Payback period is not taken into consideration is that the payback period does not take into account the cash flow earned after the payback period and also it does not take into account all the cash flows that the project yields. In addition, the payback period does not take account of the pattern of the cash flows. The payback period gives equal weights to the returns of equal amount, disregarding the fact that they might take place in different periods. There is no rational basis for calculating the acceptable basis period and thus increasing administrative difficulties. The most important drawback of payback period is that it is not consistent with shareholders’ value, as they want to maximize the market value of the shares. Accounting rate of return is quite similar to Internal Rate of Return and it also has shortcomings similar to those in Payback method. ARR does not take into account time value of money and it also disregards the non-inclusion of non-cash items in the cash flow forecasting. c) Despite the shortcomings mentioned above, payback period and ARR methods have several advantages as well. The methods are simple and cost effective. These methods are simple to understand and quite easy to calculate. In addition, the companies can save significant amount of money, which would have been spent on complex valuation techniques. These techniques put emphasis on liquidity and the early recovery of investments, greatly assisting the investors. Reference list Financial Modeling Guide, 2010. Capital budgeting and pros and cons of IRR and NPV. [online] Financial Modeling Guide. Available at: [Accessed 6 July 2012]. Read More