Investment Appraisal Matero Corp - Essay Example

? Investment Appraisal: Matero Corp Outline 0 Introduction 2.0 Net Present Value (NPV) 3.0 Internal Rate of Return (IRR) 4.0 Valuations of Equity 5.0 Consideration for Debt Financing 6.0 Reference Investment Appraisal: Matero Corp Introduction As a small growing construction company, Matero PLC requires a keen observation on the Net Present Value (NPV) and Internal Rate of Return (IIR). From the calculations, it will be possible to assess whether the company can finance its operations entirely from equity or it will be necessary to access some capital from borrowing that will have to be repaid. The financial manager of Matero PLC will have to consider Capital budgeting as a vital parameter in making this decision. The management will have to evaluate the projects which will generate stable cash flows for Matero PLC for at least 1 year. From the onset, we consider the possible consequences of Matero accepting or rejecting the project of procuring the machinery and plant. For this reason, we emphasise on the determination of the cost of capital whether there will be any form of financial leverage or not. If Matero PLC will decide to use debt financing, there is a hypothesis that the debts will generate higher payoffs for the coming years considering the risk factors that accompanies the borrowed capital. Finally, the management of Matero PLC will have to undertake the valuation of the company, of course, using four separate models for equity valuation. In order to eliminate errors, it will be vital to observe ways in which financial analysts use the models. Net Present Value (NPV) By definition, the NPV is an Investment Appraisal Methods which is the sum of the present values (PV) for all the cash flows that are expected to increase in the event that Matero PLC decides to execute the project. The adjusted capital cost of the firm added to the risk factors of the project determines the rate of discount used in the model in a way that the management will maximize the shareholder equity value (Graham & Harvey, 2001). Ultimately, if the model generates a positive NPV for the project, then the project should be accepted since it will be able to increase the shareholder equity. On the other hand, if the NPV for the project is negative, then it will reduce the shareholder equity, and the project should be rejected. Internal Rate of Return (IRR) The IRR is the cost of capital of the form and the discount rate which equalizes the PV of the cash flows that are expected to increase to the operational cost of the project from the initial stages. After obtaining the IIR for the project, we apply the IRR decision rule which states that if IRR exceeds the rate of return that is required, then the project is accepted, otherwise, we reject the project. IRR measures the profitability of the firm as a percentage of return on every dollar invested in the project. If Matero PLC applies a discount rate of 10%, the NPV is positive the project is acceptable. Again, the IRR exceeds the cost of capital, indicating that the management can approve the project. We consider a situation in which Matero Plc had $500,000 in form of assets with an operating income of $200,000. If the rate of taxation is 40 percent, we look at its impacts on the net income and the Return on equity (ROE) when the EBIT rises or falls by 10 percent. Case 1) with Full Equity financing EBIT - 10% Expected EBIT EBIT + 10% EBIT $180,000 $200,000 $220,000 Interest expense 0 0 0 Income before taxes $180,000 $200,000 $220,000 Tax expense $72,000 $80,000 $88,000 Net Income $108,000 $120,000 $132,000 Shareholders’ equity $200,000 $200,000 $500,000 ROE 54% 60% 26.4% Case 2) Finance: Equity 50% and debt 50% with 5% interest rate EBIT - 10% Expected EBIT EBIT + 10% EBIT $180,000 $200,000 $220,000 Interest expense $20,000 $20,000 $20,000 Income before taxes $160,000 $180,000 $200,000 Tax expense $64,000 $72,000 $80,000 Net Income $96,000 $108,000 $120,000 Shareholders’ equity $400,000 $400,000 $400,000 ROE 24 % 27 % 30 % In the decision on whether to accept the project or not, we calculate the NPV of Matero PLC using the model below: NPV = C0 + C1/ (1+r) 1 C2/ (1 + r) 2 + ....+ Ct / (1 + r) t In this model: C0 is the initial cash flow C1 is cash flow at time 1 Ct is the cash flow at time t t is the investment period r is the opportunity capital cost For Matero PLC, the net present values for the 5 years are calculated based on the cash flow factors as shown below: Year Cash flow PV at 10% PV at 15 % Year1 40,000 0.909 0.870 Year 2 50,000 0.826 0.756 Year 3 60,000 0.751 0.658 Year 4 70,000 0.683 0.572 Year 5 80,000 0.621 0.497 NPV = -25000 - 40,000/1.15 + 50,000 / 1.152 - 60,000 / (1.15)3 + 70,000 / (1.15)4 -80,000/1.155 NPV = - 25000 - 34782.61 + 37807.18 – 39450.97 + 40022.73 NPV = - 21403.67 We also find the IRR to be: Residual value / Cost of machine = (25000 / 210000) * 100 = 11.904 % As a result of the calculations, we just use the computation without observing the irregular cash flows. The expected rate of return is 11.81 %, slightly less than the IIR that has been calculated. The NPV and the IIR both suggest that we should accept the project and purchase the machine. A separate type of cash flow is where Matero PLC opts to finance the machine purchase project. This involves a situation where the cash flow is positive, followed by a series of negative cash flows. In this project, the IIR decision rule shows a reverse compared to the expectation. We therefore recommend that the management should reject the project since the IRR is lower than the capital cost, following a low rate of borrowing (Graham & Harvey, 2001). Even though we don’t have limited capital, we cannot approve the project. Considering a multiple project situation, it could be possible to select an alternative project. The most important issue here is that we must not use IRR in the selection of projects, whether the capital is limited or not. The IRR of the financial calculation is the crossing line and the expected return on the incremental project. The IIR rule is very essential for this project, because the decision making criteria only confirms if the IRR is lower than the required rate of return. As the dollar value increases, it appears to provide more information without the prior knowledge of the initial capital expenditure. The IRR rule involves the task of obtaining the rate of return which equalizes every cash flow values on the basis of time value. Since we compare the IRR rule to the risk of the cash flows and the required return, we are able to determine the risk index of the machinery and plant purchase project. The IRR rule thus shows how we can increase value by earning returns larger than the required rate of return. We should be expecting that if our calculation obtains an extremely large IRR, we revert to looking at the cash flow approximation all over again. In this project, the management can consider the fundamental criteria as the NPV, while giving the IRR rule a second priority, such that if the two criteria show different suggestions, the management can only use the NPV as the only criteria and the ultimate rule for decision making. The procurement of the plant and machinery could amount to investing in appropriate investment environment, showing low long-term costs. Consideration for Debt Financing It is important to note that the calculations for IIR and the NPV were considering full equity financing. Since the two calculations generated results recommending rejection of the project, there is no need to acquire additional debt financing since it will generate more negative indicators. Calculations will generate a new NPV as follows: NPV = -25000 - 44,000/1.15 + 55,000 / 1.152 - 66,000 / (1.15)3 + 77,000 / (1.15)4 -80,000/1.155 NPV = - 25000 - 38260.87 + 41587.90 – 43396.07 + 44025 = - 21044.04 NPV = - 21044.04 This NPV suggests that we reject the project, because it is less than the value of the company. IIR = 100 (25 / (210000 + 21000)) IIR = 100 * 25/231000 = 10.82 % IRR = 10.82 % It also suggests that we reject the project, considering that it would lock up all the funds for investment in the purchase of fixed assets that will generate inadequate return. The IRR decision rules and the NPV will give room to the same decision concerning the procurement project for all projects with regular patterns of cash flows. If the project has a positive NPV, then it adds value to Matero PLC and can provide more return than the required rate. The interests of shareholders would then be safeguarded by the justifications from the two criteria in decision making. Graham and Harvey (2001) argue that the calculations of NPV produce positive values and IIR produces returns above the required threshold. Based on this then, debt financing can possibly be acquired to supplement the equity finance from the shareholders’ equity. This would mean that Matero PLC has low risk factors. Reference Graham, J. R., & Harvey, C. R., 2001. The Theory and Practice of Corporate Finance: Evidence from the Field. Journal of Financial Economics, pp. 187 – 243. Read More