Net Present Value Evaluation - Essay Example

PART A Net Present value 2. Pay Back period 3. Internal rate of Return In the NPV calculation above the rate of interest used is 20% whereby the NPV of cash flows is -1940. At IRR rate NPV has to be zero. So using interest rate of 21% NPV is calculated again as under 4. Appraisal on selling price lowered by 3 pence 5. Appraisal when sale volume greater by 10% Please note that operational cost being fixed will not change with change sale volume. 6) Year sales in units = 52000 units Assuming contribution is 20% Sales = (30400/20) * 100 = 152000 Then Sales per unit = ((30400/20) * 100) / 52000 = £2.92 per unit (rounded) Yearly sale on 900 units per week = 900 * 52 = 46800 units Required per unit price to obtain same contribution and profits = ((30400/20) *100)/46800) or £3.25 per unit (rounded) 7) Existing Position Contribution = 30400 Contribution Per unit = (30400/52000)= £0.58 (rounded) PV ratio = (contribution per unit/sales per unit)*100= (0.58/2.92)*100= 20% (rounded) Break Even point = Fixed Cost/contribution per unit= 20000/0.20=100000 Effects of changes Change in BEV 900 units per week with increased sale price No Change Lowering price per unit by 3 pence (1560/0.5846) Increase by 2668 units Increase in sale volume by 10% (3040/0.5846) Decrease by 5200 units Total Effect of all three changes (3040-1560)/0.5846 Decrease by 2532 units 8) 35% of original cost will be residual value of equipment = 14000 Existing residual = 1000 Increase in cash inflow in the 10th year = 13000 Present value of total cash in flow will increase by (13000*0.162) = 2106 PART B There are various methods available for appraisal of a project like Net Present Value, Pay back period and others. Here we are using NPV and payback method to analyze the project. Let us start with NPV method. NPV method recognizes the fact that a pound today is worth more than a pound tomarrow. NPV is ‘a calculation in dollars of the present value of all future cash flows from a project. It is roughly analogous to the concept of profit.’(Gary Heerkens, page 59)1 The total production per week is 1000 units and accordingly 52000 units for the year. As per information provided the contribution or profit per units will be £0.20 and as the sale for the year is 52000 units, total contributions towards profit is £10400. As the fixed operation cost will get reduced to £ 20000 on installation of equipment, the contribution after meeting variable cost would be£ 30400 for each of 10 years except for 5th year, when the unit will be closed for overhauling for 4 weeks. In the fifth year the contribution will be £29600. As there will also be an overhauling cost of £8000, the net profit will reduce to £1600 as compared to £10400 in each year. However, in the 10th year the residual value of equipments of £1000 will increase the profits to £11400. These profits represent cash inflows for each year as depreciation on equipment has not been considered for calculation of such profits. These cash flows have been discounted at the rate of 20% (PVIF table multipliers for each year) in order to calculate the present value of cash inflows from the project. The total present value of cash in flows from the project comes to £40233. As the cash outflow is £40000, the net present value come to £233. Thus using NPV method of appraisal, the project is viable. Business is full of uncertainties. Uncertainty means more things can happen than will happen. That means each project must be put to a sensitivity analysis. ‘Sensitivity analysis is a popular way to find out how the NPV of a project changes if sales, labor, or material cost, the discount rate, or other factors vary from one case to another.’(Angelico A Groppelli and Ehsan Nikbakhat, page 71)2 Whenever cash flow statement is confronted, a sensitivity analysis is must. In the first part of sensitivity analysis, the effect of decrease in sale price by 3 pence is considered. On reduction of sales price it is natural that cash inflow will be reduced. With the result present value of cash inflow will also get reduced. In our project NPV come down to £33728 from £40233. Comparing cash flow the net present value is a negative £6262, and thus making the project not viable. The second situation in sensitivity analysis is taken when the total volume of sales goes up by 10%. With the result the total now sold will increase by 5200 from existing 52000 units per annum. With increase in sales volume cash inflow will rise giving us an increased discounted present value of cash in flow. Accordingly present value of cash inflow increased from £40233 to £52946, and the resultant net cash flow after deducting the outflow of £40000, comes to £12946. The project under the increase in volume situation is highly recommendable. The third sensitivity study relates to a scenario when the sales decreases at 900 units from present 1000 and the price required for maintaining the same level of profits is to be calculated. In other words contributions required after meeting variable cost should remain the same. Total number of units sold will now be 46800 and in order to maintain the same £ 30400 of contribution, price will now be £3.25 per unit. Let us analyses the effect of this sensitivity analysis on breakeven analysis. Breakeven point is a stage where the company’s revenue covers its variable and fixed expenditures. There is no profit or loss at this stage. Breakeven technique is used to determine how many units of product (or service) must be sold at what price for the producer or service provider to at least break even, given the cost of producing or providing that item or service.’(Daniel Covell and others, page 169)3 Originally each unit was contributing £0.20 towards profits after meeting both variable and fixed costs; the break even point is calculated at 100000 units of sales. With decrease in sales the break even point increases by 2668 units as calculated above. The BEP is now at the sale of 102668 units. In the second sensitivity analysis the sales volume goes up by 10%. It is natural that increased sales will add more to contributions after meeting variable costs to meet fixed costs and will add to profits. When volume increases by 10% the breakeven point will be lowered by 5200 and the new break even point will be at 94800 units. In the third scenario of sensitivity study, there will not any change in the contribution because of increase in sales price per unit to maintain the same contribution. That means there will not be any effect on break even point and BEP will remain at same 100000 units of sales. Quoting Laidler and Parking in his book Helmut Frisch has stated that ‘Inflation is a process of continuously rising prices or equivalently, of continuously falling value of money.’(Page 9)4 Unless sales prices rise as per rise in cost of sales inflation will result in decreasing the cash in flow from the project. Present value of such reduced cash in flow will decrease and comparing cash outflow, the project appraisal will provide a negative NPV and thus project will look unviable. But it is not easy to arrive at the results of effects of inflation, as inflation will also affect the discounting interest rates. ‘Assuming the firm could not raise the output prices above the general rate of inflation, the firm would have to accept lower NPV and hence lower profitability as measured by NPV. At the margin, the firm would have to forego investment projects unless output prices could be raised at a rate greater than the general expected rate of inflation. The exact amount which prices would have to be raised is dependent upon the degree of net working capital required relative to the overall level of investment.’(Geoffrey T Mills, page 85)5 As appraisal of a project relates to generate cash flows, the riskiness of the project is measured in terms of riskiness of cash flows. Riskiness may be considered as a standalone project or as a part of a group, say investment in a portfolio. A standalone project will be more risky as compared to when investment is held in a portfolio. In the portfolio the risk may be diversifiable risks or due to the effect of market risks. Diversifiable risk arises from company specific factors and hence can be washed away through diversification. Market risks, on the other hand, stem from general market conditions and movements cannot be diversified away. To adjust such risks the discount rate to calculate present value cash flows should be adjusted to wipe out the effect of risks. There are certain non- financial risks that should also be taken into account while making a decision about a project. Political factors, growth of the company, availability and source of raw materials, availability of market for sale of units are certain non- financial factors or risks that should also be taken into account while making a capital budgeting decision. The other method considered for the appraisal of this project is payback period. ‘The pay back period measures the length of time required to recover the amount of initial investment. It is computed by dividing the initial investment by the cash inflows through increased revenues or cost savings.’(Jay K Shim and Joel G Siegel, page 263)6 As per our calculations of cash in flow the initial investment if taken at £40000, the payback period is four years. However, when the initial investment is taken at £50000, the payback period is 6 years. Considering the total project period of ten years, the recovery of initial investment in four or six years, as the case may be, indicates that the project will be profitable over the tenure of the project. Thus the project is viable even from the point of payback period method. But the major weakness of the payback period is that it does not consider the time value of money. Also it is a measure of recovery of initial investment and not of profitability. But the method provides an indication of the viability of project. Thus both from NPV method and payback methods of project appraisal the project seems to be highly viable. Word Count:1456 References Read More