Net Present Value, Payback Period, Internal Rate of Return - Assignment Example

Managing Finance Introduction Financial analysis is an important aspect of decision making when several alternatives are available for investment. There are several approaches to financial analysis and the one most appropriate to a particular situation needs to be chosen by the analyst. This paper discusses financial analysis methods, the impact of foreign exchange rate variations and the methods available to protect against them. NPV, IRR and payback Task 1 Net Present Value The Net present Value for the three options with the three discount rates of 10%, 20% and 25% have been calculated and shown in Annexure -2. The Net Present Values for the three options are as follows: 10% 20% 25% Option 1 0.0575 -1.1419 -1.5900 Option 2 -0.5955 -1.2349 -1.4730 Option 3 0.5095 0.2701 0.1820 As can be seen from the above table, Option 1 has a positive Net present Value at a discount rate of 10%, and negative NPVs at 20 and 25%. Option 2 has negative NPVs for all discount rates considered. Option 3 has positive NPVs for all the discount rates considered. Task 2 IRR The Internal Rate of return (IRR) is the rate at which the NPV is equal to 0.This rate can be determined by interpolating between two rates, one of which has a positive NPV and the other a negative NPV. Option 1 IRR = 10 + (0.0575/(1.1419+0.0575) x 10) =10.479 Option 2 IRR = 0.375/(0.375+0.5955) = 0.386 Note: The NPV for all discount rates applied in the case of option 2 are negative. Hence the NPV corresponding to the lowest rate (10%) is used along with the undiscounted (i.e. 0% discount rate) cash flows to interpolate and arrive at the IRR. Option 3 IRR cannot be calculated for this option because there is no investment in this case, and hence no cash outflow at any stage. Task 3 – Payback Period Option 1 Payback period = 3 + (5-3.75)/(6.25-3.75) = 3 + 0.5 = 3.5 years Option 2 Payback period = 3 + (3.45-3)/(3.45-1.65) = 3 + 0.25 = 3.25. Option 3 Payback period is not applicable in this case because there is no investment. Task 4 Financial Metrics and Evaluation NPV, IRR, and Payback Various financial metrics are used to evaluate the feasibility of a project. Some of the popular metrics in use include the Payback Period, the Net Present Value (NPV) and the Internal Rate of Return (IRR). Payback Period Payback period is one of the simplest methods for assessing the feasibility of a project and can be calculated quickly. The Payback period is the number of years it takes to recover the investment made in a project, and is calculated by interpolating between the two consecutive years when the cumulative cash flows from the project are respectively below and above the investment made. Suppose an investment of 100,000 results in cash flows of 20,000, 30,000, 40,000 and 50,000 in four years. The cumulative cash flows are 20,000, 50,000, 90,000 and 140,000. It is clear that the investment of 100,000 is recovered in the fourth year. The actual figure of payback period is calculated by interpolation between the last two figures. The biggest advantage of the Payback period is its simplicity, and the ease with which it can be computed and understood.. The disadvantage of the payback period is that it fails to take in account the time value of money. Time value of money arises from the fact that cash received at an earlier point in time is more valuable than the same amount of cash received at a later point in time. If one were to invest the amount of $10,000 received today at an interest rate of 10%, that person would receive $11,000 after one year. Thus receiving $10,000 today is worth more than receiving $10,000 after one year. The second disadvantage with the Payback method is that it ignores the cash flows that accrue after the payback period is over. If the payback for Project A is 3 years and that for Project B is 5 years, using the payback method one would conclude that Project A is better. However, this need not be so. Suppose Project A has a total life of 5 years and generates 120% of the investment during the entire life of the project, while Project B has a 15 year life and generates 200% of the investment in this period, it is apparent that Project B is better although it has a longer payback period. Net present Value The Net Present value is obtained by discounting the future cash flows at a predetermined rate of return. Discounting is a process that is the inverse of compounding interest, and determines the present value of future cash flow. (Gitman 2003) The Net Present Value is the net discounted value of all future cash flows. The discounted values of all inflows and outflows are netted against each other to arrive at the net present value. The greatest advantage of the Net present Value approach is that it considers the time value of money. Moreover, the NPV approach uses cash flows rather than accounting profit, and thus eliminates judgmental inaccuracies. It is, therefore, more reliable as a method of investment appraisal. The disadvantages are that it is difficult to understand, requires accurate forecasting of future cash flows and precise determination of the cost of capital. (Watson & Head 1998) Internal Rate of return Internal Rate of Return is the discounting rate that results in zero NPV. (Lucey 1996) As the cost of capital or the discounting rate rises, the Net Present Value falls, and at one point it becomes zero. The rate at which it becomes zero is the Internal Rate of Return. Projects that have an IRR greater than the cost of capital are acceptable, while those having lower IRR are rejected. Like NPV, IRR also has the advantages of being based on cash flows and accounting for the time value of money. In addition, IRR has the advantage of being easier to understand as a concept. The disadvantage of using IRR as compared to NPV is that IRR is a relative measure and does not give the absolute picture. IRR does not give any indication of the wealth gain but merely specifies the rate of return being generated. (Atril & McLaney 2005) Thus if there are two projects, of which one has an IRR of 22% and a Net Present Value of $1,000,000 and the other with an IRR of 25% and Net Present Value of $50,000, the higher IRR would be misleading and not provide the correct perspective. Cost-benefit Analysis Cost-benefit analysis is an approach that is useful in identifying and evaluating opportunities for investment. It measures the effect of proposed improvements and investments by comparing the costs incurred in effecting an improvement with the benefits that accrue from implementing it. (Hilton, Maher & Selto 2000) Cost-benefit analysis can be used for assessing alternatives and selecting one of them on the basis of the maximum net benefits provided. In the present case, the three options involve different costs and benefits. The three methods discussed above can be employed to perform a cost-benefit analysis. The ultimate decision can be made based on one or more of these measures. Thus the company may decide to implement the option that has the lowest payback period or the highest Net Present Value. Recommended option for the company As discussed in the foregoing sections, the Net Present Value method gives the most reliable and appropriate measure for evaluating investment proposals. In the present case, the payback period for the first option is 3.5 years while it is 3.25 years for the second option. Since no investment is involved for option 3, there is no payback period. The IRR for option 1 is 10.4746 and for option 2 it is 0.386. There is no IRR for option 3 as there is no investment. Thus the second option is better in terms of payback period while the first option is better in terms of IRR. However, both these are misleading as they ignore the third option altogether. NPV gives a clear picture of all three options. Since it is negative for all values considered in the case of option 2, this option must be rejected. Option 1 gives positive NPV only for 10% discount rate, and the NPV is negative at higher discount rates. The third option yield positive NPVs at all the three discount rates considered. The Net Present value at a discount rate of 10% is marginally higher for option 1. However, the difference is quite small. The cost of capital is likely to be higher than 10% in practice. Considering these facts, option 3 is recommended for the company. Task 5 – Exports and Foreign Exchange This section presents a brief overview of where a company can look for information and assistance, the types of exchange regimes that governments can adopt, and the measures that Telton can take to protect itself from movements in foreign exchange rates. Sources of information There are a number of sources of information available to a company like Telton that is new to exporting. Most of these are online sources that are maintained by government agencies, making them authentic and reliable sources of information. Perhaps the best source of information is the “Beginner’s guide to export controls” maintained by the Department for Business Enterprise and Regulatory Reform. This site gives an overview of why export controls are required, when a license is required and how to get one, and the responsibilities and obligations of the exporting parties. The site also suggests additional sources of information. (BERR 2009) There are also a number of other government run sites that give information on various aspects of exports. In addition, Trade directories, and publications of commercial associations can also be consulted. The information that is likely to be most critical to an organization beginning to export for the first time would relate to various procedural and statutory requirements, and these can be obtained from the online sources mentioned above. Exchange rate systems that the UK government can operate Exchange rate is the price of one currency in terms of another. (Kim et al 2002) Depending on the type of exchange rate system adopted, the rate is determined by market forces or by the government, and is liable to periodic variations. The UK government can operate basically two types of exchange rate systems, namely Fixed Exchange rate systems, or Floating Exchange rate systems Under a fixed exchange rate system, the government determines a fixed exchange rate that does not fluctuate in the short term. Revisions to this rate are made only by the concerned government. Floating exchange rate systems, on the other hand, vary in the short term and are generally determined by market forces. The exchange rate variations in the case of a floating exchange rate system are higher than in the case of a fixed system. Conceptually, a floating exchange system is one in which the market forces are free to determine the rate based on demand and supply. In practice, however, even under a floating exchange rate system, the rates are not left to purely market forces, and a certain amount of intervention takes place. (Shu 2002) One form of intervention that a government can exercise is to buy and sell foreign exchange in open market through its central bank. Managing the exchange rates under a floating exchange rate system becomes necessary because it may not always be the market forces alone that determine the rate variations. (Macdonald 1993) Conceptually, a fixed exchange rate should represent less risk because the variations in the exchange rate are controlled, and the organization knows exactly at what rate it would be able to convert its foreign earnings. However, this is not entirely true. Exchange rate variations are a result of cross country consumption patterns and relative money supply. (Cavallo 2003) A floating exchange rate system adjusts itself to prevailing balance of trade positions more accurately, and is in a position to absorb shocks better. (Ricci 2006) A fixed exchange rate is at a risk of being subject to sudden and major variations depending on the government’s policy and the prevailing trade position. As can be seen from the above, both fixed and floating exchange systems have their advantages and disadvantages. Many variations are practiced in each of them. A fixed exchange rate may be linked to a basket of currencies instead of a single currency to absorb shocks better. Another variant is the currency board system under which the exchange rate is pegged to a single currency, but the country holds one hundred percent reserves against that currency thus reducing risk. (Zloch-Christy 2000) Variations in exchange rate can affect the profitability of Telton. Suppose that Telton had made a profit of $100,000 in its US operations when the exchange rate was 0.75 British Pounds to a US dollar. This would be booked as £75,000 in the company’s books. Suppose further that the money is transferred from the US account to the British account after a lapse of three months by which time, the exchange rate drops to 0.67 British Pounds to a dollar. The actual money received by the British company is £67,000, representing a loss of £8,000. This can, of course, work in the opposite direction also and result in a profit to the company. However, Finance managers prefer to eliminate uncertainty and the risks they represent, and hence high degrees of fluctuation are always a source of concern. Measures to protect against exchange rate fluctuations Telton can take a number of measures to protect itself from exchange rate fluctuations. The most common method of protecting against possible future rate variations is hedging. Hedging is usually done by entering into arrangements that ensure a specified rate in the future. There are three major types of hedging: Natural Hedging, in which the outgoing money is matched by an equally amount of inflow. This may be possible only for organizations having large volumes of two way transactions. Hence this may not be suitable for Telton. Forward trading: Under this, Telton can contract to sell (or buy) a certain amount of foreign currency at an agreed rate. Thus Telton can agree to sell 100,000 US dollars at 0.75 Pounds/ Dollar. This protects it from the risk of fall in exchange rate. Money market hedging: This refers to investing (or borrowing) in the money market for a short period in the concerned foreign currency. (Lumby & Jones 2003) Other options such as currency swaps and futures and options market operations are also available to Telton. Practical measures that Telton can take to protect itself from exchange rate variations From the above discussion, it will be clear that Telton can use some form of hedging to protect itself from exchange rate variations, if it decides to enter the export market. Options such as natural hedging may not be available to Telton because of the nature of its international business, which will involve only exporting. Even money market operations may be a little complicated and may not suit an organization new to exports and foreign exchange operations. The best methods available to Telton, therefore, are forward trading and currency swaps. Conclusion Discounted cash flow methods offer a more reliable means of assessing the feasibility of investment proposals. The Net present value method gives a more realistic picture than the IRR because it considers the wealth creation aspect. Using these methods, the three options available to Telton were assessed. Option 3 is found to be the best alternative available to Telton considering the net present values generated by the three alternatives. If Telton plans to enter the export market, it will have to take care of a number of formalities, information about which is available in several government hosted internet sites. The company will have to ensure that it is not adversely affected by exchange rate fluctuations. To this end, the company must enter into hedging arrangements that ensure that the company is able to convert its earnings in foreign exchange at a fixed, predetermined rate. Works Cited 1. Atrill, P and McLaney, E 2005, Management Accounting for Decision Makers: Fourth Edition, Pearson Education Ltd, Essex. 2. BERR 2009, Beginners Guide to Export Controls. Department for Business Enterprise and Regulatory Reform, Viewed April 17, 2009, 3. Cavallo, M. 2003. ‘1 Net Foreign Assets and Exchange Rate Dynamics’ in Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective, ed. Hairault, Jean-Olivier and Thepthida Sopraseuth:3-51, Routledge, New York. 4. Gitman, L G 2003, Principles of Managerial Finance Brief: Third Edition, Addison-Wesley, Boston, MA. 5. Hilton, R W, Maher, M W, and Selto, F H 2000, Cost Management: Strategies for Business Decisions, McGraw-Hill Higher Education, New York. 6. Kim, S H, Kim, S H, and Kim, K A 2002, Global Corporate Finance: Fifth Edition, Oxford, Blackwell Publishers. 7. Lucey, T 1996, Management Accounting: 4th Edition. Continuum, London. 8. Lumby, S. & Jones, C. 2003, Corporate Finance: Theory and practice, seventh edition, Thomson Learning, London. 9. Macdonald, R. 1993, Floating Exchange Rates: Theories and Evidence, Routledge, London. 10. Ricci, L.A. 2006, ‘Exchange Rate Regimes, Location and Specialization’, IMF Staff Papers 53, no. 1: 50+. 11. Shu, C. 2002, ‘12 Real Exchange Rates and Capital Flows’ in Monetary Policy, Capital Flows and Exchange Rates: Essays in Honour of Maxwell Fry, ed. Dickinson, D.G. & William A. A., 241-268, Routledge, London. 12. Watson, D and Head, A 1998, Corporate Finance: Principles & Practice, Financial Times Professional, London. 13. XE 2009m Universal Currency Converter, Viewed April 17, 2009, 14. Zloch-Christy, I. 2000, Economic Policy in Eastern Europe: Were Currency Boards a Solution? Praeger Publishers, Westport, CT. Annexures Annexure – I Cash Flow Calculations Option 1 (Purchase new equipment for 5M) Investment 5 Sales 1.5 1.5 4 4 1.5 Variable Costs (25% of sales) 0.375 0.375 1 1 0.375 Contribution 1.125 1.125 3 3 1.125 Fixed Costs (0.3m of existing + 0.2 m additional) 0.5 0.5 0.5 0.5 0.5 Profit (Cash Flow) -5 0.625 0.625 2.5 2.5 0.625 Option 2 (Purchase new equipment for 3M + Rent) Investment 3 Sales 1.5 1.5 4 4 1.5 Variable Costs (25% of sales) 0.375 0.375 1 1 0.375 Contribution 1.125 1.125 3 3 1.125 Fixed Costs (0.3m of existing + 0.2 m additional) 0.5 0.5 0.5 0.5 0.5 Rent for additional equipment 0.7 0.7 0.7 0.7 0.7 Profit (Cash Flow) -3 -0.075 -0.075 1.8 1.8 -0.075 Option 3 (Lease equipment) Investment Sales 1.5 1.5 4 4 1.5 Variable Costs (25% of sales) 0.375 0.375 1 1 0.375 Contribution 1.125 1.125 3 3 1.125 Fixed Costs (0.3m of existing + 0.2 m additional) 0.5 0.5 0.5 0.5 0.5 Lease 1.2 1.2 1.2 1.2 1.2 Profit (Cash Flow) -0.575 -0.575 1.3 1.3 -0.575 Annexure -2 Net present Value Year 0 1 2 3 4 5 PV DCF Rate 10% 1.0000 0.9090 0.8260 0.7510 0.6830 0.6210 DCF Rate 20% 1.0000 0.8330 0.6940 0.5790 0.4820 0.4020 DCF Rate 25% 1.0000 0.8000 0.6400 0.5120 0.4100 0.3280 Option 1 Cash Flow -5.0000 0.6250 0.6250 2.5000 2.5000 0.6250 Cumulative Cash Flow 0.6250 1.2500 3.7500 6.2500 6.8750 DCF 10% -5.0000 0.5681 0.5163 1.8775 1.7075 0.3881 0.0575 DCF 20^ -5.0000 0.5206 0.4338 1.4475 1.2050 0.2513 -1.1419 DCF 25% -5.0000 0.5000 0.4000 1.2800 1.0250 0.2050 -1.5900 Option 2 Cash Flow -3.0000 -0.0750 -0.0750 1.8000 1.8000 -0.0750 0.3750 Cumulative Cash Flow -0.0750 -0.1500 1.6500 3.4500 3.3750 DCF 10% -3.0000 -0.0682 -0.0620 1.3518 1.2294 -0.0466 -0.5955 DCF 20^ -3.0000 -0.0625 -0.0521 1.0422 0.8676 -0.0302 -1.2349 DCF 25% -3.0000 -0.0600 -0.0480 0.9216 0.7380 -0.0246 -1.4730 Option 3 Cash Flow -0.5750 -0.5750 1.3000 1.3000 -0.5750 Cumulative Cash Flow -0.5750 -1.1500 0.1500 1.4500 0.8750 DCF 10% -0.5227 -0.4750 0.9763 0.8879 -0.3571 0.5095 DCF 20^ -0.4790 -0.3991 0.7527 0.6266 -0.2312 0.2701 DCF 25% -0.4600 -0.3680 0.6656 0.5330 -0.1886 0.1820 Read More