The Value of Net Present Value - Assignment Example

Net Present Value Net present value is a discounting method of analyzing the viability of a given investment by taking into consideration the time value of money (Megginson, et al page 261). For instance, XYZ Limited has approached you for advice on an equipment to be purchased for use in a five year project. The investment will involve an initial capital outlay of $ 1.4 million and the expected cash flows are given below: Year Cash inflows Cash outflows $ $ 1 800,000 65,000 2 750,000 80,000 3 900,000 50,000 4 1,200,000 55,000 5 1,100,000 70,000 The equipment is to be depreciated on a straight line basis over the duration of the project with a nil residual value. The cost of capital and the tax rate are 12% and 30% respectively. Required: The net present value (NPV) of the investment Solution: (a) Project appraisal $ ‘000’ Year 0 1 2 3 4 5 Inflows - 800 750 900 1,200 1,100 Outflows - (65) (80) (50) (55) (70) Depreciation - (280) (280) (280) (280) (280) Inflow before tax - 455 390 670 865 750 Less tax @ 30% - (136.5) (117) (201) (259.5) (225) + dep. Back - 280 280 280 280 280 Cash flows - 598.5 553 749 885.5 805 I0 (1,400) - - - - - (1,400 598.5 553 749 885.5 805 PVIF 12%n 1.000 0.893 0.797 0.712 0.636 0.567 P.V (1,400) 534.5 440.7 533.3 563.2 456.4 Overall NPV = 1,128.1 The decision rule for NPV for accepting the project Under this method, a company should accept an investment venture if N.P.V. is positive i.e. if the present value of cash outflows exceeds that of cash inflows or at least is equal to zero (NPV ≥0). This will rank project ventures giving the uppermost rank to that particular venture with highest NPV because this will give the maximum cash inflow or capital gain to the company. Net present value recognizes time value of money and such appreciates that a shilling now is more valuable than a shilling tomorrow and the two can only be compared if they are at their present value. Internal rate of return (IRR) This is another modern method of discounting cash flow because the technique uses the principle of NPV. It is defined as the rate which the present value of cash outflows of an investment equates the initial capital invested. IRR = Pv (cash inflows) = Pv (cash outflows) or IRR is the cost of capital when NPV = 0. It is also called internal rate of return because it depends wholly on the outlay of investment and proceeds associated with the project and not a rate determined outside the venture. A = inflow for each period C = Cost of investment The value r can be found by: i) Trial and error ii) By interpolation iii) By extrapolation i) Trial and error method a) Select any rate of interest at random and use it to compute NPV of cash inflows. b) If rate chosen produces NPV lower than the cost, choose a lower rate. c) If the rate chosen in (a) above gives NPV greater than the cost, choose a higher rate. Continue the process until the NPV is equal to zero and that will be the IRR. Example A project costs 16,200/= and is expected to generate the following inflows: $ Year 1 8,000 Year 2 7,000 Year 3 6,000 Compute the IRR of this venture. Solution 1st choice 10% = 17,565.74 > cost, choose a higher rate. 2nd choice 14% = 16,453.646 3rd choice 15% = 16,194.625 IRR lies between 14% and 15%. ii) Interpolation method Difference PV at rate of 14% = 16,453.646 253.646 PV required = 16,200.000 -5.375 PV at rate of 15% = 16,194.625 Therefore, r denotes required rate of return Therefore, r = 14% + (15% - 14%) x = 14% + 0.98% = 14.98% The acceptance rule of Internal Rate of Return (IRR) IRR will accept a venture if its IRR is higher than or equal to the minimum required rate of return which is usually the cost of finance also known as the cut off rate or hurdle rate, and in this case IRR will be the highest rate of interest a firm would be ready to pay to finance a project using borrowed funds and without being financially worse off by paying back the loan (the principal and accrued interest) out of the cash flows generated by that project. Thus, IRR is the break-even rate of borrowing from commercial banks. Real option in project analysis This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can payback and for this reason PBP (or payout period or payoff) is that period of time or duration it will take an investment venture to generate sufficient cash inflows to payback the cost of such investment. This is a popular approach among the traditional financial managers because it helps them ascertain the time it will take to recoup in form of cash from operations the original cost of the venture. This method is usually an important preliminary screening stage of the viability of the venture and it may yield clues to profitability although in principle it will measure how fast a venture may payback rather than how much a venture will generate in profits and yet the main objectives of an investment is not to recoup the original cost but also to earn a profit for the owners or investors. C) (i) Marginal cost of equity (Ke) Constant growth firm – P0 = =1.60(1+0.1)/40+0.1→14.1% ii) =1.60(1+0.1)/ (40-2) +0.1→14.6% Sensitivity analysis is used to decide on how “sensitive” a project is to changes in its value based on the formulated parameters of the measurements. The sensitivity of parameter is typically performed in series of test to creating a given set of scenarios. It foresees the end result of a decision if the circumstance turns out to be in contrast with the chief predictors. While in simulation analysis of the operation of a real world system is initiated by generating artificial history of such through random numbers. Out of this model of the relationship of the objects are determined and then performance are predicted by simulation model. Q3 Year Inflows($) PV Discounted amount 0 (50,000) 0 (50,000) 1 10,000 0.8929 8,929 2 20,000 0.7972 15,944 3 30,000 0.7118 21,354 4 20,000 0.6355 12,710 5 5,000 0.5674 2,837 NPV 11,774 → Year Inflows($) Discounting Rate(1+r) (1+r)r Discounted amount 0 (50,000) 1.12 1 (50,000) 1 10,000 1.12 1.12 11,200 2 20,000 1.12 1.2544 25,088 3 30,000 1.12 1.4049 42,147 4 20,000 1.12 1.5735 31,470 5 5,000 1.12 1.7623 8,811 NPV 68,716 Yes because the project has got positive NPV which indicates that it is viable for investment. NPV   Project C($) Project D($) PV Discounted amount Project C Discounted amount Project D Investment at 0 40,000 40,000 0 -40000 -40000 Y1 10,000 20,500 0.8929 8929 18304.5 Y2 10,000 20,500 0.7972 7,972 16,342.6 Y3 47,000 20,500 0.7118 33454.6 14591.9         10,355.6 9,238.95 IRR   Project C($) Project D($) (1+r)n     Investment at 0 40,000 40,000 1 -40,000 -40,000 Y1 10,000 20,500 1.12 11200 22960 Y2 10,000 20,500 1.2544 12544 25715.2 Y3 47,000 20,500 1.4049 66030.3 28800.5         49,774 37,476 Project C because it yields much return than project D based on both IRR and NPV. Answers to case study Questions Question 1 To increase the company’s value before the eyes of investors I will have to do the following: Develop a website that provides simplified information to the potential investors Showcase the unique elements of my company by clearly stating what makes the idea outstanding. Clearly define my market to help investors understand the company’s potential. Project the potential that this market holds. Compare the growth and profitability of related ideas to help potential investors get a feel of what kind of returns awaits them in my company. Question 2 Bobs idea makes his operations B2B meaning that his will sell this concepts to businesses in operation. His main need for capital will be to address the following: Hire staff that will provide marketing and training services for new customers on the implementation of this new concept. Buy assets required in producing the new sensor in large scale to meet the demands of potential customers. Put up information and management systems that will help in operational efficiency between his company and the new customers. Question 3 Matzoll’s idea of having one company hold the patent and the other take care of operations may appear like being selfish to venture capitalists. People would not like to invest their money where they absolutely no control of the core revenue earner. Having the patent appears like Bob has baked and wants to keep his own cake. He should let potential investors have a say on the patent to attract capital. Work Cited Megginson, William L, Scott B. Smart, and Brian M. Lucey. Introduction to Corporate Finance: London: Cengage Learning EMEA, 2008. Print. Read More