New Mobile Phone Project - Case Study Example

Report on New Mobile Phone Project Summary: Fones 4 U is considering the launch of a new mobile phone and the Directors have come up with different project proposals. In order to identify the best suited project for Fones 4 U, it is essential to analyse the project proposals and estimate their profitability, returns and other issues involved (Bized – Finance and Investment, 2008). It is important to compare all the possibilities and analyse their relative merits. Initially, the three projects are compared based on the net present values (NPV) and it is found that the Project T has the highest NPV of £ 6.43 million, followed by Project F with NPV of £ 6.16 million. As the initial investments differ for the three proposals, profitability index (PI) is computed in order to arrive at a common measure to compare the profitability of the three projects. The profitability index indicates that the Project F is the most profitable one. In order to analyse the sensitivity of the three projects, the Internal rate of return (IRR) is used, as it gives a clear picture on the margin of safety. The calculations indicate that the Project S has the highest IRR value of 26.8%. However as the returns are comparatively lesser, the Project F with IRR of 23.33% is taken as the less risky project. The non – financial factors are also analysed and from these arguments, it is clear that the best choice for Fones 4 U is to go ahead with Project F. The main reasons are that, this project has considerable returns (£ 6.16 million) and is risk free and also the IRR is considerably higher indicating that the project will not undergo losses for significant changes in the profit estimates. Introduction: Fones 4 U has three options to launch a new mobile phone. The investments required for these three project proposals are estimated and the profit estimates are also made for the useful life of the project, which is 10 years. The project proposals have to be completely analysed using the various investment appraisal techniques, in order to get a clear picture of the returns. The non – financial factors should also be given importance before making the final decision. These factors are analysed in the following sections. Comparison of Project Proposals: It is clear that the management should analyze any investment in terms of financial gains, before funding the project. Hence it is absolutely necessary that the management practices appropriate investment appraisal techniques to make informed decisions and have constructive control over the funds available for investments (Samuels et al, 2000). Investment appraisal is defined as the “Evaluation of the attractiveness of an investment proposal, using methods such as average rate of return (ARR), internal rate of return (IRR), net present value (NPV), or payback period (PP). Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training” (Gotze et al, 2007, p24) (Fisher and Martin, 1994). In the case of Fones 4 U, the discounted cash flows are used to analyse the returns from the projects. Time plays an important role in cash flows. This phenomenon of time value of money can have significant effects on the returns computed and can lead to completely different decisions when compared to the traditional techniques (Johnson and Kaplan, 1991). Hence it is essential to reduce or discount the cash flow to present values before including them in investment appraisal techniques (Kruschwitz and Loeffler, 2005). Net Present value (NPV): Net Present Value (NPV) is the most commonly used method and it utilizes the discounted cash flows to compute the returns from an investment. In this method, initially all the future cash flows that will be generated by the project are discounted to present value. This value is then reduced by the initial investment to arrive at the Net Present Value (NPV) (Bott, 2008). Step 1: PV of future cash flows = (t = 1 to n)  Ct / (1 + r) t where Ct is the cash flow generated in period t, r is the discount rate used and n is the number of years. Step 2: Net Present value (NPV) = PV of future cash flows – Initial Investment (Samuels et al, 2000) The NPV of the three proposals are computed as follows: Project T: Price of the Patent = £ 5 million New factory = £ 2 million Equipment = £ 6 million Land = £ 3 million Total Initial Investment = £ 16 million The Net Present Value of the Project T is computed as follows, using 16% as the cost of capital: Project T Year Cash Flow (£ m) Present Value (£ m) 0 -16.0 -16.00 1 -2.3 -1.98 2 1.5 1.11 3 6.0 3.84 4 8.0 4.42 5 10.0 4.76 6 10.0 4.10 7 8.0 2.83 8 6.0 1.83 9 4.0 1.05 10 2.0 0.45         NPV 6.43 The NPV for Project T is computed as £ 6.43 million. The NPV is a positive value indicating that the project is profitable and does not undergo any losses. This indicates that the project, if chosen, will increase the value of Fones 4 U by £ 6.43 million. Project F: Price of the Patent = £ 5 million Equipment = £ 6 million Lease = £ 1.4 million Total Initial Investment = £ 12.4 million The annual payment for the factory £ 0.8 million are also included in the cash flows. The NPV is computed as follows: Project F Year Cash Flow (T) £ m Cash Flow (Project F) £ m Present Value (F) £ m 0 -16.0 -12.4 -12.40 1 -2.3 -3.1 -2.67 2 1.5 0.7 0.52 3 6.0 5.2 3.33 4 8.0 7.2 3.98 5 10.0 9.2 4.38 6 10.0 9.2 3.78 7 8.0 7.2 2.55 8 6.0 5.2 1.59 9 4.0 3.2 0.84 10 2.0 1.2 0.27             NPV 6.16 The calculations indicate that the NPV is positive for Project F and has a value of £ 6.16 million. However, this is lesser than that of Project T which was computed as £ 6.43 million. Project S: R & D (New Technology) = £ 3 million Equipment = £ 4 million Total Initial Investment = £ 7 million The NPV is computed as follows: Project S Year Cash Flow (Project F) £ m Present Value (F) £ m 0 -7.0 -7.00 1 1.5 1.29 2 3.0 2.23 3 3.0 1.92 4 3.0 1.66 5 2.0 0.95 6 2.0 0.82 7 2.0 0.71 8 1.0 0.31 9 1.0 0.26 10 0.4 0.09         NPV 3.24 Thus, Project S has a NPV of £ 3.24 million. This is very less compared to the other projects. From these calculations, it is clear that Project T has the highest Net Present Value of £ 6.43 million. Hence Project T will increase the value of Fones4U to the maximum extent and is the best suited project. However, it has to be noted that the investment is also higher in the case of Project T. This indicates that the profitability will be different for the three proposals. Hence the profitability index is computed for the three projects. Profitability Index (PI): The Net Present value (NPV) is an effective method in taking decisions. However, in the case of projects with positive NPV, the method indicates that the one with the higher NPV should be selected (Samuels et al, 2000). It does not focus on the amount of investment required for each project and on the profitability. The profitability index (PI) aims to standardize the NPV calculations against differing initial investments and profits of the different project proposals (Financial Scholar, 2008). It is calculated using the formula, Profitability Index (PI) = Present Value of Net Cash Flows / Initial Investment Project T: PI = £ 22.43 m / £ 16 m = 1.40 Project F: PI = £ 18.56 m / £ 12.4 m = 1.50 Project S: PI = £ 10.24 m / £ 7 m = 1.46 The PI values of the projects indicate that Project F is the most profitable investment. This contradicts the result from the Net Present Value calculations. However, the difference in the NPV between Projects T and F is just £ 0.27 million (6.43 m – 6.16 m), which comes up to 4.2%. This is comparatively lesser when considering the difference in profitability between the two projects (7.2%). Hence Project F is definitely better than Project T. However, it is essential to consider the sensitivity of the various projects to the variations in the estimates. The NPV and PI do not account for any variations in the estimates (Constantini, 2006). Internal Rate of Return (IRR) is computed to analyse the sensitivity of the projects. Internal Rate of Return (IRR): The NPV and profitability index are based on the assumption that the estimates are accurate and there will not be any fluctuations in the estimated values. In order to account for sensitivity, the Internal rate of return (IRR) is computed for the three project proposals (Weston and Copeland, 1988). Internal rate of return also utilizes the Discounted Cash Flows. It can be defined as the rate of discount that has to be applied on a project’s cash flows to make the Net Present Value (NPV) equal to zero. The meaning of Internal Rate of Return (IRR) is that the discount rate or the company’s cost of capital can increase till the IRR value and still the investment will not incur any losses to the company. The IRR is an indication of the maximum value that the discount rate can go up, so that the company does not undergo any losses. This method works on trial and error basis. Initially the NPV for an assumed rate is determined and based on this value, another rate is selected so that the new NPV approaches closer to zero. Based on these two values, the IRR can be computed using the cross-multiplication rule. The main rule of the project is higher the rate of interest over the cost of capital, the better it is for the company and hence the project can be selected (Constantini, 2006) (Samuels et al, 2000). The Internal Rate of Return is computed for the three projects in the following sections: Project T: The PV is computed for a discount rate of 20% and the values are tabulated below. Project T Year Cash Flow Present Value (16%) Present Value (20%) 0 -16.0 -16.00 -16.00 1 -2.3 -1.98 -1.92 2 1.5 1.11 1.04 3 6.0 3.84 3.47 4 8.0 4.42 3.86 5 10.0 4.76 4.02 6 10.0 4.10 3.35 7 8.0 2.83 2.23 8 6.0 1.83 1.40 9 4.0 1.05 0.78 10 2.0 0.45 0.32   NPV 6.43 2.55 IRR = 20 + [4 / (6.43 – 2.55) * 2.55] = 22.62% This indicates that the Net Present Value becomes zero at 22.62% discount rate. Hence Fones 4 U will not undergo any losses even when the discount rate increases to 22.62 %. Project F: The IRR for Project F is also computed using the two rates (16 % and 20%). Project F Year Cash Flow Present Value (16%) Present Value (20%) 0 -12.4 -12.40 -12.40 1 -3.1 -2.67 -2.58 2 0.7 0.52 0.49 3 5.2 3.33 3.01 4 7.2 3.98 3.47 5 9.2 4.38 3.70 6 9.2 3.78 3.08 7 7.2 2.55 2.01 8 5.2 1.59 1.21 9 3.2 0.84 0.62 10 1.2 0.27 0.19   NPV 6.16 2.80 IRR = 20 + [4 / (6.16 – 2.80) * 2.80] = 23.33% Hence Project F has a higher IRR than Project T. Project S: Similarly IRR is computed for Project S. Project S Year Cash Flow Present Value (16%) Present Value (20%) 0 -7.0 -7.00 -7.00 1 1.5 1.29 1.25 2 3.0 2.23 2.08 3 3.0 1.92 1.74 4 3.0 1.66 1.45 5 2.0 0.95 0.80 6 2.0 0.82 0.67 7 2.0 0.71 0.56 8 1.0 0.31 0.23 9 1.0 0.26 0.19 10 0.4 0.09 0.06   NPV 3.24 2.04 IRR = 20 + [4 / (3.24 – 2.04) * 2.04] = 26.8% This indicates that Project S is the least risky and is insensitive to the changes in the estimates, as the discount rate can go up till 26.8% before Fones 4 U can incur losses. Non – Financial Factors: There are a number of non – financial factors that impact the decision of Fones 4 U. The company deals with voice / video – imaging output; hence they would require giving a lot of importance to ensure that technology used in the product is in line with the latest technology prevailing in the market. Hence it is recommended that Fones 4 U opts for either Project T or F, as it includes the latest technology. The proposal made by the Sales Director to use the in - house technology would prove to be beneficial for the company. Fones 4 U would have chance to improve their technology. However the return from the project is lesser, though the sensitivity to variations is lesser for the Project S. Hence Fones 4 U should go for Project F and continue investing in Research and Development and come up with advanced technologies for the future. This will help the company to introduce more innovative products in the future and they can be patented by Fones 4 U. Conclusion: From the above arguments, it is evident that the optimum choice for Fones 4 U is Project F. This is indicated by both the financial and non – financial factors. 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M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Weston, J. F. and Copeland, T. E., 1988, Managerial Finance, 2nd edn., Cassell Educational Ltd, London Read More