Viability of an Investment Idea - Example

Corporate Finance affiliation Corporate Finance This research paper will analyze the viability of an investment idea that ProGen, is planning to embark on. Several accounting and budgeting methods like Net Present Value and payback will be used to examine the cash flows. Recommendations will also be provided based on the results of the accounting methods. a) Preparation of the case, recommendation and viability of the project. To assess the project, the Net Present Value (NPV), Internal Rate of Return (IRR) and payback methods will be used. This paper will analyze the cash flows generated in by the project ProGen is planning to undertake and will recommend what the company should do so that it can reap out of it. Definition of terms: NPV is the total sum of all the present values of cash inflows and cash outflows within a defined period of time, the IRR is the interest rate or rate of discount for which the NPV of all the cash flows, both positive and negative ones, amount to zero (0) and finally payback method is any method that does not employ the use of NPV to reject or accept a project depending on the time required for the project to recover the initial outlay (Antony, 2002). Exhibit Year 2014 2015 2016 2017 2018 ₤000 ₤000 ₤000 ₤000 ₤000 Sales 5,480 6,190 6,890 9,455 9,900 costs Marketing 127 Raw material(seed) 2,320 3,200 3,410 3,500 3,500 License 1,000 1,000 1,000 1,000 1,000 Vehicle fleet depreciation 130 130 130 130 130 Direct wages 630 630 630 630 630 Rent 550 550 550 550 550 Overheads 750 750 750 750 750 Variable transport cost 625 625 625 625 625 Profit 652 695 205 2,270 2,715 NPV rule NPV = -PV (Costs) + PV (benefits), r= 11% (Note: all amounts are in ₤’000) PV of benefits Sales = 5,480 + 6,190 / (1 + 0.11)1 + 6,890 / (1 + 0.11)2 + 9,455 / (1 + 0.11)3 + 9,900 / (1 + 0.11)4 = ₤30,083.51 PV of cost Marketing = ₤127 Raw materials = 2,320 + 3,200 / (1 + 0.11)1 + 3,410 / (1 + 0.11)2 + 3,500 / (1 + 0.11)3 + 3,500 / (1 + 0.11)4 = ₤12,835.24 License = 1,000 + 1,000 / (1 + 0.11)1 + 1,000 / (1 + 0.11)2 + 1,000 / (1 + 0.11)3 + 1,000 / (1 + 0.11)4 = ₤4,102.45 Vehicle fleet depreciation = 130 + 130 / (1 + 0.11)1 + 130 / (1 + 0.11)2 + 130 / (1 + 0.11)3 + 130 / (1 + 0.11)4 = ₤533.318 Direct wages = 630 + 630 / (1 + 0.11)1 + 630 / (1 + 0.11)2 + 630 / (1 + 0.11)3 + 630 / (1 + 0.11)4 = ₤2,584.5408 Rent = 550 + 550 / (1 + 0.11)1 + 550 / (1 + 0.11)2 + 550 / (1 + 0.11)3 + 550 / (1 + 0.11)4 = ₤2,256.35 Overheads = 750 + 750 / (1 + 0.11)1 + 750 / (1 + 0.11)2 + 750 / (1 + 0.11)3 + 750 / (1 + 0.11)4 = ₤3,076.83 Variable cost transport = 625 + 625 / (1 + 0.11)1 + 625 / (1 + 0.11)2 + 625 / (1 + 0.11)3 + 625 / (1 + 0.11)4 = ₤2,564.03 Total PV of costs = 127 + 12,835.24 + 4,102.45 + 533.318 + 2,584.5408 + 2,256.35 + 3,076.83 + 2,564.03 = ₤28079.75599 NPV = -1,500 + 30,083.51 - 28079.75599 = ₤503.7503 According to the NPV calculations, the project is viable. The company should therefore undertake the investment opportunity. As indicated by the NPV, the company is guaranteed to make ₤503.7503 million of wealth the end of the five years. IRR rule Assume a discount rate of 2% per annum and follow the above method of calculating NPV. The PV of marketing = 127, raw materials = 15,266.43, license = 4,807.7287, vehicle fleet depreciation 625. 0027, direct wages = 3,028.87, rent = 2,644.2508, overheads = 3,605.7965 and variable transport cost = 3,004.8304. Using the same percentage, the net PV of benefits = -37,726.80774. NPV of the investment at 2% = -37,726.80774 + 127 + 15,266.43 + 4,807.7287 + 625. 0027 + 3,028.87 + 2,644.2508 + 3,605.7965 + 3,004.8304 = 1,616.9 If a rate of discount 18% is assumed, the NPV of the investments = -106.25. Using a discount rate of 0.166188, the NPV = 0 (1d.p). Roughly, this means that the IRR is around 0.166188 x 100 = 16.6188. Since the IRR is positive and more than the discount rate, this project is viable and the company should therefore engage in it. Payback method Looking at the figures above, it is clear that the projected revenue to be earned in each of the four years is uneven meaning that the uneven payback method will have to be used to calculate the payback period. The initial investment of the project requires 1.5 million. Profit generated in each of the five years is 625,000, 695,000, 205,000, 2,270,000 and 2,715,000 respectively. Cumulatively: 2014 = 625,000, 2015 = 625,000 + 695,000 = 1,320,000 2016 = 1,320,000 + 205,000 = 1,525,000 2017 = 1,525,000 + 2,270,000 = 3,795,000 2018 = 3,795,000 + 2,715,000 = 6,510,000 The initial investment was 1.5 million. From the figures above, this amount of money would be attained in the year 2016. The investment is therefore viable since the period of investment is longer than the payback period. The final method that is also going to determine whether the project is good and should be undertaken is the profitability index. This method uses the initial investment and the present value of the projected incomes. From the above information, the company plans spending 1.5 million as the initial outlay. The net present value of the benefits that will be reaped within the five years span is ₤503.7503. The profitably index which is given by: Profitability index = net present value of benefits / initial investment = 03.7503 / 1.5 =335.8335333. Though this figure looks hyper inflated, it means that when the company invests ₤1 they make a ₤335.8335333. The business is therefore profitable and worthy of investing. The company hope and plans to operate in the industry for five years the quit its operation. According to the profit and loss account, it projects major expenditure on raw material within the last three financial years. This is dangerous since some of the raw materials bought may be under-utilized in the case where those new companies inject the market with their new biotechnological developments. ProGen should invest more within the first financial years so that its market can expand more so that incase the new companies come into the market, they will not be able to penetrate easily since ProGen would be having a large market share. The company should not have a goal of ending after five years. Even though other companies may pose a threat to its product, it should know that it has other added advantage for instance the reduction of rental expenses. Other companies will have to struggle paying this high rental expenses meaning that their profit margin will not raise a given level. With little profit, enjoying large scale economies becomes hard to the advantage of ProGen. b) “The IRR is redundant as an investment criterion because the net present value (NPV) rule will always dominate” Bhattacharyya (2001) argues that the IRR is the cost of capital that makes the NPV equal to 0, within the given period of valuation. This holds true when there are no terminal value for the business within the time frame. However, it is important to understand that this terminal value, in most investment, is significant and can never be 0 as IRR would have it. In projects that exhibit decommissioning cost, the terminal value might go as low as negative and never 0. Therefore, assuming a zero terminal values doesn’t make much financial sense. It is therefore good to understand that all projects have one correct cost of capital which is used as a discount rate, ‘r’, when one is calculating the NPV of the project. The discount rate that makes the NPV = 0 is what is referred to as the IRR. Take an example of a five year investment with initial cost of $1000 as at now (t=0). The net cash flows of this project for the five year period are (-1000, t=0), (300, t=1), (300, t=2), (300, t=3), (300, t=4) and (300, t=5). Assuming a cost of capital of r=12% the NPV of the project is = -1000 + 300 / (1+0.12)1 + 300 / (1+0.12)2 + 300 / (1+0.12)3 + 300 / (1+0.12)4 + 300 / (1+0.12)5 = $81.4329. This simply means when one invests $1000 now, they will create a wealth of $81.4329, meaning in five years the asset will be worth $1081.4329. Using different rates of r, different NPV’s result as tabulated below. Discount rate r NVP 10% 137.24 12% 81.43 15.2382% 0 16% -17.71 According to the data above, the IRR of the project is 15.2382%. From this figures, one can therefore see that the IRR rule is redundant. The following explains why it is so. From the data above, the IRR is expressed in % while the NPV is not yet it is not the annual rate of return of the project. The project does not have an annual rate of return, since it is 0. Secondly, the IRR has the assumption that the future cash flows of the project are invested back into the project using the same rate of IRR, which in most cases it is not the case. However, in a case where the reinvestment occurs at the previous IRR rate, then it would be appropriate to state the IRR is the rate of return. Finally, IRR gives wrong interpretation about the viability of project, in other words, high IRR does not necessarily mean that the project should be accepted. As to conclusion, use of IRR becomes redundant the moment NPV is calculate because it gives the direct estimate of the value of the project while IRR doesn’t. When faced by a multiple IRR problem, the NPV rule is used to make decision because it gives the actual value of capital or discount rate. The above project is stand alone, meaning that it does not compete with other project. In a case where several projects have to be compared, the IRR is still redundant. Take two projects that are mutually exclusive, meaning that only one can be chose and not both, NPV rule will always dominate over IRR. Consider the following example. A company has two mutually exclusive projects A and B with a cost capital of r=10% for each of them. However, project B is larger than project A as shown in the figures below Project 0 1 2 A -1000 750 750 B -2000 1500 1300 NPVA = -1000 + 750 / (1+0.10) + 750 / (1+0.10)2 = $301.65, and IRR = 31.87% NPVB = -2000 + 1500 / (1+0.10) + 1300 / (1+0.10)2 = $438.01, and IRR = 26.41% According to the outcome above, definitely project B should be chosen over project A. This is because it has a higher NPV ($438.01) than project a ($301.65). however, of one decide to use IRR, they would end up choosing project A over B.in is important to note that project A has a high IRR however the wealth in brings is less than the wealth brought by project B which has a low IRR. It is therefore clear that the use of IRR can be used to determine viability of two different project of the same size or scale; it will result in wrong choices. NPV rule still dominates the IRR rule. The NPV rule is dominant over IRR rule in a case where the discount rate is unknown. This discount rate is very important to validate the validity of IRR. This is because; it needs it for comparison to occur. If IRR is below the discount rate, then the project is considered infeasible and if above the project is considered feasible. If this discount rate is not there then IRR becomes redundant. On the other hand, NPV rule is superior in this case since if it is above 0, the project is considered viable. IRR rule is redundant while NPV rule is dominant in the case of a project that has a mixture of positive and negative cash flows (Elizabeth, 1995). Consider a project in which the marketers must come up with new techniques of style so as to stay competitive in the market. Assuming that the project has cash flows of -$50,000 in the first year (initial capital outlay), returns amounting to $115,000 in the second year and expenses of $66,000 in the third year, single IRR method can’t be used in analyzing and revising the project. This means the marketers will use two or more IRR techniques as shown below: 0 = -50,000 + 115,000 / (1 + IRR) - 66,000 / (1 + IRR) 2 IRR = 0.1 0 = -50,000 + 115,000 / (1 + IRR) + 115,000 / (1 + IRR) 2 IRR = 0.2 As it can be seen from the above calculations, there are at least two solutions of the IRR meant to make the sum of the equation 0. This clearly indicates that the project has multiple rates of returns which produce multiple IRR’s. In such an instance, use of NPV would have handled the multiple discount rate incidents without any problems. Thus, NPV rule is still dominant over IRR rule. In calculations that involve IRR and NPV, calculation of IRR is usually done by trial and error. One chooses a value of the rate of discount that is higher than the cost of capital and compute for the NPV. If it doesn’t net to zero, another value of rate of discount is chosen until the moment when IRR = 0. On the other hand, calculations of NPV are based on real rates of discount (Peter, 1996). It is important to understand that this rate of discount is chosen to reflect the prevailing rates on the market and therefore not based on assumptions or trial and error. This therefore makes calculations using NPV rule dominant over the IRR rule. The IRR rule has easy financial parameter that is easy to understand. Even though these parameter, peak cash requirement and cash flow payback, are very fundamental in making decisions on what to invest and what not to invest, they make IRR rule redundant. They do this by complementing the value creation as determined by the NPV rule. In doing so, they alter the perception about funding. The investor begins seeing funding as a constraint. In the long-run, the investor ends up choosing another project for another due to affordably, yet in the real since, the initial project was within the budget expenditure of the investor. It is only that IRR parameters made NPV’s value of creation look higher. Finally, IRR rule is good in calculating discount rates that do not change. However, if the rates are changing, IRR needs modification so that it can account for the changing discount rates. Consider using the rate of return on T-bill for the past 2 decades as a discount rate. The one-year T-bill returned discount rates ranging from 1% to 12%, within the 2 decades, clearly indicating that the rates were changing. In such a phenomenon, using NPV would have been the best choice. References Antony, F. (2002). Capital asset investment: strategy tactics and tools. New York: J. Willey. Bhattacharyya, N. (2001). Interpreting internal rate of return. Calcuta: Indian Institute of Management. Elizabeth, M. (1995). NII and NPV simulation are the two methods for measuring IRR consistent? Boston: Office of Thrift Supervision, Risk Management Division. Peter, S. (1996). An examination of NPV regulation. Cambridge: Center for the Study of the Regulated Industry. Read More