Investment Appraisal of Elgar Pharmaceutical Ltds Proposed Investment - Assignment Example

Investment Appraisal of Elgar Pharmaceutical Ltd’s Proposed Investment Name: University: Course: Tutor: Date: Net Present Value Analysis Net present value (NPV) is a superior investment appraisal tool. It seeks to measure by how much an investment increases the shareholder’s wealth in absolute value and in today’s terms (Dobson, 1997). It incorporates the all important concept of time value of money. This concept appreciate that a dollar received today is worth more than a dollar received tomorrow. This concept is incorporated in the net present value calculation by a process called discounting; this is done by multiplying future values by a discounting factor based on the discount rate (Dobson, 1997).  The discount rate represents the cost of capital. In the case study of Elgar Pharmaceutical Ltd, the discount rate is 12%. This was arrived at based on the assumption that the tax rate is 20% per annum and that the bank’s interest rate of 15% is the pre-tax cost of debt. Since interest on bank loans is tax allowable, then a post-tax cost of debt must be calculated. This is done by multiplying the interest rate by, one minus the tax rate (interest rate * (1-interest rate) giving a rate of 12%. From the discount rate a discount % is calculated, by adding one to the discount rate then raised to the power of time in years. In this case (1+12%) ^-1, this gives an annuity factor of 0.893 (rounded off). This figure can be obtained directly from the present value table in the column with12% and the row with year one. For the purpose of analyzing Elgar Pharmaceutical Ltd’s investment, it is assumed that the post-tax cost of debt is equal to the company’s weighted average cost of capital and thus it is an appropriate discount rate. It is assumed that the whole of the initial capital outlay is to be incurred now/time zero. This eliminates the need to discount the $ 400,000 cash outflow. It is normal for capital investments to attract capital allowances in terms of tax benefits but this has been ignored in this analysis. Assuming that scenario one prevails (ignoring probabilities). The worth of the business in one year’s time will be $ 700,000; however this has been given in future value terms. To find the present value, this figure is multiplied by the annuity factor 0.893. This gives $ 625,000 as the worth of the firm in present value terms. To find the net present value we deduct the initial outlay of $ 400,000 from the present value to give the net present value as positive $ 225,000. This would translate to investor’s wealth increasing by $ 225,000, this mean that the investment is worthwhile. Assuming scenario two prevails (ignoring probabilities). The only change in the data from scenario one is the worth after one year which change to $340,000. This is discounted using the discount rate of 12% (discount factor 0.893) to give a present value of negative $ 96,428.57. This means that if the value of the business is to be $ 340,000 in one year’s time, the shareholders will have lost $ 96428.57. This would make this investment not to be worthwhile and it should be rejected. Application of Expected Values in the Investment Appraisal This is an important tool of incorporating risk into the investment appraisal process (Helfert, 2001). The probability assigned to scenario two is 30%, therefore the probability of scenario one is 70%. This follows the basic concept that the sum of all probabilities adds up to one. An expected value can be calculated from these probabilities. This is achieved by multiplying the possible outcomes by their respective probabilities (($ 340,000*0.3) + ($ $700,000*0.7)) this give an expected value of $ 592,000, this is discounted at 12% to give a present value of $ 528,571.43. After deducting the initial outlay of -$400,000, the resulting net present value is $ 128,571.43. Net present value calculations based on expected values indicate that the project is worthwhile and should be undertaken. However other financial matters should be taken into consideration such as liquidity, alternative investment opportunities and gearing levels among other things. Other non financial factors such as ethics, environmental footprints and strategic significance should be considered. However based on the financial investment appraisal the investment should be undertaken. Sensitivity Analysis Sensitivity analysis helps to incorporate uncertainty in the investment appraisal process (Helfert, 2001). Project appraisal deals with future cash flows that are inherently uncertain. Sensitivity analysis shows the impact of a change in a variable in isolation. It measures by what percentage a variable can change before the investment decision is affected, that is, turning a positive net present value negative (Helfert, 2001). Sensitivity is measured as a percentage and is calculated by dividing the net present value based on expected value by the variable under consideration and multiplying the result by 100. Elgar Ltd management has provided data for both normal and pessimistic conditions. The pessimistic estimate is that an initial capital outlay of $500,000 would be required instead of $400,000. The sensitivity of initial capital outlay is 32.14%. This means that the initial capital outlay can increase by this percentage before the net present value turn negative. Therefore the initial capital outlay can increase to $528,560 (1.32*$400,000) before changing the net present value negative. This is more than the pessimistic estimate of $500,000 which would still give a positive net present value and would not affect the viability of the investment. The pessimistic probability of failure is 50%. This means that the probability of operating at full capacity is 50%. A net present value calculation using these figures gives a positive net present value of $64,285.71. This means that the decision cannot be affected by the increase of probability of failure to 50%. The sensitivity of business worth (full capacity) is 29.39%. This means that the business worth (full capacity) can reduce by this percentage without affecting the investment decision. This means that the business worth (full capacity) can decrease to $494,286.10, ((1-0.2939)*700000) without changing the investment decisions. This is less than the pessimistic estimate of $600,000. This means that the investment decision cannot be affected by business worth (full capacity) dropping to $ 600,000. The sensitivity of business worth (tough competition) is 141.17%. This shows the net present value is least sensitive to this variable. In fact the business worth (tough competition) can drop to negative amounts without affecting the investment decision being affected. The sensitivity of discount rate is given by calculating the internal rate of return (IRR) of the project. This is the rate of return that would give a net present value of zero. This is calculated through a process of extrapolation/interpolation which comprises the application of the internal rate of return formula (given in the appendix). This requires one to use two discount rates to find two net present values which are used for the purpose of extrapolation/interpolation. In the appraisal of Elgar Pharmaceutical Ltd, 30% pre-tax cost of debt is used for the purpose of extrapolation/interpolation. This gives a post-tax cost of debt as 24% ((1-20%)*30%), used in calculating a net present value. The extrapolated internal rate of return using these figures is 42.16%, this mean that a discount rate of 42.16% would give a net present value of zero. This can be divided by 0.8 to give a pre-tax rate of 52.7%. However, due to the inaccuracy of this formula the answer is not perfect, but using more sophisticated computer applications the internal rate of return is shown accurately as 48% giving a pre-tax rate of 60%. This means that the pre-tax cost of debt has to increase above 60% to give a negative net present value. Therefore the pessimistic estimate of a 20% discount rate cannot affect the investment decision. Investment Decision Advice Based on the net present value and sensitivity analysis calculations, this is a sound investment. The net present value decision rule is that all projects with a positive net present value should be accepted as they increase the shareholder’s value (Dobson, 1997).  The proposed investment by Elgar Pharmaceutical Ltd would lead to an increase in the shareholder’s wealth by $128571.42. This means that the project is beneficial financially and should be undertaken. Sensitivity analysis is used to assess uncertainty in an investment. The analysis indicated that the project is only modestly sensitive to the different variables. This shows that there is little uncertainty surrounding the investment and even if the pessimistic outcomes were to occur, the project run at little risk of producing a negative net present value. Therefore based on the sensitivity analysis carried out the decision would be to undertake the project. As discussed earlier other considerations should be taken into account. Elgar Pharmaceutical Ltd is a small company and such a huge capital investment may be hard to manage. Effective project management is vital to the success of capital financial investments and the management of this firm may be lacking these specialist skills. Considerations about corporate objectives should also be made; some projects with positive net present value should be rejected if they do not match the corporate goals. Financing of this project is also an issue; the proposed borrowing may be unwise as it may increase the risk profile of the company to unsuitable levels. Debt is usually attractive due to tax allowances but tax exhaustion may occur sometimes. Ethical considerations should also be made; an investment may constitute building premises that adversely affect the environment or endangered plant and animal species. Such possibilities can lead to decisions to withdraw the investment proposal. A closer look at the investment appraisal tools reveals that they are not perfect. Sensitivity analysis assumes that variables change independently whereas some variables are known to be inter-dependent. It also disregards probabilities and may show factors beyond management’s control as most critical. Some of these shortcomings can be solved by using simulation analysis (Helfert, 2001).  The net present value is not perfect either. It ignores financing side effects of the source of funds used. Increased borrowing may increase the financial risk of a company and raise its weighted average cost of capital. Issue costs associated with raising finance are not incorporated in the net present value calculations. A more advanced technique called adjusted present value can be used to remedy these weaknesses (Helfert, 2001).  References Dobson, J. 1997. Finance ethics: the rationality of virtue. New York: Littlefield. Helfert, E. 2001. Financial analysis: tools and techniques: a guide for managers. Boston: McGraw-Hill. Appendix Where; IRR –internal rate of return a-the lower of the two rates used b-the higher of the two rates used NPVa-net present value obtained using rate a. NPVb-net present value obtained using rate b Read More