Net Present Value Calculations - Essay Example

Workings Direct Material cost per unit calculation for years 2, 3 & 4 at inflation rate of 3% (a) Whistle Yr 2: 18.00 X 103% = 18.54 Yr 3: 18.54 X 103 % = 19.10 Yr 4: 19.10 X 103 = 19.67 (b) Flute Yr 2: 13.50 X 103% = 13.9 Yr 3: 13.91 X 103% = 14.33 Yr 4 14.33 X 103% = 14.76 (2) Incremental fixed production overhead calculation (a) Whistle Yr 2: 12.96 X 105% = 13.61 Yr 3: 13.61 X 105% = 14.29 Yr 4: 14.29 X 105% = 15.00 (b) Flute Yr 2: 9.63 X 105% = 10.11 Yr 3: 10.11 X 105% = 10.62 Yr 4: 10.62 X 105% = 11.15 (3) Calculation of selling prices of whistle and flute for years 2, 3 and 4 Year 2 Whistle Flute /unit / unit Direct Material 18.54 13.91 Incremental fixed production o/h 13.61 10.11 Total cost / unit 32.15 24.02 Budgeted Mark up 15.54 11.37 Selling price 47.69 35.39 Year 3 Whistle Flute Direct Material 19.10 14.33 Incremental fixed production o/h 14.29 10.62 Total cost / unit 33.39 24.95 Budgeted mark - up 15.54 11.37 Selling price 48.93 36.32 Year 4 Whistle Flute Direct Material 19.67 14.76 Incremental fixed production o/h 15.00 11.15 Total cost / unit 34.67 25.91 Budgeted mark - up 15.54 11.37 Selling price 50.21 37.28 NET CASHFLOWS OF THE INVESTMENT (CALCULATION) Year year year year 1 2 3 4 Whistle ('000') ('000') ('000') ('000') Sales volume 60 110 100 30 Sales price (sw) 46.50 47.69 48.93 50.21 Sales value ('000') 2790 5245.9 4893 1506.3 Year 1 Year 2 Year 3 Year 4 Flute ('000') ('000') ('000') ('000') Sales volume 75 137.5 125 37.5 Sales price 34.50 35.39 36.32 37.28 Sales value ('000') 2587.5 4866.125 4540 1398 Total sales value ('000') 5377.5 10112.025 9433 2904 Less advertising costs 750 300 300 (-) Earnings before interest 4627.5 9812.025 9133 2904 Depreciation and tax Less tax (-) (-) (-) (-) Operating net cashflow 4627.5 98.12.025 9133 2904 NPV CALCULATION Year Cashflow (a) PVI fr% np (b) Present Value(c) =ax b 1 4627.5 0.9174 4245.2685 2 98.12.025 0.8417 7052.5026 3 9133 0.7722 7052.5026 4 2904 0.7084 2057.1936 4 (sale of building) 1300 1 21613.746 Less initial cash outlay (I0) (6000) [300 + 1900 + 2000 + 18000 Net Present Value 16913.746 NPV of the project = 13.746 X 1000 = 16,913.746 CALCULATIONS EXPLAINED 1. To get the present value of future cash flows, we discount them using a suitable discounting rate. In this case it has been given as 9%. The annuity tables give a factor within a certain interest rate .This factor is then multiplied by the cash flows to obtain their present values. It is this factor that is referred to as the present value interest factor (PVIF). When discounted at a given discount rate (r) over a given number of periods (p) it is then denoted as PVIFr%np. np means 'no. of periods'. 2. 'Io' is the initial cash outlay. This is the initial amount of money that one starts a project with. It is subtracted from the total present value to arrive at the Net present value. I have capitalised the research costs according to the requirements of International accounting standards (i.e. 300). Other costs also capitalised and which form part of initial cash outlay are the 1900 2000 and 1800. It can be concluded that the investment of BFG P/C in products whistle and flute is worthwhile since it has a positive NPV of 15,613,746. This means that the project has the prospects of generating future benefits to the firm. Issues regarding the proposed investment by BFG P/C (1) Certainty of cashflows: - It is worth to consider the fact the cashflows are just but estimates. Any change/ deviation of the cashflows will automatically affect the Net present value of the investment. BFG would rather attach probabilities to the cashflows for the results to be reliable. (2) Economical changes: The inflation rates expected may change significantly so as to affect to the expected results. Other factors such as changes in tax rates and other government legislations will also affect the final results and decision on whether or not to invest in the products. (3) Existence of other viable products: - The firm to be compelled to explore whether other products with positive NPV - exist. However must consider whether there is enough capital to invest in other products. (4) Replacement decisions: - Project's may be viable but it would be necessary to determine at what point they may start loosing their viability. Their operational efficiency may start deteriorating or even become obsolete technologically. The firm must then contemplate abandoning the project at that point (5) Variability of sales: - The sales from the products vary considerably. It can be noted that for whistle they range from 60,000 to 30,000 and for the flute from 137,570 to 37,500. This unsteady flow of sales may render the project risky. (c) Convertible loan stocks as a means of financing investments are fixed charge securities whose rates are fixed. The rate, in this case 7% remains constant throughout the economic life of the project. Fixed charge capital has the effect of increasing the gearing of the firm hence its financial risk. When the financial risk of the firm increases its ability to meet the firm's financial obligations diminishes significantly. But the loan stock in this case is convertible. Such securities have one advantage. In an era of declining interest rates, managers are bound to make the loan refunding decisions. They retire the current loan which they are paying and take another one at the lower interest rate which is prevailing in the market. This will save the company some interest expenses or charges over the remaining maturity period of the loan. Therefore the proposal of financing the investment with a convertible loan stock issue is good ideas save for the fixed interest charges that have to be paid. The proposal would further lead to a dilution of the existing shareholders. (d) The following factors would influence the decision - maker's choice as to the most appropriate investment: - (1) Risk: - A project with a lower risk is more preferable to one with a higher risk. From the above list of available alternatives, project X has the lowest risk. Project Y has the highest risk as measured by the standard deviation. Preference would then be given to project X on the basis of risk. (2) Expected NPV: - A project with a higher positive Net Present Value is more preferable to that with a lower positive NPV. Positive Net Present value is an indicator that benefits will flow from the project on the basis of E (NPV), and then project Z will be the most preferable since it has the highest expected NPV of 150,000. (3) Co - efficient of variations: - Using the expected Net Present Value [E (NPV)] and the standard deviation differently gives conflicting results. This is because the method suggests that project X is the best on one hand and Z as the best on the other hand. To counter this problem, the co - efficient of variation is used to determine the best alternative. The best alternative would be one with the lowest co- efficient of variation. Co -efficient of variation is a relative measure of risk. It is a measure of the amount of risk per unit of return. Co- efficient of variation (CV) = = standard deviation Expected return Project X = 40,000 = 0.32 Project Z is the most 123,000 preferable since it has the lowest risk Project Y = 50,000 = 0.35 142, 000 Project Z = 45,000 = 0.30 150,000 4. Payback period: - This is the amount of time that a project would take to recoup/recover its initial investment. The shorter the payback period the better the project. The decision maker should therefore not only consider the risk or net present value of the project but also its payback period. A project may have a low risk and a high net present value and yet it takes a long duration of time to break even or recover the initial amount. This translated would mean that a lot of cash resources would be trapped in the project. References Barrow, P. and Branson, R. 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