ACC511 The Management Estimates that the New Plant
RWE Enterprises Pty Ltd is a small manufacturing firm located in Brisbane. RWE is considering setting-up a new plant. The plant has an upfront cost of $3 million. The proposed plant will have a life of 10 years at the end of which it can be sold for an after-tax scrap value of $200,000. The management estimates that the new plant will add 700,000 to after-tax profits during each year of its life. Midway through its life, that is, at the end of 5 years, the plant will have to be refurbished at a cost of $2 million.
- What are the full 10 year cash flows associated with the plant? That is, make a cash flow diagram showing the yearly cash flows from year 0 to 10.
- If RWE uses a 10% discount rate to evaluate investments of this type, what is the net present value of the project? What does this NPV indicate about the potential value RWE might create by purchasing the new production line? Explain.
- Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability? Explain.
- Calculate the payback period for the proposed investment. Interpret your findings.
Question 2 (10 marks)
Jason Katz graduated from University of the Sunshine Coast in December and has started working for Innovative Investments. When Jason arrived at work on Monday morning, he found the following memo on his desk
“To: Jason Katz, Financial Analyst
From: George Adams, CFO
RE: Project Evaluation
Provide an evaluation of two proposed projects with the following cash flow forecasts:
|
Project A |
Project B | |
|
Initial Outlay |
(275000) |
(275000) |
|
Year 1 |
50000 |
100,000 |
|
Year 2 |
75000 |
100,000 |
|
Year 3 |
100,000 |
100,000 |
|
Year 4 |
125,000 |
100,000 |
|
Year 5 |
175,000 |
100,000 |
The company requires a rate of return on both projects equal to 12%. As you are no doubt aware, we rely on a number of criteria when evaluating new investment opportunities. In particular, we require that projects that are accepted have a payback of no more than three years, provide a positive NPV and have an IRR that exceeds the firm’s discount rate.
Give me your thoughts on these two projects by 9 am tomorrow morning.”
Jason was not surprised by the memo, for he had been expecting something like this for some time. Innovative Investments followed a practice of testing each new financial analyst with some type of project-evaluation exercise after the new hire had been on the job for a few months.
After re-reading the memo, Jason decided on his plan of attack. Specifically, he would first do the obligatory calculations of payback, NPV and IRR for both projects. Jamie knew the CFO would grill him thoroughly on Tuesday morning about his analysis, so he wanted to prepare well for the experience. One of the things that occurred to Jason was that the memo did not indicate whether the two projects were independent or mutually exclusive. So, just to be safe, he thought he had better rank the two projects in case he was asked to do so tomorrow morning. Jason sat down and made up the following ‘to do’ list:
(a) Calculate payback, NPV and IRR for both projects.
(b) Evaluate the two projects’ acceptability using all three decision criteria (listed above) and based on the assumption that the projects are independent. That is, both could be accepted if both are acceptable.
(c) Rank the two projects and make a recommendation as to which (if either) project should be accepted under the assumption that the projects are mutually exclusive.
Assignment—Prepare Jason’s evaluation for his Tuesday meeting with the CFO by filling out your response
Answer:
- In accordance with the information provided, it is apparent that $ 3 million is the initial investment. Also, based on the information provided in relation to the expected cash inflows along with the scrap value at project end, the following summary can be drawn.
- Using the discount as 10%, the NPV of the given pr
oject is computed in the tabular manner highlighted as follows.
Considering that project NPV is positive ($0.14 million), therefore the project should be accepted as it would result in value creation for the shareholders (Damodaran, 2014).
- The discount rate at which NPV value becomes zero is called IRR and the relevant computation is highlighted below.
The project IRR is 11.04%. It is greater than the project’s cost of capita and hence it may be derived that the project is feasible in accordance with IRR criterion (Petty et. al., 2015).
For computing the profitability index, the following formula can be used (Brealey, Myers and Allen, 2015).
In case of the project, initial investment required is $ 3 million
Also, the future cash inflows over the project useful life have a present value of $ 3.14 million.
Therefore, PI= (3.14/3) = 1.047
Considering the value of PI exceeds one, the financial feasibility of the project is reflected.
- The amount of time that is required to recoup the starting investment is referred to as the payback period.
The payback period can be computed with the help of the table illustrated below.
Based on the above, it is apparent that the payback period would be 7 + (0.1/0.7) or 7.14 years
Since the payback period associated with the project is lower than the project life, therefore acceptance of project must be done. A key issue with the usage of payback period is that it fails to take into consideration the pivotal concept of time value of money and thereby is taken to be less accurate in terms of capital budgeting decision making (Damodaran, 2014).
Question 2
- Project A
NPV Table
IRR Table
From the above computation, IRR = 20.96%
Payback Period Table
From the above table, payback period is computed as 3 + (50000/125000) or 3.4 years
Project B
NPV Table
IRR Table
From the above computation, IRR = 23.92%
Payback Period Table
From the above table, payback period is computed as 2+ (75000/100000) or 2.75 years
- A key criterion is with regards to NPV being positive which is fulfilled by both projects. Also, both projects have respective IRR greater than the applicable discount rate or cost of capital of 12%. However, it is also required that the payback period of the project must not exceed 3 years which is not fulfilled by Project A but fulfilled by Project B.
In wake of the above discussion, the acceptable project would be project B only.
- With regards to ranking, project B would prove to be superior to project A on account of the reasons indicated below (Brealey, Myers and Allen, 2015).
- NPV (Project B) > NPV (Project A)
- IRR (Project B) > IRR (Project A)
- Payback Period (Project A) > Payback Period (Project B).
Therefore, if only one project could be selected, it has to be project B and not project A.
References
Brealey, R. A., Myers, S. C., and Allen, F. (2015) Principles of corporate finance (2nd ed.) New York: McGraw-Hill Inc.
Damodaran, A. (2014). Applied corporate finance: A user’s manual (3rd ed.) New York: Wiley, John & Sons.
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications (6th ed.) NSW: Pearson Education, French Forest Australia.
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