lONDON SCHOOL OF COMMERCE | ASSIGNMENT | ACCOUNTING AND DECISION MAKING TECHNIQUES | |
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12/17/2009 |
You are required to provide an evaluation of two proposed projects, both with five year expected lives and identical initial outlays of £110,000. Both projects involve additions to AP Ltd.’s highly successful product range and as a result, the cost of capital on both projects has been set at 12%. The expected cash flows from each project are shown below.
In evaluating the projects please respond to the following questions:
(A) Why is the investment appraisal process so important?
(B) What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback
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Project B cover money earlier than project A, that is why project B should be accepted. Because money received now is important than money receive in future.
[C] What are the criticisms of the payback period?
Ans. The payback method is not a true measure of the profitability of an investment. Rather, it is simply tells the manager how many years will require to cover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.
There are also another two major problems with the payback periods rule. First, it does not take into take into account the time value of money. Second. It ignores what happens after the pay back. Because of these two filings, the payback rule sometimes accepted projects that should be rejected that should be accepted.
[D] Determine the NPV for each of these projects? Should they be accepted – explain why?
Ans. NPV FOR PROJECT A AND PROJECT B: * NPV of project A @12% in (£‘000) * Initial outlay £110 Year Inflow PVIF@12% PVCI 1 20 0.893 17.86
2 30 0.797 23.91
3 40 0.712 28.48
4 50 0.636 31.80
5 70 0.567 39.69 Total Present Value Cash Inflow 141.74
Net Present Value = PVCI – Initial Investment = 141.74-110 = 31.74
* NPV of Project B @12% in (£’000) * Initial outlay £110 * Annual Income £40
NPV = PVAkn – Initial
Free cash flows of the project for next five years can be calculated by adding depreciation values and subtracting changes in working capital from net income. In 2010, there will be a cash outflow of $2.2 million as capital expenditure. In 2011, there will be an additional one time cash outflow of $300,000 as an advertising expense. Using net free cash flow values for next five years and discount rate for discounting, NPV for the project comes out to be $2907, 100. The rate of return at which net present value becomes zero i.e.
The payback period looks at a project only until the costs have been recovered. This analysis tool is often ignored because it does not take into consideration the time value of money. The time value of money limitation of the payback period can be modified by using the discounted cash flows of a project for the analysis of when the outflows will be recovered.
The first project proposal is Match My Doll Clothing line expansion consisted of expanding matching doll and child’s clothing and accessories. The second project proposal is Design Your Own Doll by creating customizable “one of a kind” doll features through the company’s website. The project selection criteria would base on quantitative and qualitative analysis. The quantitative analysis would base on the evaluation of discounting cash flow forecasts to determining the Net Present Value (NPV), Internal Rate of Return (IRR), and the Payback period of each proposed project. The qualitative analysis would include the potential project value of the company’s overall strategy, innovation, key project risks, and the project interdependencies to the whole company.
Evaluating the risks, calculating the probability of success, and factoring in the projected profit from sales will provide a clearer NPV to be compared with other projects in the
Project C: This project will be a scale-up of a project done last year. All the same processes will be used. The costs for the material and other resources should be scalable based on last year’s costs.
7) See Table 1 NPV=42,318.71 IRR = 14% MIRR = 12% Payback period= 2.93 years. Yes the project should be undertaken.
"a. If each project's cost of capital is 12%, which project should be selected? If the cost of capital is 18%, what
Thus, by year three the company will be making a profit off the investment as year three is 86.73 million profit by 55.35 cost giving the company a 31.38 million dollar surplus. Generally, a period of payback of three year or less is acceptable (Reference Entry) causing this project to be viable based off the payback analysis. Although, these calculations are flawed. The reason for this is because the time value of money is not taken into effect when calculating payback periods which is where IRR can further assist in a more realistic financial picture (Reference Entry).
The company should accept this project. The project payback period is between 2 to 3 years.
The ARR for the project is 12.8% this is less than required 15%. Therefore the project should be rejected.
The PAYBACK technique is based on cash flows and it measures the time which is required for a proposal’s initial cash outflow to equal its cash inflow generated by the investment, the solution is expressed in years and month or days.
The use of an accounting rate of return also underscores a project 's true future profitability because returns are calculated from accounting statements that list items at book or historical values and are, thus, backward-looking. According to the ARR, cash flows are positive due to the way the return has been tabulated with regard to returns on funds employed. The Payback Period technique also reflects that the project is positive and that initial expenses will be retrieved in approximately 7 years. However, the Payback method treats all cash flows as if they are received in the same period, i.e. cash flows in period 2 are treated the same as cash flows received in period 8. Clearly, it ignores the time value of money and is not the best method employed. Conversely, the IRR and NPV methods reflect that The Super Project is unattractive. IRR calculated is less then the 10% cost of capital (tax tabulated was 48%). NPV calculations were also negative. We accept the NPV method as the optimal capital budgeting technique and use its outcome to provide the overall evidence for our final decision on The Super Project. In this case IRR provided the same rejection result; therefore, it too proved its usefulness. Despite that, IRR is not the most favorable method because it can provide false results in the case where multiple negative
later in the project life. With a NPV of less than -$810,000, Scenario 6 is the project with the
is only three years. Second; the payback period for the project A is 3 years and for G
5. The project is assumed to end in year 4. Do you think that this is realistic? Can you estimate the value of the project’s operating cash flows beyond year 4? State any assumptions you made.