Capital budgeting is the branch in finance which deals in the evaluation of investments among those available with the organisation. By applying the various evaluation tools, the organisation can select the most beneficial and profitable investment. The present report will highlight the different available techniques using discounted and non-discounted methods. The most commonly used three methods have been discussed which are used for project evaluation (Understanding the Difference Between NPV vs. IRR, 2017). The report is presented to the Board Of Directors of Genetic Plc including an in-depth assessment of the investment and cost benefit analysis on the proposal. In this reference, the financing and investment decisions are taken for the company. Presently Genetik is considering an investment in the proposal of marketing and production of new genetically developed mustard seeds. The duration of the project is five years.
Recommendations to Board Of Directors
In the present report, the discounted, as well as non-discounted methods, are used. A brief understanding of the different methods used in the project evaluation is being provided as follows-
Payback Period Evaluation- This is the period in which the initial investment is recovered of the project. Hence it is used to evaluated the whether the period in which the investment is recovered is feasible for making the investment or not. The project with less payback period is more viable as it covers the initial investment in the lesser period than that of the duration of the project. In the present case payback of the project is 4.13 years which means that the initial investment of £ 2150000 will be recovered in this period (Understanding the Difference Between NPV vs. IRR, 2017). It is less than the total duration of the period and so is beneficial for the company to make the investment in this project. Moreover, the payback period is higher because of the fact that the initial cash inflows are negative which means instead of inflows there are going to be net outflows. However, the situation got improved in the fourth year in which the cumulative cash inflows were positive. The inflows are more skewed towards the end of the project. Hence it would be not be generating immediate cash inflows in the initial years.
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Net Present Value Evaluation- This is the most suitable method for project evaluation. This is due to the fact that it uses the discounted cash inflows. The consideration of time value of money gives more accurate and clear picture about the feasibility of the project. The major assumptions used for the purpose of project evaluation are-
- Marketing Cost is assumed to be sunk costs and thus not included in the calculation.
- Cash Flows for the are considered over a five-year period which constitutes the lifecycle of the project.
- An annual license fee of £1 M per annum has been included for making the necessary conclusions.
- Purchase of vehicles is the capital investment of £ 650 K and therefore will not be discounted annually (Percoco and Borgonovo, 2012).
- In the year five there will be realistic cash inflows of £ 120 K by the sale of the vehicles.
- No tax implications are assumed, and so the effect of depreciation has not been considered.
- Assumed a £50 K reduction in the overheads costs from £750 K to £700 K as the allocated overheads are not incremental to the group as the whole (Weijermars, 2013).
- The analysis will not include depreciation as this is not the part of cash flows.
- Working Capital will increase by £1.5 M in the starting of the project and will subsequently reduce back down at the end of the project.
- Assumed there is no inflation.
- Discount Rates are assumed to be 11%.
NPV method is based on the principal of netting of the present values of the investments inflows with that of the initial investment incurred. For the evaluation of the project using this method, the following steps were performed in sequence-
Identification of Initial Investment- In the present case the initial investment computed by the accountant for calculating profits was not correct as it did not include the working capital which had to apply in the current year. Than the cost of buying the fleet vehicles will be directly added to the initial cost which brings the total initial investment to £ 21,50,000.
Computation Of Cash Inflows- Cash inflows in the total duration of the project are derived by deducting the relevant expenditures from the sales figures. In the given case while arriving at the figure of cash inflows the effect of depreciation was not given. This is because the company is not liable for taxes as it falls in the special status growth company. Also, the annual allocation of the overhead expenses will not be deducted as it is not directly related to this project. Also, the opportunity cost of the rent expenses has not been considered as they were not the actual outflows. After making the necessary adjustments, the inflows are evaluated.
Residual Value- For the purpose of the computation of the residual values the working capital applied initially to the project will be added back. Also, the residual value of the vehicles will be realised at the end of the fifth year, and so the final residual value would be £1620000. This residual value will be discounted by using the present values of the fifth year as they are recovered in the fifth year.
Discount Rate- The rate at which the present values in the project are discounted to bring them at par with the present value is known as the discount rate. For the purpose of evaluation of the present project the discount rate used will be 11%. This rate is given in the proposal for carrying out the evaluation (Dorfman and Cather, 2012).
Evaluation Of Project based on NPV- Finally the NPV is calculated by the netting of the present values of the inflows with the initial investment in the project. If the NPV is positive then the project must be accepted as it is yielding the return at the desired rate. In the given case the NPV comes out to be £1396000. Thus the NPV is positive and therefore it would be beneficial for the company to invest in the proposal of genetically developed mustard seeds.
Evaluation by IRR- Internal Rate of Return is used to make capital budgeting decisions. It is that discount rate at which the NPV of all the cash inflows become zero. The IRR of the present projects comes out to be 21.83% which is much higher than that of the discount rate used by the company which is only 11%. Hence this project should be undertaken by the corporation due to the high IRR of the cash inflows.
Conclusion- As per all the investment appraisal methods, the project of advanced genetically developed mustard seeds should be undertaken by the company. (All the necessary calculations which form the basis of the conclusions form part of the appendix.)
Capital budgeting is a vital activity which includes different investment evaluation techniques. These techniques are used by many organisations to perform evaluation regarding their long-term investment decisions. In this section, the different methods that will be discussed are as follows-
Net Present Value (NPV) & Internal Rate Of Return (IRR)
NPV is computed by the deducting the initial investment with the present values of cash inflows that are expected from the investment and the respective outflows from the project. The NPV rule states that the investment should be made in the project only if the NPV is a positive value. This rule is based on the intuitive promise that the money held today is more than that same amount of money tomorrow (Weijermars, 2013). The discount rate in NPV formula provides the accountability for this rule. There are different ways used be the company to assess the discount rates but the most common method is using the expected rate of return as the discount rate. This rate is used to evaluate the various investment options with similar characteristics. An example has been explained to illustrate this-
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As per the NPV criteria, the decision favours Project A because it leads to higher NPV than that of project B. As per the opinions of many financial decision makers. There are many other methods in practice which are used that do not consider the discounted method of project evaluation. However, the projects with a positive NPV should be taken only if the project does not prevent another competing project from being undertaken because every project compete in itself delayed in time (Coles, Lemmon, and Meschke, 2012). On the contrary, IRR is the measure of profitability of the investment that is internally invested over a period to period and has not been recovered or recaptured by the investor. The major limitation of IRR is it uses the same discount rate to evaluate every investment. However, if the all the other factors remain constant, the IRR and NPV method will give the same results. The higher the IRR of the project the most desirable it will become. Although the single discount rate simplifies the matters, there are ample situations in which IRR does not produce profitable outcomes (Difference Between NPV and IRR, 2017). For making the analysis of the simpler projects which have a common discount rates and carry equal risks and a shorter period IRR is appropriate. But for the purpose of evaluating those projects which are subject to different risk factors and are of longer duration IRR method will not produce profitable results. In such case, NPV methods bring a more clear picture. IRR method is redundant due to the single discount rate used by it whereas in an actual scenario the discount rates change eventually over a period (Brealey, and et, al., 2012). Hence without adequate modifications, IRR will not be appropriate for the evaluation of complex investment projects. An illustration of how IRR is ineffective in the projects has been illustrated as follows-
Example- Consider a project with the cash flows of -£50000 as the first year outlay and the inflows in the year 2 are £ 115000, and there are additional costs to be incurred in the third year of £66000. Now since the project has been subsequently revised due to the additional outflows, IRR evaluation technique could not be used. IRR rate makes the project break even but if the market conditions change over a period than the project has different IRR's. Hence there are multiple rates at which the project will be discounted (Understanding the Difference Between NPV vs. IRR, 2017). Here lies the advantage of using NPV method which can handle multiple discount rates without any problem and produce relevant solutions. Each of the cash flows can be discounted separately from that of others.
nother problem in using IRR is when the project is with unknown discount rates. To analyse the viability of the project, IRR must be compared with the discount rate. In the event of unknown discount rate such comparison cannot be made and IRR may produce indefeasible results. Therefore NPV is a better analytical tool than IRR.
The present report evaluates the project of producing and marketing the genetically developed mustard seeds by Genetic Plc. Payback, NPV and IRR methods are used to reach a reasonable conclusion of undertaking the investment project. Section B covers the importance of using NPV over IRR method along with some supporting illustrations.
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