Evaluation Of Investment Project For DCL: NPV, IRR, Payback Period And ARR
Question 1
Part 1)
|
Initial investment |
$ 2.40 |
|
Loan amount |
$ 1.20 |
|
Loan rate |
5.70% |
|
Loan instalment |
$ 0.28 |
|
Year |
Opening |
Instalment |
Interest |
Principle |
Closing |
|
1 |
$ 1.20 |
$ 0.28 |
$ 0.07 |
$ 0.21 |
$ 0.99 |
|
2 |
$ 0.99 |
$ 0.28 |
$ 0.02 |
$ 0.27 |
$ 0.72 |
|
3 |
$ 0.72 |
$ 0.28 |
$ 0.02 |
$ 0.27 |
$ 0.45 |
|
4 |
$ 0.45 |
$ 0.28 |
$ 0.02 |
$ 0.27 |
$ 0.19 |
|
5 |
$ 0.19 |
$ 0.28 |
$ 0.10 |
$ 0.19 |
$ – |
|
Total cost of new equipment |
$ 2.40 |
||
|
Rate of depreciation |
40% |
|
Depreciation |
|||
|
Year |
Opening Balance |
Depreciation |
Closing Balance |
|
1 |
$ 2.40 |
$ 0.96 |
$ 1.44 |
|
2 |
$ 1.44 |
$ 0.58 |
$ 0.86 |
|
3 |
$ 0.86 |
$ 0.35 |
$ 0.52 |
|
4 |
$ 0.52 |
$ 0.21 |
$ 0.31 |
|
5 |
$ 0.31 |
$ 0.12 |
$ 0.19 |
|
Year |
Cash flows before loan payment |
Principle |
Interest |
Net Cash Flows |
[email protected] 12.5% |
Present Value |
|
0 |
$ -2.40 |
$ -2.40 |
1.000 |
$ -2.40 |
||
|
1 |
$ 1.04 |
$ 0.21 |
$ 0.07 |
$ 0.76 |
0.889 |
$ 0.67 |
|
2 |
$ 0.60 |
$ 0.27 |
$ 0.02 |
$ 0.32 |
0.790 |
$ 0.25 |
|
3 |
$ 0.97 |
$ 0.27 |
$ 0.02 |
$ 0.68 |
0.702 |
$ 0.48 |
|
4 |
$ 0.55 |
$ 0.27 |
$ 0.02 |
$ 0.27 |
0.624 |
$ 0.17 |
|
5 |
$ 0.70 |
$ 0.19 |
$ 0.10 |
$ 0.42 |
0.555 |
$ 0.23 |
|
5 |
$ 0.24 |
$ – |
$ – |
$ 0.24 |
0.555 |
$ 0.13 |
|
NPV |
$ -0.46 |
Net present value =$ -0.456 millions
|
IRR |
||
|
Year |
Cash flows |
|
|
0 |
$ -2.40 |
|
|
1 |
$ 1.04 |
|
|
2 |
$ 0.60 |
|
|
3 |
$ 0.97 |
|
|
4 |
$ 0.55 |
|
|
5 |
$ 0.70 |
|
|
5 |
$ 0.24 |
|
|
IRR |
21.34% |
Internal rate of return= 21.34%
Payback period (years)
|
Year |
Cash flows |
Cumulative Cash Flows |
|
0 |
$ -2.40 |
$ -2.40 |
|
1 |
$ 1.04 |
$ -1.36 |
|
2 |
$ 0.60 |
$ -0.76 |
|
3 |
$ 0.97 |
$ 0.21 |
|
4 |
$ 0.55 |
$ 0.76 |
|
5 |
$ 0.70 |
$ 1.46 |
|
5 |
$ 0.24 |
$ 1.70 |
|
2.79 |
|
Part 4) Accounting rate of return |
|||
|
ARR |
Average Net Profit |
||
|
Average Investment |
|
Year |
Cash flows |
Depreciation |
Interest |
|
|
1 |
$ 1.04 |
$ 0.96 |
$ 0.07 |
$ 0.01 |
|
2 |
$ 0.60 |
$ 0.58 |
$ 0.02 |
$ 0.01 |
|
3 |
$ 0.97 |
$ 0.35 |
$ 0.02 |
$ 0.60 |
|
4 |
$ 0.55 |
$ 0.21 |
$ 0.02 |
$ 0.33 |
|
5 |
$ 0.70 |
$ 0.12 |
$ 0.10 |
$ 0.48 |
|
Net profits |
$ 1.43 |
|
Average Net Profit |
$ 0.29 |
|
Average Investment |
0.240+ 0.5(2.4-0.240) |
|
|
$ 1.32 |
ARR 22%
|
Part 5) Profitability Index Profitability Index |
Total present value of cash flows |
||
|
Initial investment |
|
$ 1.94 |
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|
$ 2.40 |
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= 0.81 In this case the new contract opportunity of capital investment is evaluated on the basis of following capital budgeting decision. Net present value method: Under this method the present values of all the cash inflows and outflows are calculated using the discounting rate of 12.5%. The aggregate of all the cash inflows net of all the cash outflows is the net present value. In this case, the net present value of the new contract is negative and it is recommended that the project must not be accepted. Internal Rate of return: It is the discounting rate where the net present value of the project is zero which means the point where project neither incurs any loss nor generates any return. The internal rate of return of the new project is 21.34% which is greater than the company’s required rate of return i.e. 12.50%. Hence it can be accepted. Payback period: It is the period taken by the project to recover its initial investment. The acceptable payback period of the company is 2.5 years. However, the payback period of the project is 2.79 years which is not acceptable. Hence the project must not be accepted. Accounting rate of return: The company must make the investment in the new contract opportunity as its ARR i.e. 22% is greater than the required rate of return of 12.50%. Profitability index: Profitability index of more than 1 is favourable. However, the profitability index of the company is 0.81 which is less than 1. Hence the project must not be accepted. Overall decision: Dukeview Corporations Ltd. must not accept the new project opportunity as it is not suitable and profitable for the company from the viewpoint of various capital investment appraisal techniques such as Net present value, payback period technique and the profitability index. As these techniques are not giving results in favour of accepting the proje Question 2 Part 1
|
Sales revenue sensitivity analysis can be done by changing two elements of sales figure i.e. the sales units and sales price.
Following sensitivity analysis has been carried by changing both the elements by certain percentages:
|
Table-1:Sales Units |
NPV |
|
|
% Change |
Unit sales |
$ 51,12,435.71 |
|
5% |
1,50,150.00 |
5718492.216 |
|
10% |
1,57,300.00 |
6324548.722 |
|
15% |
1,64,450.00 |
6930605.228 |
|
20% |
1,71,600.00 |
7536661.734 |
|
25% |
1,78,750.00 |
8142718.241 |
|
Base value |
1,43,000.00 |
5112435.709 |
|
-5% |
1,35,850.00 |
4506379.203 |
|
-10% |
1,28,700.00 |
3900322.697 |
|
-15% |
1,21,550.00 |
3294266.191 |
|
-20% |
1,14,400.00 |
2688209.684 |
|
-25% |
1,07,250.00 |
2082153.178 |
The above table shows that with every change of 5% in sales units the net present value of the project will vary in the above manner.
|
Table-2: Unit price |
NPV |
|
|
% Change |
Unit price |
$51,12,435.71 |
|
5% |
$ 103.95 |
5718492.216 |
|
10% |
$ 108.90 |
6324548.722 |
|
15% |
$ 113.85 |
6930605.228 |
|
20% |
$ 118.80 |
7536661.734 |
|
25% |
$ 123.75 |
8142718.241 |
|
Base value |
$ 99.00 |
5112435.709 |
|
-5% |
$ 94.05 |
4506379.203 |
|
-10% |
$ 89.10 |
3900322.697 |
|
-15% |
$ 84.15 |
3294266.191 |
|
-20% |
$ 79.20 |
2688209.684 |
|
-25% |
$ 74.25 |
2082153.178 |
The above table shows that with every change of 5% in selling price per unit, the net present value of the project will vary in the above manner.
|
Table-3: Cost of capital |
NPV |
|
|
% Change |
Rate |
$ 51,12,435.71 |
|
5% |
10.67% |
5036033.517 |
|
10% |
11.18% |
5030905.366 |
|
15% |
11.68% |
5025745.757 |
|
20% |
12.19% |
5020554.582 |
|
25% |
12.70% |
5015331.732 |
|
Base value |
10.16% |
5041130.318 |
|
-5% |
9.65% |
5046195.876 |
|
-10% |
9.14% |
5051230.3 |
|
-15% |
8.64% |
5056233.698 |
|
-20% |
8.13% |
5061206.178 |
|
-25% |
7.62% |
5066147.848 |
From the sensitivity analysis, only the change in one input parameter can be assessed at a single time to check the sensitivity of net present value of the project. However, in scenario analysis change in multiple inputs can be made to assess the impact of changes in complete circumstances on the overall business plan. Scenario analysis helps the managers to determine the net present values in the worst case, best case and in the base case. These scenarios help the managers to assess the financial situation of the project if it faces the unfavourable (worst) business environment situation or when it experiences the favourable business environment situation. It also depicts the net present value in the scenario that is most probable to happen i.e. in the normal business situations. Whereas, the sensitivity analysis does not help managers in analysing these scenarios of the business.
In the present case of Curtis Industries Ltd, the risk is priced into the project on the basis of sensitivity analysis. Through the sensitivity analysis the risk is analysed by measuring the extent to which the net present value of the project will change with the change in the various factors. The return of the project of the capital investment is affected by various factors such as investments, tax rate, revenue from sales and cost of sales. The overall net present value of the project is positive hence it shows that net inflows are greater than the cash outflows and hence it can be said that the return on the investment is in accordance with the risk.
Bennounna, Karim, Geoffrrey Meredith and Teresa Merchant. “Improved capital budgeting decision making: evidence from Canada”. Management Decision 48(2010): 225-247.
Bieerman, Harold and Seymour Smidt: The Capital Budgeting Decision: Economic Analysis of Investment Projects (Routledge, 2007)
Cron, William and Thomas DeCarlo: Sales Management: Concepts and Cases (Wiley, 2010).
Jensen, Michael, “Paying People to Lie: the Truth about the Budgeting Process”, European Financial Management 9(2003): 379-406.
Saltelli, Andrea, K. Chan, and E. M. Scott: Sensitivity Analysis (Wiley, 2000).