- Worksheet entry figures
Cash flow figures and adjustments:
The price used for sales estimation is the £50/MWh tariff that is guaranteed by the government. On the other hand, the megawatts used for the two projects over the 15years period include 60,000 MWh for the small wind-farm and 120,000 MWh for the large wind-farm project.
Cash flow items from the profit and loss account
- Government grant cash-flow is accounted for in year 1 since it is received in the first year although spread over the 15 years for purpose of profit and loss computation. In that respect the grant receipts for the two projects is calculated as (30,000 * 15) = £450,000 for the small wind-farm project while that of the large wind-farm is taken as (60,000 * 15) = £900,000.
- Annual management fee is adjusted for the £10,000 that is included but which does not directly relate to the project as it an apportionment for head office overheads. Thus, the annual management fees for the projects are calculated as (25,000 – 10,000) = £15,000 for the small project and (60,000 – 10,000) = £50,000 for the large project.
- Refurbishments costs accounted for on the capital cost outlay for year 5 have to be included in the two projects cash-flows since they are direct costs for the project. In that respect, year 5 refurbishments will reflect an added cash outflow of £200,000 for the two projects which was is expended in the year to hire machinery for refurbishment. Thus, capital cost outlay for year five which relate to refurbishments is adjusted to £2,200,000 and £5,200,000 for small and large wind-farms respectively. (Ittelson, 2009)
Remains unadjusted over the 15 years
- Sales = £3,000,000 for small wind-farm and £6,000,000 for large wind-farm.
- Maintenance/insurance = £250,000 for small wind-farm and £500,000 for large wind-farm.
- Business rates = £50,000 for small wind-farm and £100,000 for large wind-farm.
- Land rental = £75,000for small wind-farm and £100,000 for large wind-farm.
- Other energy costs = £25,000 for small wind-farm and £40,000 for large wind-farm.
- Depreciation = £1,400 for small wind-farm and £3,000,000 for large wind-farm.
The capital cost outflows for year 0, 1 and 5 are calculated by adding up the capital costs for outlined on the capital cost for respective years.
The calculated profits of £1,205,000 and £2,260,000 for small and large wind-farms respectively has been adjusted considering the £10,000 annual management fee that was wrongly accounted for the projects but belonged to head office overheads. Thus the new average profits for the two projects require adding back the deducted £10,000 to get the appropriate average profits as being:
Small wind-farm = [[1,205,000+ 10,000] *15] /15 =£ 1,195,000
Large wind-farm = [[2,260,000 + 10,000] *15] /15 = £2,250,000
The closing investment only comprise of the decommissioning cost after the 15 years equivalent of £3,000,000 for small wind-farm and £7,000,000 for large wind-farm.
- Discount rate used is the provided 10%
- The 8 years required payback is used for purpose of appraising the project on payback method.
- The current return on capital employed of 12% is used as the benchmark expected return for appraising the projects against the ARR value.
- Project choice
A combination of payback period, Net Present Value and IRR methods is a suitable way of measuring a project’s appropriateness by providing a way of picking the most suitable project in consideration of the expected payback time, expected return and cost of capital. (Vinci, 2010) In that respect, the project’s choice is made by considering the three methods evaluation that can be summarized as follows.
Pay back method
The method entails evaluating projects in terms of the number of years that it would take for the invested capital to be paid back. In that respect, the suitable project among the list is the one with the shortest payback period. According to the method, a shorter payback period is an indication of a higher return on capital while a longer payback period denotes a lower return. Further, the method is useful in ranking projects for a business that has liquidity problems hence needs a quick repayment of its investments. However, the method has weaknesses that require it to be used in combination with other techniques like the NPV, IRR and ARR. Among the key weakness is that it ignores money’s time value, it fails to consider other cash flows beyond the capital recovery period a period during which some projects are capable of delivering significant returns, it may fail to qualify projects which have suitable return rate just on the basis of the payback period benchmark. In that respect, although the two projects falls within the benchmark expected payback period, the small wind-farm project ranks as favorable for having a shorter payback period of 6.01 years as compared to the larger project which has 6.21 years. (Dayananda, 2002)
Net Present Value (NPV) Method
After identification of the suitable project in terms of the payback period which is suitable in application as the screening model, NPV method which uses discounted cash flows considering time and risk variables of an investment is then applied. (Bodie, Kane & Marcus, 2008) The method discounts the cash flows expected from a project with application of the businesses cost of capital and the projects’ life span. In that respect, projects with positive net present value are deemed suitable while those with negative value are unsuitable. Thus, although both projects are acceptable for having positive NPV values, the large wind-farm project is favorable for having a large NPV value of £45,281 compared to the small wind-farm project’s NPV of £26,383. (Dayananda, 2002)
Internal rate of return evaluation method (IRR) provides a discount rate with which a projects’ net present value equals zero hence equating the projects value with the initial cash outlay. In that respect, a project is suitable if its IRR is greater than the targeted rate of return hence the higher the IRR value the more suitable a project is. Therefore, the method evaluates both projects as suitable for having IRR rates of 26.6% and 24.7% for small and large projects respectively which are higher than the 12% benchmark. However, the small wind-farm project is favorable for having a higher IRR than the large project. (Zaharuddin, 2008)
The ARR evaluation method is usually applied in a project’s evaluation as a means of estimating its rate of return that should be achieved. In that respect, the method uses benchmark return rates which if exceeded makes a project suitable for capital allocation. In that respect, the higher the value of the ARR, the more suitable a project is relative to the alternatives. (Agar, 2005) Thus, the method both projects as unsuitable for having ARR rates of 11% for small wind-farm and 10% for large wind-farm that are lower than the benchmark return of 12%. However, the method ranks the small wind-farm project as favorable for having a higher ARR rate as the large project.
In that respect, the most suitable project to invest in for the above two alternatives is the small wind-farm which ranks favorably with Payback, IRR although it fails to meet the requirement of the required return of 12% by ARR evaluation and has a lower NPV than the large wind-farm. (Zaharuddin, 2008)
- Sensitivity adjustments
Considering possible variation in key factors, the projects evaluation is adjusted for sensitivity analysis by adjusting all the worksheet variables by +10% and -10% to reflect the possible effects of having optimistic and pessimistic outcomes respectively. In that respect, the adjustments produces different NPV and IRR values for the two projects as indicated below that indicates the two projects to remain suitable on both scenarios as indicated by the values on the sensitivity answers worksheet. (Zaharuddin, 2008)
- Projects evaluation using sensitivity analysis
Sensitivity analysis entails evaluating the effects that possible variation and changes in revenues, costs and discount rates have on projects’ suitability as investments which involves an analysis of optimistic, expected and pessimistic outcomes. Further, the analysis entails identification of key risk areas or uncertainty areas that needs to be tested with assumptions that are systematic for the purpose of determining those factors that could have the most effect on a project’s success. This would act as a guide to establishing suitable measures to improve the project’s survival chances which could involve adjusting the project’s life time and/or discount rate. (Zaharuddin, 2008)
In that respect, sensitivity analysis is a part of risk management that involves analyzing and managing economic, technical, social and political uncertainties hence being the most crucial and essential function in addressing uncertainties and complexities associated with projects. This comes from the fact that projects are temporary struggles rather than being permanent as they are formed to achieve particular objectives within a given period of time with a specified investment amount and expected performance level. (Holmes, Sugden & Gee, 2008)
In light of the two project’s analysis, the criteria used as the basis of evaluation are through input of values that serve to calculate the expected outcomes. However, due to the effect that different factors have, it is possible that the input values may not produce results that can be realized in the hence future making the evaluation incorrect. Therefore, managing possible risks requires an analysis of possible changes through the sensitivity analysis which helps in risk management as uncertainty presents several possibilities whose probabilities cannot be determined. (Kane & Marcus, 2008)
In that respect, the sensitivity analysis for the two projects entails adjusting all the variables by +/-10% producing NPV and IRR results as shown on the table below. (Weil, Schipper & Francis, 2012)
Although the 10% adjustment in variables have an effect on NPV and IRR, the two projects remains suitable on both scenarios since their NPV values remains positive while IRR rates remains above the 12% benchmark. This is an indication that the two projects are low risk as their suitability would not be affected by a 10% change in all variables. However, the analysis indicates that the larger wind-farm project remains favorable as it has a large NPV value compared with the small wind-farm in both pessimistic and optimistic cases. (Kurowski, 2011)
In addition, variables’ adjustment that lowers NPV and IRR indicates an increase in project risk hence the project becoming less undesirable. On the other hand, variables’ adjustment that increases NPV and IRR is an indication of a risk decrease hence increasing the projects desirability. In that respect the variation of all the projects’ variables by +10% indicates significant rise in NPV and IRR hence decrease in risk while a variation of all variables by -10% indicates a significant fall in NPV and IRR for both projects hence an indication of rising risk. In addition a review of the adjusted figures shows that a10% change has a great effect on sales, depreciation and cost capital: all which are significant figures in the appraisal hence the adjustments significant effect on NPV and IRR for both projects and for both pessimistic and optimistic scenarios. Therefore, sales and capital cost should be estimated effectively to avoid large variations that could negatively affect the chances of the projects success. On the other hand, the operating cost factors have low risk since their variation’s effect is not significant enough to change NPV and IRR by a huge margin. In conclusion, risk management should pay much attention to the estimation of sales and cost of capital for the two projects. (Damodaran, A. 2010)
- Use of expected values in analyzing the projects
It is crucial for those responsible for projects appraisal to realize that there are usually allot of uncertainties that affect projects’ prospects in the future. Such factors include change in interest rates as well as the cash-flows that are beyond decision makers’ control while other changes may include sales variation. In that respect, project appraisal can involve listing of the decision options and determining the possible future occurrences to which possibilities are assigned. (Kurowski, 2011) This is caused by that fact that decision making process involves three components including
- The alternatives and project choices that are under the control of the decision maker.
- Economic environment that influences the decision’s outcome.
- A payoff that requires a comparison of decision options and economic environment combination. (Damodaran, A. 2010)
In that respect, the expected values’ use can be applied to address the involved uncertainty by introduction of probabilities application with expected values being the weighted averages of the expected outcomes multiplied by corresponding probabilities. Thus expected values use is a way of managing risk using probabilities that can be estimated from past history of those which are estimated. In this case, probabilities of obtaining the projects’ variables can be determined using past data from similar projects or by best estimates and used to calculate each variables outcome. This would be a crucial way of minimizing the risk of future variation in the variables that could negatively affect the projects suitability. However, probabilities assessment is difficult and subjective and could expose investors to high risks thus the values not being a suitable guide for projects appraisal. (Bender & Ward, 2008)
- How the company could account for inflation
Inflation is an economic factor that affects investments and projects in all countries and could be considered a project risk for its effect of changing prices which eventually affects projects’ outcomes. Thus, the factor distorts projects selection with use of the discounted cash flow methods. (Strong, 2009) The principal reason is that an increase in income with inflation is usually associated with an increasing proportion of that income being taxed as depreciation charge is based on the original costs rather than the replacement costs hence a failure for real cash inflow to keep up with inflation. This means that an inflation rise increases the required rate of return for a project. (Kent, 2010)
In projects appraisal, inflation rates can only be guessed in evaluating projects suitability with such guessed rates having a probability of being wrong as it is difficult to forecast accurate inflation rates. Thus, the way to account for inflation in project appraisal is through uncertainty and risk analysis. In addition, inflation could be general which means that it affects all kinds of prices and it could also be specific where it affects specific prices. (Strong, 2009) In that respect, general inflation has a number of effects including:
- It results to higher costs and higher prices hence the difficulty of determining the effect of high prices on demand.
- Inflation affects projects finance needs as well as the cost of capital and the company’s gearing. (Kent, 2010)
Thus, since inflation the increases project’s assets in money value, they must be financed through capital increase. In addition, if future inflation can be predicted with accuracy, the company can determine the amount of extra capital that is needed and act accordingly by either borrowing the excess or increasing its earnings retention. However, in the event that inflation rates cannot be estimated with accuracy, the company should estimate what inflation could be and make plans to obtain the extra financing through provisions like contingency funds in case inflation exceeds the expected rate. (Schoenebeck & Holtzam, 2012)
In that consideration, there are been different ways of accounting for inflation that the company could apply including the current cost accounting (CCA) and current purchasing power (CPP).
- CPP involves making adjustments to capital and revenue values to allow for the general inflation rate.
- CCA involves taking into account the specific inflation by adjusting the values of assets. (Collins & Bruce, 2008
Therefore, in a case where the company could be concerned with the real value of the cash-flows rather than nominal value, the cash flows could be deflated using an anticipated inflation rate. This would involve dividing the net cash-flows by the inflation factor for purpose of obtaining real net cash-inflows. Thus, there are ways in which the company could deal with inflation in project appraisal. One such way involve the company including the inflation factor in the cash-flows by use of inflation rates that are replicable to every component and then using the nominal discount rates that incorporate a risk free time value of money, a risk premium as well as anticipated inflation’s premium. On the other hand, if inflation rate is expected to vary, the company could use different nominal rates to adjust the varying inflation rates’ denominator. (Kurowski, 2011) In that way, the company could apply either of the two main methods of addressing inflation one being the money method in which inflation is included in discount rate and cash-flows forecasts. The other is the real method that involves ignoring the factor in both discount rate and cash-flow forecasts. (Bender & Ward, 2008)
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