Part A: Net Present Value calculation
Working capital will be regarded as the initial investment outlay which is £ 1 million. Discount rate used in calculating the net present value of the project is 7%. The internal rate of return will be hypothetically obtained with the aim of obtaining the break-even situation of the project.
All costs and expenses are treated as cash outflows which will reduce the cash inflow in the project i.e. the project’s sales revenue. The cash outflows from the entire project will be deducted from the project’s inflows so as to determine the returns or profit obtained at the end of every year. All the vehicles used in the project have a salvage value of £ 200,000. The total amount of the salvage value from all the vehicles will have to be considered when calculating the net present value and internal rate of returns by adding it back to the project’s cash inflows.
Depreciation of the vehicle fleet for the International Food Genetics company will be calculated as:
= cost of the vehicles – salvage value after the 5 years
= £ 500,000 - £ 200,000 = £ 60,000
Profit and Loss account
The profit is the cash inflow of the International Foods Genetics. Net Present Value will be calculated as;
This net present value of £ 1,801.76 has to be summed up with the salvage value of the vehicle fleet at the end of the fifth year. This is because a salvage value from an asset that is either written off or disposed is considered to be a positive cash flow to a firm and, therefore, should be considered in evaluating a project. This, therefore, would be calculated as;
= 200,000 = £ 142,597.24
The total net present value will be; 1,801.76 + 142.60 = £ 1,944.36.
Net present value indicates that a project would be considered viable if it has a positive end results or earnings after the calculations. It is also regarded that the higher the net present value, the better the project hence in a situation where there are two projects, the one that yields a higher net present value should be invested.
This project, according to net present value calculations, indicates that the management of International Foods Genetics should venture into the business since it has a positive net present value. This indicates that the business will be able to recover the initial working capital ploughed into the business at the end of the five years. The positive value shows that the company investing in this project would also earn the company profits. This means that the company would be left with an additional amount of income after the company ploughs back the working capital that had been invested into the project.
Part B: Internal Rate of Return calculation
Internal rate of return requires one to obtain a cost of capital percentage that will be able to minimize net present value to zero. The Internal rate of return can, therefore, be described as a hypothetical discount rate.
The project that the International Foods Genetics plans to undertake requires a cost of capital that is higher than 10,000% for a zero net present value to be obtained. While at 10,000% cost of capital, the net present value obtained is still a positive value. The exact value of the project that equates the net present value cannot be easily identified as it surpasses the 10,000% point. This creates a limitation to this calculation approach.
This clearly indicates that the internal rate of return is not only affected by the projects that have both negative and positive cash flows but also other projects that may have positive cash flows like the above project.
Part C: The Payback Period Approach
This is a method of capital budgeting that does not incorporate the time value of money as it is only interested in the number of years a project will take to refinance the initial investment outlay used as capital to start the project. This method does not consider the cash flows that are generated after the investment outlay had been recovered and gauges projects depending on the number of years taken to recover the capital ploughed into the project. The smaller the period taken by a project to obtain revenues that will equivalent to the initial cash outlay that was spent, the better the project as the funds will be used to invest in another project.
This approach does not consider the fact that the excess outcome from a project after the initial investment outlay has been recovered could be reinvested hence generating more returns than anticipated. The calculation of the payback period of the project that International Food Genetics plans to undertake could be calculated as follows:
According to the accumulated cash flows calculated, the company will be able to generate back the initial working capital ploughed in 1/19/25 years. This is obtained by observing the year in which the project’s accumulated earnings reach a level that is similar to the cash outlay invested in the project. The period obtained is what is called the payback period. The main problem of this strategy is that it does not consider the proceeding cash flows in any deduction.
Why Net Present Value approach always dominates the internal rate of Return Approach
Internal rate of return cannot be used to evaluate mutually exclusive projects but only single projects. The IRR only enables a person or an entity to evaluate the best project in which to invest. This is because in mutually exclusive projects, the net present value may not agree with the internal rate of return values. Internal rate of return is only effective, in scenarios where there are two projects, if the two projects have the same cost of capital, a same level of risk is involved when investing in either of the projects, where cash flows are very predictable, and projects have a shorter time period. Different costs of capital, in most cases, lead to complications when formulating the conclusions obtained by the capital budgeting approach that has been used to evaluate the project.
The calculation of the internal rate of return involves the identification of a hypothetical cost of capital that will give a different value than what the net present value offers. In the above question, the cost of capital that offers a negative net present value supersedes the 10,000% mark which is very large. This creates a limitation to the internal rate of return approach; therefore, making the net present value as a better capital budgeting evaluation technique.
In projects that make losses i.e. having negative cash flows; computation of internal rate of return leads to multiple IRR’s which creates an ambiguous inference. This also exists in projects that have a mixture of both positive and negative cash flows. This would require changes in the computation of the internal rate of return since the break-even would not exist if a project that had a negative cash flow in year one made a positive cash flow in year two. The computation would result in two rates since it would form a quadratic function. This will affect the conclusion as it would be hard to identify the optimal rate between the two results obtained. This is referred to as the multiple rates problem.
The internal rate of returns cannot be used in assessing projects of different project size as it will overstate the desirability of the smaller project size over the larger. The IRR has the tendency of making a larger project look undesirable unlike net present value which will just consider the time value of money irrespective of the project’s size. This point can also be supported by the fact that the internal rate of return does not consider changes in the discount rate hence it would not be able to make better judgment on a long-term project when compared to a short-term one.
The internal rate of return assumes that there is no capital rationing, unlike net present value approach. While net present value assumes that the cash flows of a project are reinvested at the cost of capital of the firm, the internal rate of return approach assumes that it is reinvested at the internal rate of return computed.
The Internal rate of return deduces, in most cases that the higher the internal rate of return the better the project. However, over time, it has been realized over time that this condition may not necessarily hold as there are situations when a lower IRR project is considered a better project. This scenario may exist in businesses which only target social benefits rather than the private benefit which is usually evidenced by a higher rate of return. Another situation where a lower IRR is considered to be better than a high IRR is when a project has high cleanup costs and a different timing of benefits and costs. In such a case, a high IRR would not lead to a better deduction. This concept makes internal rate of return inconsistent and unreliable as one cannot make conclusions based on the internal rate of return alone.
The Cost of capital of a project is the rate at which investments are evaluated on, and it shows the minimum amount that a project should make or generate for it to be considered to have added value and hence rendering it feasible to investors. The Internal rate of return approach would not be reliable in situations where the cost of capital of a given project of e valuation is unknown. This is as a result of the conclusion rule of internal rate of return method as it compares the internal rate of return’s computation with the project’s cost of capital so as to come up with a deduction. If the rate is higher than the cost of capital, the project is considered feasible and viable, but if it does not supersede the cost of capital, the project should not be undertaken. This, therefore, creates the unreliability part that the concept cannot be relied upon in situations when the project’s internal rate of return does not exist or is unknown.
The Internal rate of return approach also has a limitation of ignoring the initial investment outlay made in a project. This is due to the fact that it mostly favors projects with a higher cost of capital that have a lower initial investment outlay. In a case where there is a 60% return project that has a $ 20,000 initial outlay and another that has a 15% return with a $ 85,000 initial outlay, the internal rate of return will tend to favor the project with the lower outlay as compared to the project with a higher outlay. This clearly indicates how the approach ignores the sizes of projects compared to the net present value that is not affected with such issues. The IRR approach also outlines its inadequacy by indicating that cash flows would be reinvested at the same rate of return. This is an idealistic scenario as it may not occur at all during the lifetime of a project.
As much as the internal rate of return approach is widely used by management, it popularity is due to its easy nature in that there are fewer assumptions made as compared to net present value which, at each stage, requires assumptions to be considered. Net present value approach is able to overcome all these shortcomings of the internal rate of return hence making it a better and reliable method of capital budgeting compared to the internal rate of return. In fact, the net present value is better than most of the capital budgeting approaches. Though net present value is a better method than the internal rate of return approach, it also has its limitations. This creates the need of evaluating project using both approaches they would offer a better and more reliable inference than the reliance of one conclusion. The underlying factor is that if the computations of the net present value and the internal rate of return collide and offer different inferences, net present value supersedes and holds.
R. Charles Moyer, J. R. (Feb 1, 2008). Contemporary Financial Management. Cengage Learning.
Siddiqui, S. A. (Jan 1, 2006). Managerial Economics and Financial Analysis. New Age International.