The Conch Republic is an organization which produces reputable electronics is seeking to advance one of their current production lines to stay abreast to changing technology. The company is seeking to introduce a new smart phone with the hopes of boosting the company’s revenue and reputation as a smart phone producer. As a person hired to assess the financial undertaking of Conch Republic an overview of the projects planned expense must be generated. However, in order to accomplish this task a capital investment analysis must be conducted in order to determine the projects viability. This will be done by analyzing several things. Those things that must be understood are the projects payback period, the net present value (NPV), internal …show more content…
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). IRR is the rate at which the net present value becomes zero (Ross, Westerfield & Jordan, 2013). Additionally, IRR is calculated first by determining the Net Present Value. The Net Present Value is the variance concerning the market value and its cost (Ross, Westerfield & Jordan, 2013). Net present value is calculated by first finding the present value. For instance, 21.83 million (year 1 revenue from above) divided by 1 plus the companies rate of return of 12%. Thus, 21.83/(1+.12)= 19.49 is the present value for year 1. Furthermore, by adding the total revenue over the next 5 years we get 21.85+ 28.025+36.875+30.975+23.6=132.325 million is the expected value of revenue. That amount now needs to be placed into the present value equation previously discussed only this time with the exponent of 5 to cover the next 5 years. 132.325/(1+.12)^5=75.08 (rounded). Moreover, if
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Additionally, the calculated profitability index of 1.11 suggests the project should be pursued. Note that the discounted payback period is just under 7 years, 4 years beyond the contractual commitment under consideration with HPL’s largest retail customer.
Based on the payback approach, Advo should still implement Project 2 because it has a shorter payback period than Project 1. Thus, Project 2 will have recouped more than the initial investment in the second year. Furthermore, Project 1 still falls short of investment recovery by $109,000 ($400,000 - $291,000). Thus, Project 1 will not begin to recoup the cost of the initial investment until year three. Therefore, Project 2 will begin to generate a return on investment much sooner than Project 1 and money received sooner has more value (Edmonds et al., 2011).
Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.
The payback formula cannot be used with Proposal B because that project has no stable annual cash flows. The "dumb" way of calculating payback must be used, simply adding the figures until it becomes positive, and then figuring out where the point where the project's cash inflows have equaled its outflows is. Proposal B has a payback period of five years and 262 days. Proposal B has the
A final important factor concerning the expansion project is potential investments to accelerate profit. ABC Company has the option to purchase additional equipment. One thing necessary before investing in something is to calculate the net present value of the potential investment. “The net present value of an investment is the difference between the present value of cash inflows and the present value of cash
If we are only looking at the financial implications of investing in the company using the expected IRR and NPV we may be fooled into thinking this new television program would be a great investment. Even if our WACC were 20%, we can expect the NPV of the project to be $1,716,414. When we look at discounted payback, however, we see that at a WACC of 20% the project payback period would be a little over 4 years and even the simple payback period is 3 years (see exhibit 2). This
Payback analysis takes cash income from capital investment projects that equal the initial cost of the investment. When choosing between projects, accepting the one with the shortest payback time is typically chosen. Calculating the payback period is fairly easy to calculate by dividing the amount of the investment by the projected cash inflow each year. Higher return on the capital investments is the result of shorter payback period. Many companies have a target number of years in which they want to consider for the payback period. For those reasons, they will only consider projects that fall within those timeframes.
For this project, the best method to use is the net present value. There are inherently flaws in both IRR and payback period that invalidate them as serious choices for determining a project's value. Payback period ignores all cash flows beyond the payback period, so does not effectively measure the contribution that the project makes to the value of the firm. IRR is better, but does not distinguish between the size of the projects. This weakness is most evident when comparing two mutually exclusive projects of different sizes. The IRR does not distinguish which project adds the most value to the company, only the one with the better return. The NPV distinguishes which option adds the most value to the company. Remember that management's role is to maximize shareholder wealth, and NPV is the measure that tells you which project does that. For this project, IRR is fine because there are no other options, but it is best to be in the habit of using NPV.
Payback Period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. Formula The formula to calculate payback period of a project depends on whether the cash flow per period of the project is even or uneven. In case they are even, the formula to calculate payback period is: Payback Period = Initial Investment Cash Inflow per Period When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: Payback Period = A + B C In the above formula, A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A Profitability Index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. Formula: Profitability Index = Present Value of Future Cash Flows Initial Investment Required = 1 + Net Present Value Initial Investment Required Explanation: Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability index is a relative measure (i.e. it gives as the figure as a ratio). Decision Rule Accept a
Two new software projects are proposed to a young, start-up company. The Alpha project will cost $150,000 to develop and is expected to have annual net cash flow of $40,000. The Beta project will cost $200,000 to develop and is expected to have annual net cash flow of $50,000. The company is very concerned about their cash flow.
The first two can potentially be worked out by looking at the Payback period (PP). This is the time taken for the investor to regain their money. If there isn’t one then the investment will make a loss. This can be used to look at cash flows – when will there be money free to invest in the next project? The PP is relatively easy to work out and used to compare to projects at the same value. One failure of the PP is that it is not very useful as a comparative tool: it gives no indications of the amount of money that the investment will return, or when: only the point where the project will break even.
It is easy to understand and calculate, but it ignores cash. PB measures the number of years required so that the estimated returns can cover the initial outlay. It is also easy and simple to use, but it takes no account of cash flow after payback period. Both methods take no consideration of time value of money. To overcome those problems resulted from ARR and PB so as to make optimal decisions, the project appraisal process needs to consider the time value of money. Expected future cash flow of potential investments shall be discounted and added together to derive a lump sum of the present value using a given discount rate. Three types of discounted cash flow are NPV, IRR and PI. NPV is the difference between sum of present value and initial outlay for the proposed investment. A positive NPV indicates that the proposed investment is accepted and vice versa. NPV takes account of the time value of money and all relevant cash flows over the life of the project. However, it is difficult to understand and rely on to provide an available appropriate discount rate. IRR is the discount rate at which NPV is zero. If IRR is greater than the cost of capital, then the potential investment is recommendable. IRR is easy to understand and it excludes the drawbacks of ARR and PB that both ignore the time value of money. However, IRR often gives an unrealistic rate of return unless the calculated IRR is a reasonable rate for
Investment Appraisal or so called capital budgeting is a technique used to identify several investment’s impacts on a business by considering stakeholder’s value in both private sector and public sector to justify the viability of project. The primary purpose of an investment appraisal model is to measure project related costs, using basic methods such as Net Present Value (NPV), Internal Rate of Return (IRR), Accounting Rate of Return (ARR) and the Payback Method (PB). Considerably, discounted cash flow techniques such as Net Present Value (NPV) involves determining the sum of the present values of all project’s cash flows. Investment therefore is favorable in term of positive present value as the highest net present value program should be adopted. Similarly, Internal Rate of return (IRR) is referred as the discount rate at which the present value of costs equals the present value of benefits when NPV is zero. Generally, projects with higher IRR values are preferred as this will give positive NPV at high discount rates, leading to the assumption of same results for both NPV and IRR method. Whereas payback (PB) is another investment appraisal technique which is applied if the project is able to recoup the original investment within a predetermined period, Accounting Rate of Return (ARR) is defined as “Average Annual Net Profit After Tax divided by Average Investment”. Theoretically speaking, all of listed investment appraisal methods are applied within an
IRR is the return that set NPV to zero. Similarly, the calculation is based on cash flows and discount rate (i.e. same benefit as NPV). It provides a simple tool without estimating all details but intuitively appealing to know. If IRR is high enough, the time spent on estimating a required cost of capital is avoidable.