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ACC00716 Finance Session For Project Evaluation Methods

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  • Course Code: ACC00716
  • University: Southern Cross University
  • Country: Australia

Question:

Explains project evaluation methods used and assumptions made: Provides a risk assessment based on base case and three sensitives modelled; evaluates impact on the project feasibility: Provides a recommendation supported by the base case model and sensitivities modelled
 
 

Answer:

Introduction 

In the present report, the methods relating to evaluating the projects are discussed to guide Pinto Limited for making an investment decision. In this aspect, the five major methods of capital budgeting are assessed in the report along with its risk and sensitiveness. After discussing and estimating the net present value, internal rate of return discounted payback period and profitability index of the project the recommendation is provided regarding whether the company should continue with the project or not.   

Explanation Of Project Evaluation Methods

Net Present Value 

Net present value (NPV) method refers to the present value of the future net cash flow from a project in which the company is invested. The NPV of the company can be calculated through discounting of cash flows with the accurate rate of interest which is the capital cost of the company. Positive net present value shows that the project is beneficial for the business.

Internal Rate of Return

The internal rate of return (IRR) can be defined as a discount rate at which the NPV of the investment proposal is zero.  In simple words, the situation when the sum of projects’ expected cash inflows and amount of initial investment is equal. This method depends on the discounted cash flow technique (Ghiyasi, 2018). Furthermore, it is broadly used in capital budgeting as well as while taking the investment decisions whether to selecting or to repudiate the proposal. It is significant to consider that the project which exceeds the desired rate of return of a company should be accepted.

Payback Period Method

Payback period assists the firm to assess the extent of time needed to recuperate the initial cash expenditure in investment proposal.  In other words, by application of this method, the company can calculate the extent of time to recover the cost incurred on the proposal by succeeding cash inflows (Schlegel, ] Frank and Britzelmaier, 2016). Under this method, the cash flows are calculated which has resulted from investment every year of the life of the project. The same is accumulated every year until they get equal to the original investment amount of the project. In addition to this, it also assists in ranking the investment proposals.

Discounted Payback Period 

Discounted payback period (DPP) refers to a capital budgeting process utilised to assess the productivity of the proposal. This method relies on the discounted cash flows technique. It is utilised to evaluate the project as a supplemental screening criterion. Further, it is the number of years required to recuperate cash outflows or initial cost incurred in a project from its future cash inflows (Nawaiseh et al. 2015). The project which has less payback period than the targeted period should be selected. In addition to this, it represents the length of time required to break even in a proposal based not only on what cash flows arise but also when they arise along with the existing rate of return in the market. 

 

Profitability Index

Profitability index can be defined as a financial analysis which helps the company whether to accept the project or not. This method utilises the concept of time value. It also assists the firm to give rank to proposals so that the best proposal could be selected (Rossi, 2015). When the profitability index is higher than 1, it implies that the present value of future cash inflows from the investment will exceed the initial investment and company will earn profits through that particular investment.

risk assessment of project on the basis of three sensitivities modelled

Reduction in sales volume by 10%

Sales volume is a contributing factor in deciding the fate of the company’s profits. It’s seen frequently that the companies struggle to meet their target volume of production due to two main factors, which are: -

  • Underutilisation of the Resources – If the personnel deployed for the job work aren’t well versed with their tasks, then it is highly likely that they may not be able to grind the maximum output out of the available resources (Borgonovo and Plischke, 2016). The abnormal wastage goes up, which ultimately leads to lower input-output ratio.
  • Lack of Market Space – If the market is at a saturation point or the product doesn’t have enough demand, then it adds friction in the company’s progress. Thus, the company is forced to curb its production which ultimately cuts short the sales output.

Reduction in sales price by 20%

Sales price is a governing factor in the product’s demand. As the law of demand states, “Higher the price, lower is the demand and vice versa”, the demand is directly proportional to the increase or decrease in the sales price of the product (Nagle and Müller, 2017). So, if the company pulls down the sale price by 20%, then it may significantly increase the demand for the product.

Increase in initial investment by 10%

The net result of the project depends upon the present value of all the future cash flows when compared with the initial investment. If the initial investment increases with no change in the cash flows, then the NPV (Net Present Value) will be reduced to the extent of the increase in the initial investment (Grant, 2016). If, however, the cash flows increase to some extent due to the increased charge in initial investment (say an expenditure for improved machinery), then the NPV might gain heights than the previous level achieved with the old machinery.  

recommendation for acceptance of project

By considering the application of capital budgeting techniques and sensitivity analysis following results has been obtained:

 

With the given information

Reduction in sales volume  by 10%

Reduction in sales price  by 20%

Increase in initial investment by 10%

NPV

$5,596,502

$3,521,143

$1,445,783

$286,954

Payback period

3.38 years

3.55 years

3.76 years

3.91 years

Discounted payback period

3.17 years

3.40 years

3.68 years

3.88 years

Profitability index

1.31

1.20

1.08

1.02

IRR

21.1%

17.3%

13.1%

10.6%

Above statement shows that the company will be able to earn positive returns despite adverse impact on three crucial factors of proposals. On the basis of this aspect, the proposal should be accepted by the company as even if estimated projections are not favourable in the near future then also invested amount in the proposal will deliver positive returns.   

 
 

References

Borgonovo, E. and Plischke, E., 2016. Sensitivity analysis: a review of recent advances. European Journal of Operational Research, 248(3), pp.869-887.

Ghiyasi, M., 2018. Performance assessment and capital budgeting based on performance. Benchmarking: An International Journal, (just-accepted), pp.00-00.

Grant, R.M., 2016. Contemporary strategy analysis: Text and cases edition. John Wiley & Sons, United States.

Nagle, T.T. and Müller, G., 2017. The strategy and tactics of pricing: A guide to growing more profitably. Routledge, Oxon.

Nawaiseh, M.E., Al-nawaiseh, H., Attar, M.D. and Al-nidawy, A., 2017, September. The Use of Capital Budgeting Techniques as a Tool for Management Decisions: Evidence from Jordan. In International Conference on Engineering, Project, and Product Management (pp. 301-309). Springer, Cham.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

Schlegel, D., Frank, F. and Britzelmaier, B., 2016. Investment decisions and capital budgeting practices in German manufacturing companies. International Journal of Business and Globalisation, 16(1), pp.66-78.

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