Analysis Of R Reed Co Pty Ltd - Net Present Value, Internal Rate Of Return, Payback Period, Accounting Rate Of Return, Profitability Index Essay.

Task: 1

How does R Reed Co Pty Ltd compare?

Do you think the profit or loss for the company is reasonable in the circumstances and explain why?

What recommendations would you make for Ryan Reed to improve his business performance in these areas

Task 2

Task 2B is made up of an Excel document that shows the accounts and financial reports for the entire accounting cycle for the business AND a Word document containing the financial report.  The Excel template is provided for you.  You must create the Word document in the format set out later in this document.

Part1: Net Present Value

Question 1

Part1: Net Present Value

Part 2: Internal Rate of Return

Part 3: Payback Period

Part 4: Average Rate of return

Average net profit/ Average investment

Average Profits = 0.012 + 0.008 + 0.603 + 0.327 + 0.483   =$ 0.286

                                                               5

Average Investment= salvage value + 0.5 (Initial investment – salvage value)

                                     = .0240 + 0.5 (2.40-.0240)

                                     = $ 1.32

Accounting Rate of Return= 22%

Part5: Profitability Index

NPV + Initial Investment/ Initial Investment

Part 6: Analysis

According to the calculation done, NPV of the project is negative that is $ -0.46. A negative NPV means project is not able to generate sufficient cash inflows and is not considered to be profitable for the purpose of investment. The project has a negative NPV which implies that it will not generate enough cash inflows to recoup its initial outlay. Hence, it will be recommended not to invest in such project (Agarwal, 2013).

According to the policy DCL has of repaying its capital investment within 2.50 years, the payback period calculated for the project is much more. The proposal has a payback period of 3.10 years which states that it will take 3 years and 10 months to repay the initial investment. Once the period is over, the project will start generating returns. Hence as per the policy, it should not be accepted (Bierman & Smidt, 2012). 

As far as IRR is concerned, it is very much less than the project’s required rate of return of 12%. The IRR is 3.85% and is considered as a discount rate on which project earned no profit and loss. So it should be rejected. However, it’s ARR of 22% is more than the desired rate, which gives a valid reason to accept the project from ARR point of view (Agarwal, 2013).

The last calculative part include the determination of profitability index which is 0.81 of the project. For a proposal to be accepted by the managers, its P.I should be more than one. As it is clear that the P.I of the project is less than one so it should be rejected. Four out of five capital budgeting techniques shows the result that the project is not appropriate for investment. These are mostly used techniques which measures the viability of an investment proposal. So it will be recommended not to invest in such project (Bierman & Smidt, 2012).

Part 2: Internal Rate of Return

The entire instalment amount per year is deducted from the cash flows to reach at net cash flows to determine the net present values, Profitability index, and internal rate of return and payback period. But to calculate the accounting rate of return the net profits are to be calculated. For the purpose of net profit calculation only interest amount is deducted from the cash flows as it is operating expense but payment of principle amount is not an operating expense. The tax benefit of interest could be availed but since no tax rate is given in the questions. Salvage value of fixed asset will be received at the end of project life and it will be treated as the cash inflow. Hence it will be added to the given cash flows. Also, the capital gain on sale of asset will not be taxed as there is no tax rate given.

It is assumed that the company is operating in tax heaven treaty and hence no tax obligations are there in this case of company.

Question 2

Calculation of Depreciation

Calculation of cash flows after tax

Part 1: NPV evaluation

The net present value of the project is positive which means it will generate enough cash inflows that will recover its initial outlay. The NPV is $ 5112435.709. Hence, the project should be accepted.

Part 2: Sensitivity analysis

 It is the analysis which measures the sensitivity of the NPV of a project with its various factors. It determines the changes occurring in the value of NPV corresponding to the changes in its factors like sales amount, sales units and so on. Here, sensitivity analysis of the project is done on the sales revenue and cost of capital. Changes in these two factors will affect the NPV of a proposal.

• Sensitivity to the change in sales units

• Sensitivity to the change in cost of capital

Part 3: Scenario analysis VS Sensitivity analysis

Scenario analysis takes into account three scenarios of a project which are worst case, base case and best case. The situation under which project operates is unfavourable is known as worst case and where the situation is favourable, it is known as best case. When the project is carried out under normal situations, it is called as base case. The net present value is determined in all these cases and is analysed on the basis of probability of these three cases. Therefore it can be said that scenario analysis has a broader scope as compare to sensitivity analysis. It provides project manager with broader insight regarding the changes in the situations and their effect on the NPV of a project. On the other hand, sensitivity analysis considers only one variable to examine the sensitivity of the project. It does not take into account the overall effect on NPV due to the changes in the scenario. Whereas scenario analysis considers all the factors and provide additional insights to the management while evaluating an investment proposal.

Part 4: Risk pricing

Risk is the factor which reflects the uncertainty of the returns which occurs due to the changes in key factors like inflation rate, demand, economic growth and many more. In this discussion, sensitivity analysis is used for pricing the risk, where the sensitive of the project is determined in accordance with the changes in sales units and cost of capital. The net present value of the project is also calculated to check the risk associated and getting a positive NPV implies that less amount of risk is there as the project is capable enough to make sufficient cash flows which covers its cash outflow. This also shows that project will create good returns and are in accordance with the risk. Hence, project manager must be confident about the project and it viability (Alessandri, Ford, Lander, Leggio & Taylor, 2004).

References

Alessandri, T.M., Ford, D.N., Lander, D.M., Leggio, K.B. & Taylor, M., (2004). Managing risk and uncertainty in complex capital projects. The Quarterly Review of Economics and Finance, 44(5), pp.751-767.

Agarwal, V., (2013). Managerial Economics. Pearson Education India.

Bierman Jr, H. & Smidt, S., (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.