- The company (RWE Enterprises) plans to undertake a new project whereby a plant would be set up. Based on the details provided, it is apparent that the project would lead to the following cash flows.
- Initial outlay at t=0 is $ 3 million
- Subsequent annual cash inflow (post tax) of $ 0,7 million
- Refurbishment cash outflow of $ 2 million at t =5
- Scrap value (post tax) inflows of $ 0.2 million at t =10
The above projects details will lead to the following incremental project related cash flows.
- For the given project, the applicable discount rate is 10%. The present value the cash flows has been estimated and used to derive the NPV as showcased below.
The computation leads to a positive NPV ($0.14 million) which implies that accepting the project would be beneficial for the shareholders (Northington, 2015).
- The objective is to compute the IRR which is referred to as the discount rate that yields NPV as zero. The computation in this regards yields the NPV as 11.04% as apparent from the table below
Based on IRR, the project would be accepted since the discount rate applicable for the new plant project is 10% and hence lower than IRR computed (Brealey, Myers and Allen, 2015).
The profitability index computation is executed in line with the formula stated below (Damodaran, 2015).
As the profitability index tends to be cross the hurdle rate of 1, hence the new plant is financially feasible as per this criterion.
- The payback period is defined as the time required for the initial investment recovery. Using the table highlighted below, payback period computation has been performed.
Therefore, payback period amounts to 7 + (0.1/0.7) = 7.14 years
This implies that 7.14 years would be taken to recover the initial investment of $ 3 million. But considering that the life of the project is 10 years, a payback period not exceeding the useful life is considered financially viable provided there is no other hurdle rate set by the management (Petty et. al., 2015).
- Project A
NPV computation using 12% as the discount rate yields NPV as $ 79,350 as shown follows.
IRR computation yields resultant value as 20.96% as at this value, the NPV becomes zero as indicated below.
The computations to assist with payback period calculation are as shown below.
NPV computation using 12% as the discount rate yields NPV as $ 85,478 as shown follows.
IRR computation yields resultant value as 23.92% as at this value, the NPV becomes zero as indicated below.
- In order to see which of the project(s) would be acceptable, it is essential to discuss them on each of the criteria pivotal for the management.
- NPV Criterion – Both are acceptable as NPV has come out positive.
- IRR Criterion – Both are acceptable as IRR in both cases exceeds 12% (cost of capital).
- Payback Period Criterion – Only project B is acceptable as the company desires a payback of less than 3 years which is adhered to only by project B since project A payback period exceeds 3 years.
The inference drawn from above analysis is that project B only is financially viable.
Now considering the situation, only one of the given two projects may be accepted. Thus, the evaluation of the two projects is carried out as indicated below.
Based on the above, project B is superior and would be given preference over the other project i.e. project A.
Brealey, R. A., Myers, S. C., and Allen, F. (2015) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.
Damodaran, A. (2014). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.