Project Feasibility Using NPV And IRR

Discuss about the Project Feasibility using NPV and IRR.

Capital Budgeting is the method where a business determines and evaluates potential expenses or investments which are large in nature. These are mainly concerned with investment in a long-term venture or building of a new plant. The management has to use techniques of capital budgeting for determination of that project which is going to yield most return over applicable time period.  Various methods that are included in capital budgeting are Net Present Value (NPV), Internal Rate of Return (IRR) or Payback period.

KKP Ltd. Is in the business of automation. They are keen to launch in the food industry a new type of proximity sensor. We will use capital budgeting tools to determine whether it is feasible for KKP to invest in the proximity sensors.

They have already spent $75,000 on the research and to study the markets. This $75,000 spent is the sunk cost, which has no role play in the decision making for the firm as its already spent and cannot be removed, we won’t be considering it in the cash flow.

The company has made an initial cash outflow that consists of $500,000 on building the new machinery and working capital increment of $25,000 which the company will receive back at the end of the time-period. This implies that our COF (Cash outflow) at the zero year will be $(500,000+25,000) = $525,000.

This machine will be sold at the 5^th year at a value of $220,000. The depreciation rate of the machine based on the straight-line method is 10% i.e. 10% of $500,000 = $50,000 every year for 5 years. The book value of the machine at the end of 5^th year would be = $500000-(50000*5) i.e. $250,000. The difference between the book value and the salvage value is going to be the profit/loss of company. The Loss on machine would be $(220,000-250,000) = $30,0000. This would be discounted at the 5^th year to reach to the NPV of the machine.

The firm is having revenue of $50 per unit which comprises of variable cost of $30 per unit. The contribution per unit is $30 for 5000 units i.e. $150,000. The company is having an incremental cash flow of $80,000 in the form of reduced production costs every year. Also, there is reduction in sales every year of $17,000. This will be adjusted to arrive at the revised contribution. The fixed costs of $100,000, depreciation of $50,000 will be deducted from the contribution getting us to the profit/loss before tax. Further tax would be reduced to arrive at profit/loss after tax. To this we would add the depreciation and post-tax loss on sale and reach to Cash Inflows of the company. The cash inflows must be discounted PVIF of 8% and from that we would deduct cash inflow, discounted working capital and salvage value. The NPV of the project comes to $3,158.

Quantitative

NPV has been the most used techniques for investment evaluation. As the NPV is positive we would recommend the company to accept the proposal. The present value of revenue generated is greater than the cost of the machine and hence the project would be beneficial to the company. If the NPV is positive it is expected that it would generate additional wealth for the shareholders.

IRR or Internal Rate of Return is another metric that is used in decision making related to capital acquisitions, investment valuation and proposal. It is basically that rate of return where the post-tax discounted cash inflows equal the present value of the cash outflows. It viewed positive if it is greater than the firm’s required rate of return. It measures percentage of profitability, showing how much return is earned on every rupee that has been invested (espark-viridian.org, 2018). It has more advantage compared to NPV as it provides information of margin of safety. In our example, the required rate of the return of the company is 8% whereas the IRR of the proposal is 8.19%. Since the IRR exceeds the required rate of return we should accept the project.

One other method to evaluate company’s financial position to decide whether the project should be accepted or not is the calculation of payback period. It is a very simple method which calculates the period in which the initial investment is recovered. Any investment which can be recovered within some prescribed timeline. The shorter the period the better it is.

A method like payback period is the discounted payback period which uses the Present value of cash flows to calculate the length of time required for an investment’s discounted cash flows to equal its initial cost. Although It takes the time value of money into consideration but this should not be taken as a primary decision rule nor does it provide an indication about an increase in value. Also, it does not take into consideration the cash flows after the payback period.

For KKP Ltd the payback period is coming out to be 4.47 years and discounted payback period is 4.099 years i.e. KKP Ltd will be able to generate enough cash flow to recover its initial investment in less than 5 years which seems to be a good sign of growth but since the rule does not indicate if we are creating value for the firm, it should not be the primary decision rule.

Qualitative

PVI or Present Value Index also known as Profitability Index is calculated by dividing the present value of the future cash flows of the project by the initial investment made by the company. The formula goes as:

Present Value Index = present value of future cash flows / initial investment

If the PVI is greater than 1 it implies that the project is creating a value i.e. it is generating a return that is greater compared to the required return. On the other hand, if it is less than 0 than it destroys the value. It is advantageous as NPV is not useful for determination in percentage terms of the project’s return. PVI fixes that problem by comparison of two or more than two projects and the value created by them for each dollar invested.

Here KPP Ltd. Is having a PVI of 1.3229. Since the PVI of the project is greater than 1 hence it is considered to create value and generate returns. Thus, investment should be made by KPP in this proposal.

Although quantitative factors are dominant when doing investment decisions, but the qualitative factors also should be considered. Some of the factors are:

Competitive Advantage: The long-term success of the company is largely driven by its ability to maintain competitive advantage. This helps creating a moat around the business and keeping the competitors at bay thereby enjoying profits and growths. KPP should consider how its capital investment is going to give it an edge over its competitors providing it operational effectiveness.

Company Culture: Work performed in an organization can be impacted with capital investments. For example, if an automation is added to business line then it can lead to change in the dynamics of the team. Before making any decision related to capital investment the management should understand its effect on the culture of the company. Cultural considerations more heavily come into play with physical resources of production. Since KKP Ltd is making a capital investment in machinery it should keep in mind the effects the decision is going to have on the cultural environment of the company.

Product Quality: Capital investments are made for enhancing production capacity. Therefore, quality of resources of capital can affect the goods and services quality. The management needs to understand the importance of striking a balance in between the quality and cost in capital resources for maximizing the cost efficiency of the investment.

Environmental Concerns: Capital Investments effect the environment too. Frequently more financially appealing options are said to have greater impacts when compared to costlier options. Due to this the quantitative factor can be at odds with the environmental responsibility qualitative factor. Management must keep in mind the impact that can be caused on the environment by the capital investment. KPP Ltd must consider what impact would the installation of the new machinery could be considering the pollution etc. emitted.

Ethical Considerations: This include local employment, employee safety, local quality of air which can be affected by investment in new equipment and facilities. Overhauling of a production facility which automates tasks of manufacturing thereby reducing the staff drastically can introduce public animosity and cost efficiency at the same time.

If we analyze the investment with regards to the qualitative view, then it can yield competitive advantage to the firm by generating positive wealth. Quality of the product can also be improved. Not only this the company can expect positive results with regards to Company Culture, Ethics and Environmental Concern. Thus, we can see that will all the available tools of decision making it is quite evident that the company should be investing in the proposal as it is expected to generate wealth and synergy altogether.

Conclusions

From the various capital budgeting tool, we used it can be said that KPP should invest in the machine as the stakeholders are going to be benefitted by this decision of capital investment. The cash generated can be deployed in further investments or retained in the compay.

References

espark-viridian.org (2018). How to Determine Project Feasibility using NPV and IRR - Espark Viridian | India's leading early stage startup Accelerator. [online] Espark Viridian | India's leading early stage startup Accelerator. Available at: https://espark-viridian.org/determine-project-feasibility-using-npv-irr/ [Accessed 30 Jul. 2018].