Net Present Value (NPV) and Internal Rate of Return (IRR) in Capital Budgeting

The NPV and IRR investment rules explained

Net Present Value (NPV) is an indicator of how much value an investment or project adds to the firm to help firm in making investment decision. NPV rule is the most accurate and reliable rule, in practice a wide variety of rules are applied. However, Graham and Harvey’s study indicates that one-fourth of U.S. corporations do not using the NPV rule. Exactly why other capital budgeting techniques are used in practice is not always clear. Similar to NPV, the internal rate of return (IRR) investment rule, one of capital budgeting tools is based on the concept that the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity. In general, the IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows. In most cases, investment with high NPV will tend to have higher IRR. However, in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. The conflict happened when mutually exclusive project has higher NPV but has lower IRR than the other project. This conflict can be solved by preparing NPV profile. Figure 1 and Figure 2 illustrate two different NPV Profile. Figure 1: NPV Profile : NPV Profile 2 Required: (a) Based on the NPV profiles above, explain how this conflict (NPV vs. IRR) can be solved.  (b) A survey found that a sizable minority of firms (25%) in their study do not use the NPV rule at all. In addition, about 50% of firms surveyed used the payback rule. Furthermore, it appears that most firms use both the NPV rule and the IRR rule. Explain this phenomenon on why do firms use rules other than NPV if they can lead to erroneous decisions?  Question 2Kike Ltd is a retailer dominance of the athletic shoe and sporting apparel businesses. Kike Ltd, which currently views itself as operating in the sporting wear (shoes and clothes) segment, is considering an expansion into the fashion apparel business, producing high-priced casual clothing for teenagers and young adults. The Company therefore, is contemplating building another new retail store across the town. Followings are information on this expansion. • The company already owns the land for this store, which currently has an abandoned warehouse located on it. The land cost at $350,000 and has a useful life of 10 years. Kike Ltd bought this land 5 years ago. • The cost of $45,000 for demolishing the abandoned warehouse and clearing the lot. • The marketing department spent $20,000 on market research to determine the extent of customer demand of the new segment for the new store. • The construction of the new store would cost $500,000, with 5-year life and depreciated using straight line method. • The loss of 30% sales in the existing retail outlet (old segment), if customers who previously drove across town to shop at the existing outlet (old segment) become customers of the new store (new segment) instead. • Kike Ltd issue bond at 6% to finance the construction cost. • Assumes the cost of capital is 10% and tax rate is 27%. • Kike Ltd is expecting the sales of the new segment which will be constant at $150,000 per year for 5 years. : (a) Discuss should the land cost that has an abandoned warehouse be included as part of incremental earnings for the proposed of new segment. Would the value of land if sold be considered as opportunity cost? (b) Discuss should the cost of $45,000 for demolishing the abandoned warehouse and clearing the lot and the marketing cost of $20,000 be included as part of incremental earnings for the proposed of new segment. (c) Discuss in detail how the cost of the construction of the new store, $500,000, with 5-year life and depreciation using straight line method and the cost of issuing bond at 6% to finance the construction cost are treated as incremental earnings for the proposed of new segment.  (d) In the situation where the employees leave the new store sitting idle due to some unavoidable circumstances (such strike, natural disaster), should the cost in (c) is treated as opportunity cost?(e) Discuss in details how this loss of 30% sales in the existing retail outlet (old segment), if customers who previously drove across town to shop at the existing outlet (old segment) become customers of the new store (new segment) instead will impact the incremental earnings for the proposed of new segment. (f) Explain why it is advantageous for Kike to use the most accelerated depreciation method compared to straight line method. (g) Is it realistic for Kike to forecast a constant sale for 5 years? Question 3 (Total 30 marks) Moon Chemicals and Minerals (Pvt) Limited is a small-scale industry. The company purchased and constructed building in the year 1993. It started production in the year 1996. Its main product is lubricants for automobile. It is a private company situated in the Industrial estate, Ambewadi, which is enjoying all the required facilities like water, power, transport, labours and good environment and materials. Moon Chemicals and Minerals (Pvt) Limited, invest nearly 20% of its total asset in net working capital. This number is quite high compared to other company such Delhi Airlines, regional airline because Moon Chemicals and Minerals (Pvt) Limited requires a large investment in inventory compared to other company whose profitability relies more on investment in long term asset. The level of net working capital reflects the length of time between when cash goes out of a firm at the beginning of production process and when it comes back in. Moon Chemicals and Minerals (Pvt) Limited has traced the path of $15,000 worth of inventory and raw materials as follows; I. Moon Chemicals and Minerals (Pvt) Limited buys $15,000 of raw materials and inventory from its suppliers, purchasing them on credit, which means that the firm does not have to pay cash immediately at the time of purchased. II About 14 days later, Moon Chemicals and Minerals (Pvt) Limited pays for the materials and inventory, so two weeks have passed between when Moon Chemicals and Minerals (Pvt) Limited purchased the materials and when the cash outflow occurredAfter another 10 days, Moon Chemicals and Minerals (Pvt) Limited sells the materials (now in the form of finished lubricants) to an automotive manufacturer, but the sale is on credit, meaning that the automotive manufacturer does not pay cash immediately. IV A total of 30 days have passed between when Moon Chemicals and Minerals (Pvt) Limited purchased the materials and when it sold them as part of the finished product. V About 24 days later, the automotive manufacturer pays for the lubricant, producing a cash inflow for Moon Chemicals and Minerals (Pvt) Limited. A firm’s sources of financing, which usually consist of debt and equity, represent its capital. The typical firm raises funds to invest by selling shares to stockholders (its equity) and borrowing from lenders. Like other company Moon Chemicals and Minerals (Pvt) Limited raise funds from debt and equity. Moon Chemicals and Minerals (Pvt) Limited uses the following securities to fund its operation: VI Moon Chemicals and Minerals (Pvt) Limited has $100,000 bonds due in 2019 that were originally issued in 2009; these bonds have a coupon rate of 10%. With the collapse of the U.S. real estate market in 2010, Moon Chemicals and Minerals (Pvt) Limited performance suffered and the risk that it might not be able to meet all of its debt obligations increased. By mid-2015, those 10% coupon bonds were rated BB (below investment grade) and trading at a yield to maturity of about 12.6%. Thus, to be willing to take a creditor position in Moon Chemicals and Minerals (Pvt) Limited, investors demanded a yield to maturity of 12.6%. Taking into account the probability of default and the expected loss in default, BB rated bonds had an average expected loss of 1.3%. Thus, the true expected return was closer to 11.3% (12.6% promised minus 1.3% expected loss). VII Suppose the equity beta of Moon Chemicals and Minerals (Pvt) Limited is 1.60, the yield on 10-year Treasury notes is 3%, and market risk premium is estimated to be 6%. Moon’s cost of equity using CAPM is 3% + 1.60 * 6% = 12.60%. VIII If Moon Chemicals and Minerals (Pvt) Limited keeps its dividend payout rate constant, then the long-run growth in dividends will equal the long-run growth in earnings. The average forecast for long-run earnings growth rate was 7.9%. Thus, with an expected dividend in one year of $1.80, a price of $57.66, and long-run dividend growth of 7.9%, the CDGM estimates cost of equity as 11%. Required: (a) Compute the operating cycle and cash cycle of Moon Chemicals and Minerals (Pvt) Limited. Discuss the difference between these two. (b) Discuss how Moon Chemicals and Minerals (Pvt) Limited may have negative CCC? (c) Discuss how the working capital needs are different between Moon Chemicals and Minerals (Pvt) Limited and Delhi Airlines (assume Delhi Airlines has negative CCC)?  (d) Discuss how working capital management can increase Moon’s value?Based on the company’s cost of capital information, which is a better estimate of the cost of debt capital for Moon in 2015, the 10% coupon or something based on the 12.6% yield to maturity? (f) Discuss why the return paid to the debt holders is not the same as the cost to the firm. Provide calculation to justify, and assume borrowed amount is $100,000 at 10% of interest and tax rate is 35%.  (g) Discuss why the two estimates of cost of equity in (VII) and (VIII) do not match.  US Pizza is one of those foods with which Americans have an abiding love affair. It is also one that lends itself to all sorts of variations. It was started in the 1990s by Crank Frankly in Kansas. FIN 222 US Pizza, due to its brand recognition has been offered to invest in Yummy Brands Inc., one of the world’s largest restaurant companies which is operating in Europe. This investment requires US Pizza to make an upfront investment of $240,000. FIN 222 will be expecting to generate a cash flows of $340,500 every end of the year after covering all operating expenses. This return may seem like a good deal for  Ltd US Pizza, however in reality, the cash flows are uncertain (depends on business’s demand) and will have an impact on the security returns. The uncertainty is shown in Table 4.1 below; Table 4.1: The uncertainty of free cash flows Security cash flows Security return Demand Free cash flows Unlevered equity Debt Levered Equity Unlevered Equity Debt Levered Equity Weak $270,000 Expected $345,000 $345,000 $157,500 $187,500 15% 5% 25% Strong $420,000 The current risk-free interest rate is expected to be 5%. US Pizza believe, however, that their profits will be somewhat risky and sensitive to the overall market (which will affect the level of activity in the building and demand for your business), so that a 10% risk premium is appropriate, for a total discount rate of 15%. As an alternative, FIN 222 US Pizza may also consider borrowing some of the money it needs to invest. Suppose the business’s cash flow is certain to be at least $160,000. Then FIN 222 US Pizza can borrow $150,000 at the current risk-free rate of 5%.Required: (a) Calculate the NPV of the investment on Yummy Brand.  (b) IfUS Pizza has two options (equity and levered) in raising money for this investment, discuss how these options may affect the total amount raised by  US Pizza. (c) Based on (b) answer, discuss how leverage will affect risk and return of FIN 222 US Pizza’s equity and raise its equity cost of capital.  (d) Consider the different levels of demand and free cash flows in Table 4.1 and compute the security cash flows and returns for unlevered equity, debt and levered equity (compute figure in empty area of the table). Discuss and illustrate the effect of leverage on returns in Table 4.1 (includes your computation) with graph.e) The effect of leverage on the firm’s cost of equity is illustrated by the insight of Modigliani and Miller. Describe how it is that the firm’s weighted average cost of capital stays the same even after adding leverage computation). Discuss why this WACC remains constant. (f) If Ltd US Pizza decides to pay cash to shareholders, it can do so through either dividend payments or share repurchases. Assume,  US Pizza has cash of $400,000 cash in excess and no debt with 100,000 of outstanding shares. Discuss three possible options that may be considered by the board and determine the impact of each decision on market value of  Ltd. US Pizza. Assume including the cash in excess,  US Pizza’s total market value is $1,000,000 and future free cash flows of $345,000 per year. (g)  US Pizza agrees to invest in Yummy Brands Inc., which is operating in Europe, US Pizza knows it will have to pay the upfront investment in euros within 3 months with exchange rate of 1.4500 dollars per euro, discuss how forward and options contracts can be used by the company to hedge its exposure