Business NPV Essay, Research Paper
The NPV is £56700 for the
project given the best estimate cash flows. Therefore under the assumption that
the firm is operating to maximise the market value of their common stock, and
under the assumed conditions of certainty of prices of all assets, the firm
should accept the project, as the NPV is positive. This will increase the value
of the firm as long as no other groups of projects can be found which will
increase the value of the firm.B)The project has 2 internal
rates of return (multiple IRR?s) that are 4.8% and 13.45%.? Affects of multiple IRR?s are shown in graph
1.? The discount rate exceeds 4.8%
the proposal becomes positive and at 13.45% the present value of all the cash
flows is 0.? Therefore when the cost of
capital is between 4.8% and 13.45% the NPV is positive, and following the NPV
rule the project should be accepted.?
However if the IRR calculation of 4.8% is used the project maybe
incorrectly rejected as the cost of capital is in excess of 4.8%. Graph 1
however indicates this is an incorrect decision when the cost of capital is
between 4.8% and 13.45%.C)Both the IRR and the NPV
take account of time value of money, but situations arise where the IRR method
leads to different decisions being made from those that would implement the NPV
method.Mutually exclusive
projects exist when there is
acceptance of one project excludes the acceptance of another. The following
example will illustrate how the NPV and the IRR lead to different decisions. ??????????????????????????????????? Initial
Investment Outlay?? Net Inflow End Of Year
(£)??????????????????????????????????????????????? ??????????????????????????????????????????????? ??????????????????????????????????????????????????????????????????????????????????????????????? 1????????? 2????????? 3????????? Project A?????????????????????????????? £7000???????????????????????????????????? 3430?? 3430?? 3430 Project B?????????????????????????????? £12000?????????????????????????????????? 5520?? 5520?? 5520 Cost of Capital = 10% The NPV and IRR calculations
are as follows: ??????????????????????????????????????????????? ??????????????????????????????????????????????? IRR (%)????????? NPV (£) Project A?????????????????????????????? 22??????????????????? 1530 Project B?????????????????????????????? 18??????????????????? 1728 ??????????????????????????????????????????????????????????????????????????????????? Source:
Principles of Corporate ??????????????????????????????????????????????????????????????????????????????????? ? ????????? ?Finance, 6th edition ??????????????????????????????????????????????????????????????????????????????????? ? ????????? ?Brealy and Myers The IRR ranks A first
and NPV ranks B first.? If
the projects were independent this would be irrelevant, since both would be
accepted.? However the case is mutually
exclusive, therefore raking is crucial.?
Graph 2 illustrates this. A discount rate greater than
12% no contradictions arise, below 12% project B has higher NPV and
project A has a higher IRR.? The
IRR gives incorrect ranking proved by considering the increments of cash flows
of project B over A. Years ??????????????????????????????????????????????? 0????????? 1????????? 2????????? 3 ??????????????????????????????????????????????? (£)?????? (£)?????? (£)?????? (£) Project A?????????????????????????????? 120005520?? 5520?? 5520 Project B?????????????????????????????? 7000?? 3430?? 3430?? 3430 Incremental Cash Flow???? 5000?? 2090?? 2090?? 2090 If the firm did use the IRR
method and chose product A, we can establish if it is worthwhile to the
incremental investment (B-A). The acceptance of this investment + incremental
investment = A + (B-A), this is = to accepting project B.? Firm therefore accepts the incremental
investment.? Using the IRR rule is the
same as moving from A to B.? The IRR of
the incremental investment is (B-A) 12%.?
The cost of capital is 10%, the incremental project should be accepted,
as the IRR rule indicated a move from A to B.?
The superiority of the NPV method has been established, using the IRR
analysis to contradict the IRR rule.The IRR expresses results
as a percentage.? This is misleading; for example, compare an
investment of £100 that yields 50% return, with an investment of £1000 that
yields 25%.? If one project can be
accepted, the first will yield £50 and the second £250.? If the cost of capital is 10%, surplus fund
will be invested at the cost of capital.?
The first investment will be £90 + the £50 return from the £100 =
£140. Clearly the second investment, which yields a return of £250, is
preferred, as the objective of the firm is to maximise the firm?s wealth, so
the NPV provides the correct measure.Where there are unconventional
cashflows the IRR has a shortcoming.?
If the signs of net cash flows changes over successive periods,
calculations could produce as many IRR?s as there sign changes.? Only one rate is economically significant in
determining whether the investment is profitable.?????????????????????????????????????? ??????????????????????? D1)Considerations of
uncertainties are: ??????????????????????????????????????????????? ·
50% probability of
Standard Price oil ·
40% probability of
Higher Price oil ·
10% probability of
Lower Price oil And??????????????????????????????????????? ·??? 80%
probability of Standard Reclamation cost?????????????????????????????????????? ·?? 20%
probability of high Reclamation cost ??????????????????????????????????????????????? ·?? 0%
probability of low Reclamation costs ???????????????????????????????????????????????????? Using the above scenarios
the probability of:·
Standard Price /
Standard Reclamation costs = 40% NPV = £5607 ·
Standard Price /
High Reclamation costs = 10% NPV = -£50841 ·
Low Price / Standard
Reclamation costs = 8% NPV = -£210541 ·
Low Price / High
Reclamation costs = 2% NPV = -£266988 ·
High Price /
Standard Reclamation costs = 32% NPV = £113680 ·
High Price / High
Reclamation costs = 8% NPV = £57233It can be noted that the
most likely outcome will be standard price oil / standard reclamation costs
which has a 40% chance.However further calculations
need to be done to make a more informed decision. The calculations of which are
done in excel and are referenced in the appendices.The ENPV = £15930 The Standard deviation =
£96880 The Variance = 9368.58 The Expected Return =
2.343% ?D2)? Using the information, most
likely outcome will be: standard price oil / standard reclamation
which has a 40% chance.The ENPV of £15 930 is the
outcome expected if a project similar to this is undertaken again.? But risk needs to be accounted for, which is
both positive and negative from the mean (£15 930).? The standard deviation of £96 880, is very high which
reflects a large dispersion around the ENPV of £15930, hence greater risk.? Therefore there is a possibility that the final
result being under £15 930.? It could be
£10 930, £5 930 or -£4 030.? On the
other hand there are similar chances of obtaining £30 930, £35 930 or even
higher.As this is a large project,
there is a chance that the firm will incur an economic loss.? Therefore we have a 43.62% probability of
the NPV for the project will be negative.?
That is a 1 in 2 chance of losing money!D3) ???????????????????????????????????????????????????????????????????????????????????????? Probability analysis however
involves juggling with a lot of numbers; therefore decision makers could find
it hard to interpret them.The ENPV gives incomplete
information about project risk by itself because it measures central tendency,
whereas the management maybe concerned with the dispersion of possible outcomes
around the mean.Degree of uncertainty to the
various alternative is viewed in isolation, whereas it is important to take
into account the amount of risk, that each alternative will contribute to the
overall risk of the firm; such portfolio analysis.E)The WACC is useful for
investment appraisal as it used in capital budgeting decisions as a percentage
discount rate, which incorporates the effect of tax shields, to find the NPV of
projects that would not change the risk of the firm, by acting as a handle rate
for capital investments, which give the minimum required return on an
investment, on its discount cashflow calculations.? If the risk is not similar, a firm that invests in projects like
the one being considered is found and the equity cost of capital of that firm
is compared to ours.? The difference
being the firm?s beta compared to ours.?
To be able to use the firms WACC to discount the project, we assume that
the company will continue to home the same capital structure, which can be
classified into two types: (i) all equity and (ii) mixed with where debt and
equity are held in varying proportions.The traditional WACC can be
calculated by:Kd???? D???? +?? Ke???
E ?????? D+E???????? ???? D+EWhere Kd?????? = ???????? cost
of debt Ke
????? = ???????? cost
of equity D
??????? = ???????? proportion
of debt E
??????? = ???????? proportion
of equitySource : J Wyld WACC is calculated using
actual balance sheet data of companies and industries and all the variables in
the formula refers to the whole firm, therefore, when considering investment
appraisal using WACC, the company must be aware that industry costs might be
better than individual firms cost when used for investment appraisal.? Therefore the WACC can be adjusted for
changes in debt ratios according to WACC, debt is constantly rebalanced or
business risk by applying changes to the equation, which can also be used for
beta.Different investments have
different levels of risk, therefore the higher the risk the higher the rate of
return and vice versa.? Therefore the
WACC of 10% to be appropriate for any investment appraisal depends if the project
is of similar risk.? If the level of
risk is higher, then a risk premium should be added.? The CAPM approach provides a starting point.? The risk premium depends on the firms risk
level.? The higher the risk, the greater
the required rate of return or equity.?
The risk level of business and the financial coverage will have an
affect on the risk premium. The CAPM model, states that
the risk premium varies in direct proportion to beta which means all
investments slope along the security market line. See graph 3The expected risk on an
investment with a beta of 0.5 is half the expected risk premium on the market.The firms risk using the
CAPM approach is measured by its systematic risk, the beta and not by its
variance alone, therefore the required rate on an investment is given by: ??????????????????????????????????????????????? kei = r + (Exm ?
r) Where ·
r = risk free rate ·
Exm = the expected
return of the market portfolio ·
???= the ith firms systematic
risk ·
kei = the required rate
of return on an investment of the ith firm. TOTAL WORD COUNT = 1646APPENDICESCalculations for Question ANPV = A projects net contribution to wealth ; present value
minus initial investment. YEAR CASH DISC DISC’TED FLOW FACT. CASH (10%) FLOW 0 -680 1.000 -680.000 1 400 0.909 363.636 2 400 0.826 330.579 3 250 0.751 187.829 4 200 0.683 136.603 5 100 0.621 62.092 6 -700 0.564 -395.132 NET PRESENT VALUE 5.607 ?Definitions for Question BInternal rate of return = Discount rate at which investment
has zero NPV.Calculations for Question DProbability;? Standard Price Oil / Standard Reclamation Costs = (5/10) * (8/10) = 40% Standard Price Oil / High Reclamation Costs = (5/10) * (2/10) = 10% Low Price Oil / Standard Reclamation Costs = (1/10) * (8/10) = 8% Low Price Oil / High Reclamation Costs = (1/10) * (2/10) = 2% High Price Oil / Standard Reclamation Costs = (4/10) * (8/10) = 32% High Price Oil / High Reclamation Costs = (4/10) * (2/10) = 8%The Expected Return = 15933 / 680000 =
2.343%Calculation for D2A negative NPV means a value
less than zero hence we can say that the probability that an NPV will be
negative is given by the formula;z = (0 ? ENPV) / sd = sd
unitsThe equation is measuring
how far from the expected mean value an NPV might be in the left hand direction
of the normal curve.The ENPV = £15930 and the
standard deviation associated with this = £96880. By using the above equation
we can find the number of standard deviation units by which this varies from
the mean relative to zero.? This gives:z = ( 0 ? 15930 ) / 96880 =
-0.16 standard deviation (sd) units.? We
need to know now the probability associated with this number of sd units from
the normal distribution function.? Using
the normal distribution table read down to 0.1 then across to 0.06 to give us
0.16.? The value in the table is
0.0638.? This is not the probability of
a negative NPV, because we are interested in the left hand side of the normal
curve.? To do this we need to subtract
our table value from 0.5 (ie we are only concerned with the left hand tail of
the distribution) so that the probability the NPV will be negative is given in
the table as:(0.5 ? table z) = (0.5 ?
0.0638) = 0.4362 which is 43.6%.100 / 43.6 = 2.2.