• Author / Uploaded
• chew97

Citation preview

3.0 Evaluation of investment project using IRR and NPV. Scenario: Ali Paper want to expand their business to Hatyai, Thailand. There are two companies had proposed their own project to the administrators of Ali Paper. After that, the administrators conduct a meeting to discuss which project should be accepted if the projects are mutually exclusive. In this case, mutually exclusive projects are projects in which acceptance of one project excludes the others from consideration. In such a scenario the best project will be accepted. Table 1 and 2 are the detailed cash flow of both project A and B offered by two companies. The cost of capital /discount rate for the company is 12% per annum. In order to solve Ali Paper to solve this problem, we can actually use NPV and IRR method in evaluating both projects before making a right decision.

Table 1: Project A Period (Year)

Project Cash outflow (RM)

0

Cash inflow (RM)

25000

1

12500

2

10000

3

7500

4

2500

5

1250

Table 2: Project B Period (Year)

Project Cash outflow (RM)

0

Cash inflow (RM)

25000

1

1300

2

2500

3

8500

4

12000

5

17000

Net present Value (NPV) of project A: 𝑁𝑃𝑉 =

−25000 12500 10000 7500 2500 1250 + + + + + (1 + 0.12)0 (1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

𝑁𝑃𝑉 = RM 1769.08

Net present Value (NPV) of project B: 𝑁𝑃𝑉 =

−25000 1300 2500 8500 12000 17000 + + + + + 0 1 2 3 4 (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5

𝑁𝑃𝑉 = RM 1476.30

Comment Both project A and B have a positive net present value and it indicates that both investment proposal is profitable and worth selecting. However, the economic situation of Ali Paper causing them can only afford one project at the time. In a situation, where the projects are mutually exclusive, Ali Paper should choose to approve project A for their business expansion since the value of its NPV of project A (RM1769.08) is higher than NPV of project B (RM 1476.30). In other words, a maximum profit can be expected by the shareholder if project A is chosen.

Internal rate of return (IRR)

Project A Using trial and error method to find the rate, followed by the formula:

Cost of capital (%)

NPVA

14%

851.29

15%

413.23

15.8

72.25

15.9

30.21

16%

-11.70

Use the formula to calculate IRR 𝐼𝑅𝑅 = 15% + 𝐼𝑅𝑅 = 15.97%

413.23 × (16% − 15%) (413.23 − (−11.70))

Project B Using trial and error method to find the rate Cost of capital (%)

NPVB

13%

585.98

13.5%

155.90

13.6%

71.6

13.7

-13.41

14%

-264.50

Use the formula to calculate IRR 𝐼𝑅𝑅 = 13% +

585.98 × (14% − 13% ) (585.98 − (−264.50))

𝐼𝑅𝑅 = 13.69%

Comment Both projects are good and ideal in this case because their internal rate of return is bigger than the cost of capital of the company which is 12%. Based on the value of IRR, project A will be chosen because it has greater IRR compared to project B. To put it differently, the higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. Besides, the IRR of project A also indicates that the shareholder can get back the modal (cash outflow) invested earlier, then the risk of investment will automatically reduce.

Discussion From the calculation and analyse of two projects based on their net present value and internal rate of return, I suggest Ali Paper to choose project A in expanding their business. This is the best option since there is no contradiction between this two values. A project that brings higher net present value and higher internal rate of return will definitely yield profit if there is no other factor affect it, Hopefully, with this analysis and decision Ali Paper able to expand his company to more and more country successfully. However, when we compare two projects in some cases, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the two projects. In this case, it is recommended that we stick to the net present value as a screening criteria. (David, 2013). The background of such a recommendation is that the reinvestment rate plays the key role. The basic assumption of the NPV method is that future cash flows are reinvested at cost of capital rate, and the IRR method assumes that future cash flows are reinvested at an internal rate of return. Hence, the reinvestment rate equal to the cost of capital is a more realistic assumption, especially in the long term project. From my point of view, even we can make use of IRR method it is a great complement to NPV and will provide you accurate analysis for investment decisions.

References: Amy, G. (2014, November 19). A Refresher on Net Present Value. Retrieved from Havard Business Review: https://hbr.org/2014/11/a-refresher-on-net-present-value David, F. (2013, August 27). FInancial Evaluation technique. Retrieved from Keylogic: http://www.keylogic.com/blog/blog/2013/08/27/which-financial-evaluation-technique Hahn. (2006). European Regional Development Fund. Council Regulation, 30. Harold, B. (1993). A Survey,” Financial Management, Autumn. Capital Budgeting in 1993 , 24. Marcela, C. (2008). Projects. INVESTMENT PROJECTS: GENERAL PRESENTATION, DEFINITION, CLASSIFICATION, CHARACTERISTICS THE STAGES, 92. Natasha, K. (2017, April 12). Evaluating Profitability of Investment Projects. Retrieved from Economics Discussion: http://www.economicsdiscussion.net/investment/analysisinvestment/evaluating-profitability-of-investment-projects/18885 Nayab, N. (2010, November 14). Advantages of Using IRR method. Retrieved from BrightHub Project Management: http://www.brighthubpm.com/projectplanning/95360-advantages-of-using-irr/ Project Planning and Evaluation. (2005, December 17). Retrieved from Public Safety Canada: https://www.publicsafety.gc.ca/cnt/cntrng-crm/crm-prvntn/tls-rsrcs/prjctplnnng-en.aspx Robert, S. (2014, June 9). What is IRR and How Does it Work? Retrieved from Property Metrics: https://www.propertymetrics.com/blog/2014/06/09/what-is-irr/ Sudong, Y. T. (2000, May 1). NPV: Method in Infrastructure Project Investment Evaluation . Retrieved from ASCE LIbrary: http://ascelibrary.org/doi/10.1061/%28ASCE%2907339364%282000%29126%3A3%28227%29