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 costs

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.

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