MANAGING FINANCIAL RESOURCES AND DECISIONS

Managing Financial Resources and Decisions

Managing Financial Resources and Decisions

Capital Investment Appraisal

Answer (a i):

The general rule is that the NPV enables maximization of value. But when a project is larger than another and it has a higher NPV it is necessary to ask whether the cash flow difference between the two projects is being used. The question arises only in the context of mutually exclusive projects and only when the project is the largest that has the highest NPV. Naturally, if projects do not exclude each other, all those who have a positive NPV are chosen. However, some projects which are not exclusive to them initially may become so if the funds are rationed. (Weygandt, Kieso & Kell, 1996, pp. 800) The general analysis of capital rationing will be discussed later. Here we only study how to choose between projects of different sizes which are mutually exclusive. Several methods come to mind: a) - bring both projects to the same size b) - calculate the NPV of the difference in size between the two projects c) - using IP Bring both projects to the same size, although mathematically possible, is very complicated and only possible if the smaller project is duplicable. Calculate the NPV of the difference is simple and assumes that if the difference is acceptable, then the project the higher the better. Some manuals recommend using IP but we will see later that PI does not give the correct solution. (Groppelli, Angelico & Nikbakht, 2000), pp. 433)

NPV is a financial indicator that measures the flow of future revenue and expenses will have a project to determine if, after deducting the initial investment, we would make a profit. If the result is positive, the project is viable. Simply find NPV investment project to see if the project is viable or not. The NPV also allows us to determine which project is most profitable among several investment options.

The IRR is the discount rate (TD) of an investment project that allows the BNA is equal to the investment (NPV equal to 0). If the IRR is the maximum, the investment is considered profitable.

Answer (a ii):

This is not always conclusive when you want to prioritize projects. Both techniques can rank the projects in a different order. The difference between the results provided by both techniques is due to the circumstances in which each is based. The IRR criterion is that the funds generated by the project would be reinvested at the rate of return on the project, the criterion of NPV assumes reinvestment at the discount rate of the company. (Medlik & Ingram, 2000, pp 137 - 141)

Answer (b)

Project A

Discount rate

6%

Year

Assumed Outflow

1

2

3

4

5

6

Net Cash flow

(4,000)

1,000

900

1,000

800

1,000

800

Discount Factor

1.06

1.12

1.19

1.26

1

1

Discounted CF

(4,000)

€943.396

€800.997

€839.619

€633.675

€747.258

€563.968

Investment Measures

NPV =

€528.914

IRR =

10.20%

Project B

Discount rate

6%

Year

0

1

2

3

4

5

6

Net Cash flow

(4,000)

400

400

3,000

900

400

400

Discount Factor

1.06

1.12

1.19

1.26

1

1

Discounted CF

(4,000)

€377.358

€355.999

€2,518.858

€712.884

€298.903

€281.984

Investment Measures

NPV =

€545.987

IRR =

10.32%

The IRR of both the projects is more or less the same with a difference of 0.12%. However, on the assumptions that the initial investment was €4,000, Project A generated only €528.914 while Project B generated ...