ASSIGNMENT 1
Introduction
This paper consists of three parts. Part 1 includes the evaluation of two investment projects for a car manufacturer Chrysler Ford using the key five capital budgeting techniques. These include payback period, discounted payback period, net present value, internal rate of return, and modified internal rate of return. As a result of application of these investment appraisal methods, the projects that would lead to the maximization of the stockholders wealth were identified.
Part 2 represents a critical appraisal of the given techniques for making capital budgeting decisions. It is explained why discounted cash flow methods are preferable to those which do not consider time value of money. The pros and cons of each method are described in this part. Finally, answers to the multiple choice questions on financial management are given in part 3.
Part 1
A car manufacturer, Chrysler Ford, has to decide whether or not to undertake proposed investment projects. Project L consists in adding a new item to the company’s ignition line, and its cash flows would increase over time. Project S involves adding a complement to an existing line, and its cash flows would decrease over time. Both projects have three-year lives. The detailed information about cash flows associated with projects S and L is presented in tables 1 and 2 accordingly.
Apart from the information about cash flows given in the assignment, discounted cash flows values are given in the tables. They are necessary to compute net present value and discounted payback period. Discounted cash flow is calculated with the help of the formula
DCF = CFt / (1 + r)t,
where CF is cash flow, r is discount rate, and t is the year after initial investment (Investopedia, Discounted Cash Flow, 2016). In the case of Chrysler Ford weighted average cost of capital (WACC) equal to 10% is used as a discount rate. Cumulative cash flows which are needed to compute payback period and discounted payback period are also shown in tables 1 and 2.
Besides, the future values of cash flows used to compute modified internal rate of return are also stated in tables 1 and 2. The future value of a cash flow can be calculated as follows: FV = CF * (1 + r)N-t, where FV is future value, CF is cash flow, r is the discount rate (WACC), N is a project’s life in years, and t is the number of year (Investopedia, Future Value – FV, 2016).
Project S (in thousands of dollars)
Project L (in thousands of dollars)
The appraisal of the two projects with the help of five most popular techniques is presented below.
(1) Payback period states how quickly a project will pay for itself. In other words, it is the time passed before the cumulative cash flow equals the initial investment (Brealey, Myers and Allen, 2014, 109). Payback period (PB) can be calculated with the help of the formula PB = years before cost recovery + remaining cost to recover / cash flow during the year (Parrino, Kidwell and Bates).
For project S the payback period is PBS = 1 + 30 / 50 = 1.6
For project L the payback period is PBL = 2 + 30 / 80 = 2.38
According to the payback rule, the project should be accepted if the payment period doesn’t exceed a stated cutoff period (Ross, Westerfield and Jaffe, 2013, 139). If a three-year cutoff period is assumed, then both projects S and L should be accepted.
(2) However, as it will be described in part 2, the payback period method has several drawbacks, including ignoring time value of money. Thereby, some companies use discounted payback period technique, where cash flows are discounted at a stated opportunity cost of capital (WACC) to calculate the payback period (Ehrhardt and Brigham, 2011, 402).
Thus, using the data on discounted cash flows from tables 1 and 2 and applying the formula given above, discounted payback period for project S can be calculated as DPBS = 1 + 36.36 / 41.32 = 1.88. Discounted payback period for project L is DPBL = 2 + 41.32 / 60.11 = 2.69.
The rule for accepting or rejecting an investment project is the same as in the simple payback period method. As discounted payback periods for both projects are less than 3 years, both projects should be accepted. However, according to these techniques, project S would be preferable to project L if they were mutually exclusive, as its payback period is shorter.
(3) Net present value (NPV) is one of the best techniques to appraise an investment. It is the present value of cash inflows associated with a project less the present value of its cash outflows. It shows how much will be added to the shareholders wealth, or common stock value, in case the project is accepted (Ehrhardt and Brigham, 2011, 383). Below is the formula to calculate a project’s NPV:
NPV = CF0 + CF1 / (1 + r) + CF2 / (1 + r)2 + + CFN / (1 + r)N = t=0NCFt / (1 + r)t,
where CF is cash flow, r is discount rate, t is the year after initial investment, and N is the project’s life (Ehrhardt and Brigham, 2011, 384). In other words, net present value is the sum of discounted cash flows associated with the project, including the initial investment.
The NPV values are presented in tables 1 and 2 as cumulative discounted cash flow for the third year. Thus, the net present value of project S is NPVS = -100 + 63.636 + 41.322 + 15.026 = 19.98 (thousands of dollars). The net present value of project L is NPVL = -100 + 9.091 + 49.587 + 60.105 = 18.78 (thousands of dollars). The same results may be obtained in Excel by using a special formula NPV.
The investment rule states that projects with a positive net present value should be accepted and those with a negative NPV should be rejected (Ross, Westerfield and Jaffe, 2013, 136). Thereby, both projects S and L should be accepted as their net present values are greater than zero.
(4) Internal rate of return (IRR) is also a widely used investment appraisal method. IRR is the discount rate that makes NPV equal to zero (Brealey, Myers and Allen, 2014, 112). In other words, to find the IRR value one should solve the following equation:
NPV = CF0 + CF1 / (1+ IRR) + CF2 / (1 + IRR)2 + + CFN / (1 + IRR)N = 0.
IRR can be found either through trial-and-error, by using a financial calculator, or by applying a special Excel formula IRR (Ehrhardt and Brigham, 2011, 383). It can be found with the help of Excel that internal rate of return for project S is IRRS = 23.56%, IRR for project L is IRRL = 18,13%.
In accordance with the IRR rule, a project should be accepted if its internal rate of return exceeds its WACC (Ehrhardt and Brigham, 2011, 388). As both IRRS > 10% and IRRL >10%, both projects should be accepted.
(5) Finally, an investment can be assessed with the help of computing modified internal rate of return (MIRR). The difference between IRR and MIRR is that the first method presumes that cash flows can be reinvested at the IRR itself, while the last method is based on the assumption that cash flows can be reinvested at the WACC (Ehrhardt and Brigham, 2011, 383).
The MIRR can be found from the following equation: PVcost = TV / (1 + MIRR)n, where PVcost is the present value of the initial investment, TV is the terminal value, and n is a project’s life in years (Parrino, Kidwell and Bates). Then MIRR = (TV / PVcost)1/n – 1. The terminal value is the sum of future values of cash flows. Using the data from tables 1 and 2, we can find the MIRR for projects S and L: MIRRS = ((84.7 + 55 + 20) / 100)1/3 – 1 = 0.1689, or 16.89%; MIRRL = ((12.1 + 66 + 80) / 100)1/3 – 1 = 0.165, or 16.5%. The same results can be obtained by using an Excel formula MIRR.
As modified internal rates of return for both projects S and L are greater than the WACC, they both should be accepted under the MIRR rule.
Thereby, all of the five appraisal techniques show that both projects are acceptable. However, if the management had to choose between these two projects, it would have to select project S, as its payment period and discounted payment period are shorter than those of project L, and its NPV, IRR, and MIRR exceed those of project L. The summary on appraisal of the two projects is given in table 3 below.
Summary of projects appraisal
Part 2
According to a survey conducted by John H.Graham and Campbell R. Harvey, the NPV and IRR techniques are the most commonly used ones when making capital budgeting decisions (2002). Watson and Head also agree that discounted cash flow methods are gaining popularity nowadays (2010, 212). Indeed, these investment appraisal techniques have far fewer drawbacks than payback period methods.
The most important deficiency of the payback method is that it ignores the time value of money (Investopedia, Payback Period, 2016). It doesn’t take into account that earlier cash inflows have greater value than those which will occur later. However, this drawback is neutralized in the discounted payback period technique, where the present values of cash flows are appraised.
Nevertheless, both standard and discounted payback period methods do not take into account cash flows after the payback period, or cutoff period. Thus, valuable long-term projects with a high net present value may be rejected if only payback method technique is applied (Ross, Westerfield and Jaffe, 2013, 139).
Another problem with payback period method is that the selection process of the cutoff date is somewhat arbitrary (Ross, Westerfield and Jaffe, 2013, 139). Thereby, some attractive projects may be missed in case of an incorrectly set cutoff period. This is a potential ethical issue as such assumptions may be changed deliberately to meet criteria for approval (Kinney and Raiborn, 2013 ). So, considering these drawbacks, payback is an “ad hoc rule” and its use to appraise an investment is justified only in addition to other methods like NPV or IRR (Brealey, Myers and Allen, 2014, 122).
Internal rate of return along with net present value are most commonly accepted techniques for making capital budgeting decisions. However, NPV is still better than IRR. A good example proving this is given by Ehrhardt and Brigham. Suppose one project has an approximate IRR of 49% and NPV of $200,000, and another project has approximate IRR of 59% and NPV of $2.5. By applying the internal rate of return rule the managers would choose the second project, but it is obvious that the first one would add much more to the firm’s stock value as its NPV is much greater (Ehrhardt and Brigham, 2011, 389). The form of IRR may be more appealing as it is likely that investors want to know the rate of return for a project. However, this technique has several imperfections which are listed below.
First of all, under some conditions a project may have multiple internal rates of return. This happens when a project has nonnormal cash flows, and their signs change several times. In other words, this is the case when more than one cash outflows are followed by cash inflows (Ehrhardt and Brigham, 2011, 390). An example of such a situation is when after receiving a series of positive cash flows from initial investment the company suffers clean-up costs. Moreover, there are cases when there is no IRR at all (Brealey, Myers and Allen, 2014, 115). Thus, net present value method is preferable as there can be only one NPV for a project.
Besides, when making decisions based on the IRR value, the management should consider the nature of the project. I.e., in case of money lending a high rate of return is preferable, but in case of borrowing a lower IRR is better (Brealey, Myers and Allen, 2014, 113). Moreover, the example by Ehrhardt and Brigham provided above states that the results of applying IRR rule can be tricky when selecting between mutually exclusive projects.
Another problem with IRR is that it assumes that cash flows may be reinvested at the IRR itself. However, it is not quite reasonable as if the true reinvestment rate is below IRR, then the true rate of return must also be less than IRR; thereby internal rate of return may be “a misleading measure of a project’s profitability” (Ehrhardt and Brigham, 2011, 393). A company should better accept investment projects with positive NPVs at an opportunity cost of capital, which may be below IRR, thus, the IRR rule assumptions may be doubtful. Net present value method is preferable as it supposes that cash flows may be reinvested at WACC (Ehrhardt and Brigham, 2011, 393).
Finally, according to the internal rate of return rule, a project should be accepted if IRR exceeds WACC, or opportunity cost of capital. But the situation when the WACC changes over time makes it rather difficult to calculate the IRR (Brealey, Myers and Allen, 2014, 117). In this case it is better to use NPV instead of IRR.
Thus, internal rate of return has several deficiencies, and it’s preferable to use NPV instead of it. However, a modified internal rate of return has been introduced to eliminate some of them. Thus, MIRR presumes that cash flows are reinvested at WACC and not IRR itself. Besides, there can be only one MIRR for a project, while there can be multiple IRRs in some cases. Thereby, if managers are willing to know an expected rate of return for an investment project, it is suggested to calculate MIRR instead of IRR. Nevertheless, in case of selecting between mutually exclusive projects, NPV is still better than IRR or MIRR as it selects the project that would maximize the company’s stock value (Ehrhardt and Brigham, 2011, 395).
Thus, from all the project appraisal techniques NPV seems to be the best one. It helps to determine the projects which will maximize the shareholders’ wealth, it takes into account time value of money and uses a correct discount rate. However, there are some problems with applying the NPV rule when the capital is strictly limited. In this case, a company should select projects with the highest profitability index (net present value per dollar of investment).
However, in case there are also other obstacles to the usage of NPV, e.g. the capital is rationed in more than one period, linear programming is the only general solution (Brealey, Myers and Allen, 2014, 123). Besides, the usage of NPV may result in adverse effects on accounting profits in short-run as long-lived projects with cash flows increasing over time may be chosen under this technique (Bhatti). Still, regardless of these drawbacks, NPV remains the best alternative among the given methods to make capital budgeting decisions.
Without doubts, the quantitative characteristics described above are essential in capital budgeting. However, management should pay appropriate attention to qualitative factors like social and ethical ones. Thus, sometimes companies seek to select projects with low initial costs, but cheap investments may adversely affect the quality of the products, so a golden mean should be found. Besides, the impact on the environment should be taken into account. Moreover, such ethical concerns as employee safety and local employment should also be considered. For example, increasing automated operations may lead to staff reduction. Finally, when making such decisions, management should assess their impact on the corporate culture and the potential attitude of the employees and consumers to the notions (Ingram). Thereby, the role of qualitative factors shouldn’t be underestimated.
Part 3
Below are the answers to the multiple choice questions given in the assignment.
Q1. 1.
Q2. False
Q3. 2.
Q4. 4.
Q5. 2.
Q6. 3.
Q7. 3.
Q8. 3.
Q9. 4.
Q10. 2.
Q11. 2.
Q12. 3.
Q13. Systematic risk is associated with the whole market, while unsystematic risk is related to a particular industry, company, or security. Besides, systematic risk is uncontrollable and can affect expected returns on an investment project, while unsystematic risk can be controlled and eliminated through portfolio diversification. Finally, systematic risk has a macroeconomic nature, and unsystematic risk arises due to microeconomic factors. Systematic risk includes interest risk, market risk, and purchasing power risk. Unsystematic risk can be divided into business risk and financial risk categories (Surbhi, 2016).
Q14. 2.
Q15. 4.
Q16. 4.
Q17. 1.
Q18. 2.
Q19. 3.
Q20. 4.
Conclusion
I have used the key five investment appraisal techniques to make a capital budgeting decision on proposed projects S and L for Chrysler Ford. The results have been presented in part 1. Both projects have payback periods and discounted payback periods below cutoff periods (PBS = 1.6 < 3; PBL = 2.38 < 3; DPBS = 1.88 < 3; DPBL = 2.69 < 3), positive net present values (NPVS = 19.98; NPVL = 18.78), and their IRR and MIRR exceed the WACC (IRRS = 23.56% > 10%; IRRL = 18.13% > 10%; MIRRS = 16.89% > 10%; MIRRL = 16.5% > 10%). Thereby, as the two projects are independent, both of them should be accepted according to all of the suggested methods. However, if the projects were mutually exclusive, project S should be accepted.
Internal rate of return is a widely used method alongside with NPV, but it has several deficiencies. There may be multiple IRRs or none IRR at all; the IRR assessment criteria depend on whether the project supposes lending or borrowing; it may give wrong results when applied to mutually exclusive projects. Besides, the assumption that cash flows are reinvested at IRR itself is questionable, and it is preferable to use NPV as it presumes that cash flows may be reinvested at WACC. Finally, the IRR technique fails when there are different opportunity costs of capital in different time periods.
The modified internal rate of return is based on the assumption that cash flows may be reinvested at WACC unlike the IRR method, and there can be only one MIRR for a project. However, it is still better to use NPV for mutually exclusive projects.
Finally, both quantitative and qualitative factors should be considered when making capital budgeting decisions. The qualitative ones include employee safety, environmental impact, corporate culture, quality issues, employment, etc. Detailed information on investment appraisal methods and qualitative factors is given in part 2.
The solutions to the multiple choice questions and short answers are given in part 3 of this paper.
References
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