Question 1: Net present value, Internal Rate of Return and simple payback period
Net present value
The NPV of the project above is positive indicating that the project is viable.
Internal Rate of Return (interpolation)
NPV when r is 15%
Positive NPV, P = 138,642
Negative NPV, N = -3,852
Higher discount rate, B = 15%
Lower discount rate, A = 8%
IRR = 8% + 138,642138,642+3,852 [15 – 8]
= 8% + 138,642142,494 × 7
= 8% + 6.81
= 14.81%
The internal rate of return for the project is 14.81% indicating that if the discount rate is 14.81%, then the NPV of the project will be zero. Since the IRR is more than the company’s cost of capital, the investment is viable and should be considered for investment.
Simple payback period
Payback period = 2 years + 1,000,000-800,000300,000
= 2 years + 0.66667
= 2.6667 years
= 2 years 8 months
The project will take 2 years and 8 months to recoup its initial investment of $1,000,000.
Question 2: Investment gains from outsourcing the central office functions
Outsourcing central office functions could lead to cost savings. The company will outsource the functions to a specialist firm which, by virtue of economies of scale can perform the duties at a lower cost. The savings from central office administration costs could be used to finance capital projects that generate cash to the company.
Outsourcing the functions will also enable the business to focus o its core activities. In this case, all the staff and other resources will be concentrated on the activities that generate revenue for the organization. It implies that capital projects are likely to have adequate allocation of financial, human and time resources.
Question 3
Net present value
This technique compares the present value of benefits generated by the project to that of the costs associated with the project. The method is reliable since it discounts cash flows at the organization's cost of capital. It implies that it incorporates risk and considers the time value of money. This is unlike payback period that ignores the time value of money. In addition, it uses all cash flows generated throughout the life of the project (Megginson & Smart, 2009). Unlike Internal rate of return, NPV gives a single value for each project. When evaluating projects using the IRR technique, a project may have multiple values of IRR especially for projects that have both cash inflows and cash outflows during its lifetime (Megginson & Smart, 2009). This technique will, therefore, give the business the maximum value in evaluating investments.
Simple payback period
Simple payback period gives the duration it will take for the project to generate adequate cash flows to recoup the initial cost. Its defect is that it ignores the time value of money since it does not discount cash flows (Brigham & Ehrhardt, 2013). In addition, the technique only considers cash flows up to the payback period. It ignores any cash flows generated after the payback period. Therefore, simple payback period will give the least value to the organization in determining the viability of an investment.
References
Brigham, E., & Ehrhardt, M. (2013). Financial management: Theory and practice. (14th ed.). New York: Cengage Learning.
Megginson, W. L., & Smart, S. B. (2009). Introduction to corporate finance (2nd ed.). Mason, OH: South-Western Cengage Learning.
