Full 10 Year Cash Flows of the New Plant
1.As per the case study which is provided in the question, RWE Enterprise Pty ltd is engaged in manufacturing business which is located in Brisbane. The company is planning to set up a new plant which has an upfront cost of $ 3 million. The management of RWE Enterprise wants to decide whether the business should invest in the project or not. For the purpose of taking an appropriate decision, the management has decided to conduct capital budgeting analysis which would be including analysis of how much cash inflows would the project be able to generate in the coming year (Rossi 2015). The necessary computation of the capital budgeting analysis is shown in the table below:
Figure 1: Table Showing Capital Budgeting Analysis)
Source: (Created by the Author)
As per the table which is shown above, the capital budgeting analysis is being conducted for a period of 10 years. The initial investment for setting up the nee plant is estimated to be around $ 30,00,000. As shown in the above table, the new plant will be adding $ 7,00,000 to the operating profit before tax in the business. The above table also shows that at the end of five years, the business needs to incur a refurbishment costs for the plant which costs the business around $ 20,00,000. At the end of 10 years, it is anticipated that the plant will have a salvage value of $ 2,00,000 which will be revenues for the business. The cash flows which is estimated to be generated with the help of new plant is shown to be $ 9,80,000 for the first four years constantly. Then there is a significant fall in the cash flows which is shown as negative in the fifth year as $ 10,20,000. This is mainly due to the refurbishment cost which was undertaken by the business during the fifth years as per the estimates of the management. Thereafter at the end of the 10th year, the plant is estimated to generate a cash flow of $ 11,80,000 which is a bit higher due to the realization of the salvage value of the plant which the business will selling at the end of the 10th year. For the purpose of better understanding of the cash inflows which is generated by the new plant a graph demonstrating the changes in the cash inflows of the business is shown below:
Net Present Value Analysis
Figure 2: (Line diagram showing changes in the Net Cash flow)
Source: (Created by the Author)
As per the line diagram which is shown above, the net cash flows from the new plan t is constant for the first four years and then there is a significantly fall in the cash inflows in the fifth year due to extra investment for refurbishing cost which the management has to incur during the fifth year. After the fifth year the cash flows generated is back to normal and are constant through the useful life of the plant (Farshadfar and Monem 2013). There is no growth in the cash flows and the cash inflows of the business remains constant as shown in the above graph except for the estimates of the fifth year.
For the purpose of estimating the worthiness of the new product line which RWE Enterprise Pty ltd is intending to invest in, the company has decided to conduct NPV analysis. NPV analysis is used by business to estimate the net cash inflows from a project and also judge whether the product is worth investing in or not (Matos et al. 2015). NPV analysis is considered to be one of the most popular methods of determining whether the investment decision as intended by the management is appropriate or not (Peña, Azevedo and Ferreira 2014). For the purpose of calculating the NPV of the product line, the discounted rate is assumed to be same for every year and the same is shown in the above table as 10%. The NPV as calculated for the project is shown to be $ 18,56,942 which suggest that the product will be generating appropriate cash inflows for the business. In addition to this, judging by the NPV analysis which is shown in the table above, RWE Enterprise should invest in the project. The NPV analysis also shows that it can be clearly estimated that the cash inflows of the business is much more than the cash outflows of the business and therefore the profitability of the project is also secured (Ognjenovic et al. 2016).
The internal rate of return is the rate at which the cash inflows which can be generated from the project and the cash outflows which is incurred on the project becomes zero. In other words, IRR is the rate at which the NPV of the project becomes zero (Magni 2013). The IRR of the project as computed in the above table is shown at 23.42% which signifies that NPV of the project will become zero when the discount rate is 23.42% and beyond this rate the project will be earning negative returns (Burns and Walker 2015). Profitability Index of a business shows the profits which can be generated by the profit which considers the cash inflows and cash outflows of the business for such a purpose. The profitability index for the project is shown to 1.62 in the above table which signifies that the business will be able to generate profits with the implementation of the project. The profitability index is greater than 1 which signifies that the cash inflows which is generated by the project is much more than the cash outflows which is related to the project (Visser and Fiksen 2013). Thus, considering IRR and Profitability index as the base for decision making, the company should invest in the project as both the results are shown favorable.
Internal Rate of Return and Profitability Index Analysis
The payback period is also one of the techniques which is used in capital budgeting analysis. The technique reveals the minimum time which a business takes for the purpose of recovering the initial investment which the company had made in the project (San Ong and Thum 2013). The payback period of the project as shown in the table is 3.06 years which means in a little more than 3 years the business will be able to recover the initial investments of the business. This is a favorable result and on the basis of such a result the company should invest in the project.
The management of RWE Enterprise considering all the results which have been calculated in the figure 1, can accept the project and invest in the same as all the results which have been computed are favorable.
2.Calculation of NPV, IRR and Payback Period for Project A and Project B
As per the case study, the company is planning on investing in projects which have similar cash inflows as anticipated by the business. The requirement of this part is to estimate whether the cash inflows of the business. The management of the company wants to verify whether the two projects which the company has in mind is worth investing or not. The management of the company has decided to rely on Capital Budgeting practices so as to establish the profitability of the project. The management may also select both the projects based on the analysis of NPV, IRR and payback period (Dill, da Costa Jr and Santos 2014). The discounting rate which is taken for the project is 12%. In order to accept any or both the projects the conditions which needs to be fulfilled which are the payback period must be less than 3 years, the NPV results should be a positive figure and the IRR rate should be more than the discounting rate of the business (Gorshkov et al. 2014). The calculation for NPV analysis, payback period analysis and IRR for both the projects is shown below in table:
Figure 3: (Chart Showing Capital Budgeting Calculations for Project A and Project B)
Source: (Created by the Author)
As per the calculations which is shown in the above figure, the cash outflow or the initial investment which both the project will be requiring is estimated to be $ 2,75,000. This shows that the initial investment in case of both Project A and Project B is similar. The cash flows which can be expected from Project A shows growth in the cash inflows from year to year basis whereas in case of Project B the cash inflows which can be expected is constant through out the years and it is shown at $ 1,00,000. The analysis is conducted for a period of 5 years and the rate of discount is considered to remain the same throughout at 12%.
Analysis of the Results
Payback Period Analysis
The NPV analysis of both the projects shows favorable outcomes considering the conditions which are set by the management of the company. The NPV as calculated for Project A and Project B is shown to be $ 79,350 and $ 85,478 respectively. The NPV for both the projects are shown to be positive and therefore they are favorable and can be accepted by the management of the company considering the NPV analysis of the business. The Internal rate of Return (IRR) which is shown to be 20.97% and 23.92% for Project A and Project B respectively. The IRR results for both the project meets the requirement of the management and thus are favorable in nature (Hurley, Rao and Pardey 2014). The IRR computed is more than the discounting rate which is taken to be 12% in both the projects which suggest that both the project can be accepted if the management considers IRR approach. The payback period of the projects is shown to be 3.40 for project A and 2.75 for Project B. The payback period analysis for project A does not meet the criteria which the management of the company has established whereas the requirement of the management of a payback period of less than three years is fulfilled by Project B. Therefore, Project A should not be accepted and Project B should be accepted.
If the assumption is made that the two projects are independent to each other than the management of the company should select Project B as the best option as Project A ‘s payback period which is computed to be 3.40 years is more than the criteria which is established by the business. The requirement of the business is to accept a project which has a payback period which is less than 3 years. Therefore, the management will be selecting project A and will be rejecting project B.
Ranking of Projects
In this situation it is assumed that the projects are mutually exclusive and therefore one of the project is to be selected out of the two options. The ranking on the basis of a favorable results are shown in the figure below:
|
Particular |
Project A |
Remarks |
Rank |
Project B |
Remarks |
Rank |
|
Payback Period |
3.40 |
Rejected |
2 |
2.75 |
Accepted |
1 |
|
Net Present Value |
$79,350 |
Accepted |
2 |
$85,478 |
Accepted |
1 |
|
IRR |
20.97% |
Accepted |
2 |
23.92% |
Accepted |
1 |
Figure 4: (Table Showing ranking of the two projects)
Source: (Created by the Author)
As per the ranking of the projects, it is done on the basis of the first preference choice and second preference choice. As per the table above, Project B is the first preference choice of the management as all the criteria of the business are effectively satisfied in such a case and moreover the estimates which are shown in the table above for project B are all favorable. For project A, this would be the second preference choice of the business as the estimates which are shown for such a project is not as good as compared to the estimates of Project B. In addition to this, the payback period of Project A which is shown to be 3.40 years. is significantly more than the payback period which is estimated by the management of the company which is less than 3 years.
Reference
Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.
Dill, R., da Costa Jr, N. and Santos, A.A., 2014. Corporate profitability analysis: a novel application for paraconsistent logic. Applied Mathematical Sciences, 8(26), pp.1271-1288.
Farshadfar, S. and Monem, R., 2013. Further evidence on the usefulness of direct method cash flow components for forecasting future cash flows. The international journal of accounting, 48(1), pp.111-133.
Gorshkov, A.S., Rymkevich, P.P., Nemova, D.V. and Vatin, N.I., 2014. Method of calculating the payback period of investment for renovation of building facades. Stroitel’stvo Unikal’nyh Zdanij i Sooruzenij, (2), p.82.
Hurley, T.M., Rao, X. and Pardey, P.G., 2014. Re-examining the reported rates of return to food and agricultural research and development. American Journal of Agricultural Economics, 96(5), pp.1492-1504.
Magni, C.A., 2013. The internal rate of return approach and the AIRR paradigm: a refutation and a corroboration. The Engineering Economist, 58(2), pp.73-111.
Matos, C., Bentes, I., Santos, C., Imteaz, M. and Pereira, S., 2015. Economic analysis of a rainwater harvesting system in a commercial building. Water resources management, 29(11), pp.3971-3986.
Ognjenovic, S., Ishkov, A., Cvetkovic, D., Peric, D. and Romanovich, M., 2016. Analyses of Costs and Benefits in the Pavement Management Systems. Procedia Engineering, 165, pp.954-959.
Peña, I., Azevedo, I.L. and Ferreira, L.A.F.M., 2014. Economic analysis of the profitability of existing wind parks in Portugal. Energy Economics, 45, pp.353-363.
Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.
San Ong, T. and Thum, C.H., 2013. Net present value and payback period for building integrated photovoltaic projects in Malaysia. International Journal of Academic Research in Business and Social Sciences, 3(2), p.153.
Visser, A.W. and Fiksen, Ø., 2013. Optimal foraging in marine ecosystem models: selectivity, profitability and switching. Marine Ecology Progress Series, 473, pp.91-101.
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