Example Of NPV And IRR, Capital Spending, Strategic Plan Report

Net present value for the two projects

Crackers division: Camilla’s Project
Determination of cash flows
The NPV of the project proposed by Camilla will be £30,147 implying that the present value of its cash inflows will be more than the present value of its costs by $30,147.

Cakes and Cookies Division: Sergio’s project

Determination of cash flows
Note that the $10,000 spent on market research is not included in the determination of the project’s cash flows. It is a sunk cost, and it is irrelevant to the capital budgeting decision. The amount has been spent and will not have any effect on cash flows irrespective of whether the project is accepted or rejected.

The NPV of the project is £63,584.

Internal Rate of Return for each of the two projects
Crackers division: Camilla’s Project

NPV at 10% discount rate

Change in NPV per unit change in discount factor = 30,520/3 = 10,173.333
In order to arrive at IRR, the current discount rate must be increased so that the NPV falls from £30,147 to zero.
Increase in discount rate required = 30,147/10,173.33 = 2.9633
IRR = 7% + 2.963 = 9.96%
Cakes and Cookies Division: Sergio’s project

NPV at 10% discount rate

Change in NPV per unit change in discount factor = 69,363/9 = 7,707

In order to arrive at IRR, the discount rate must be increased so that the NPV falls from £63,587 to zero.

Increase in discount rate required = 63587/7,707 = 8.25
IRR = 7% + 8.25%
= 15.25%

Comparison of IRR and NPV

Net present value gives the difference between the present value of cash inflows expected from an investment and the present value of the cash outflows or costs associated with the investment (Weygandt, Kieso and Kimmel, 2008). On the other hand, internal rate of return refers to the discount rate that at which the net present value of a project is zero. In other words, it gives the minimum return a project must generate to be viable. Below the internal rate of return, the present value of costs outweighs the present value of benefits hence the project is no longer viable. Below are the similarities and differences between the two techniques.

Similarities between NPV and IRR

Both NPV and IRR are modern capital budgeting techniques. They both consider the time value of money in evaluating proposed investments. Under both techniques, all the cash flows associated with the proposed investment are discounted at the company’s cost of capital or equity (Weygandt, Kieso and Kimmel, 2008). Thus, the two methods recognize the fact that the value of a sum of money today is not similar to the value of the same amount in the future. They, therefore, place emphasis on both the amount and the timing of cash flows.
In both methods, all cash flows generated throughout the entire useful life of the project are considered. In the determination of NPV and IRR, all cash flows are discounted at the cost of financing the project (Mowen, Hansen and Heitger, 2012). These include the salvage value of the project at the end of its useful life. NPV and IRR are different from traditional capital appraisal techniques like the payback period, which ignores cash flows after the project’s payback period.
In addition, both NPV and IRR can be adjusted to accommodate for variations in the risk facing a project. Investments have different risk levels depending on the nature of the industry, source of financing, competition, among other factors. The discount rate used in calculating the present value of cash flows in both NPV and IRR can be adjusted to reflect the risk level. For instance, a project financed through equity will have a different NPV and IRR from that financed through both equity and debt (Drury, 2013). The use of debt has an impact on the risk and hence the cost of capital of the respective firm. We can, therefore, have a base case NPV and IRR and the adjusted present value (APV).
Both NPV and IRR give the same accept-reject decision for independent projects. If a project has a positive NPV, its IRR will be more than the firm’s discount rate hence it will be viable (Drury, 2013). Thus, for a single project or independent projects, there will be no difference if the analyst uses NPV or IRR.

Differences between NPV and IRR

NPV gives the absolute value of an investment by determining the difference between the present value of its cash inflows and that of its cash outflows (Moyer, McGuigan and Rao, 2005). On the other hand, IRR is a relative measure since it gives the percentage return per dollar of investment in the project. It means that the company can assess the viability of the investment by just looking at the NPV. The criterion for NPV is that investments with a positive value are viable and should be considered for funding. Projects whose NPVs are negative are not viable hence they are not regarded for investment. In the case of mutually exclusive projects, the NPV technique chooses the investment that has the highest positive NPV (Megginson and Smart, 2009). On the other hand, IRR method compares the project’s IRR and the company’s cost of capital. The criterion is that a project whose IRR is more than the cost of capital for the firm is accepted while those whose IRRs are less than the company’s cost capital are rejected. IRR may, therefore, be misleading if used to rank mutually exclusive projects. IRR for a project X may be higher than that of another project Y even if Y has a higher NPV than that of Project X. It implies that IRR can choose a project that generates a net value of $100,000 over another project producing $200,000. However, IRR gives better results if comparing projects with different initial outflows.
The assumption in NPV and IRR techniques are different. The assumption in the NPV method is that cash inflows generated from the project are reinvested at the company’s cost of capital (Mowen, Hansen and Heitger, 2012). IRR assumes that cash flows generated by the investment are reinvested at the project’s internal rate of return.
Furthermore, the NPV technique gives a unique value for each investment for a given required rate of return (Megginson and Smart, 2009). Projects with similar cash flows, initial outlays and timing of cash flows will have the same NPV at a particular discount rate whether the cash flows are unconventional or conventional. Unlike NPV, IRR gives multiple values for a project especially if the project’s cash flows are unconventional. It is difficult to decide which rate to use for the project. Therefore, the IRR technique may be misleading if used to rank and appraise mutually exclusive projects.
4. Capital spending approach
The two brothers are unwilling to spend resources on capital projects. For instance, the company’s policy is to replace items of plant and machinery after five years but they always replace them after eight years. The approach may limit the productivity of the company as well as its profitability (Drury, 2013). Keeping items of plant and machinery for eight years is not a good approach since, at the later stages, machinery produce less and has high maintenance costs.
The company currently has just over £600,000 of free cash flow to spend on investments. The approach of using free cash flow to finance capital projects is appropriate. It enables the company to ensure that it maintains its current asset base and cover its operating expenses. Maintaining free cash flow allows the company to exploit unexpected opportunities.

Accept or reject the projects?

Both projects under consideration are not mutually exclusive hence the company can consider both of them provided the amount of free cash flow is adequate to meet the initial capital requirements (Davis and Davis, 2012). Both projects have a positive net present value, and their internal rates of return are more than the company’s cost of capital of 7%. The project for the Cakes and Cookies Division has a higher NPV and IRR than that of the Crackers Division. Had the two projects been mutually exclusive, the company would have chosen the project of the Cakes and Cookies Division over that of the Crackers Division.
The company should, therefore, accept both projects since they both have positive net present values (Collis, Holt and Hussey, 2012). Investing in both projects will increase the firm’s value since the benefits will be more than the associated costs. It is feasible to invest in both because the free cash available is more than the total initial capital requirement for both projects. The Crackers Division’s project requires a total of $355,000 although $15,000 for training will be incurred after one year. The Cakes and Cookies Division’s project will require an initial outlay of $260,000. The company will, therefore, need a total of $615,000 to start both projects. The firm has over $600,000 of free cash flow hence it can afford the two projects and may only need to borrow a small amount if there is a deficit.

Linking capital budgeting to the strategic plan

The company should consider Tom’s suggestion of looking at the projects in the light of the firm’s strategic plan. The strategic plan outlines the long-term goals of the company and formulates measures of achieving such plans. It describes what the organization exists to achieve in the long-term. All the activities in the business must conform to its strategic plan. Capital expenditures are long term projects and are aimed at achieving certain objectives such as expansion, increasing profitability, among other goals. The business must stay focused on the strategic plan in order to attain its corporate objectives. Therefore, capital projects should be evaluated on the basis of their impact on the company’s strategic plan. This implies that the company should invest in all projects that fit into its strategy provided there is adequate capital to finance it. For instance, the company seeks to maximize the wealth of Tom and Jerry as its shareholders. Any projects that that increase this value should be accepted (Bierman, 2010). In this case, both projects will be in line with its strategic plan.

References

Bierman, H., 2010. An introduction to accounting and managerial finance. Singapore: World Scientific.
Collis, J., Holt, A. and Hussey, R., 2012. Business accounting. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.
Davis, C. and Davis, E., 2012. Managerial accounting. Hoboken, N.J.: John Wiley & Sons.
Drury, C., 2013. Management accounting for business. Andover: Cengage Learning.
Megginson, W. and Smart, S., 2009. Introduction to corporate finance. Mason, OH: South-Western Cengage Learning.
Mowen, M., Hansen, D. and Heitger, D., 2012. Managerial accounting. Australia: South-Western Cengage Learning.
Moyer, R., McGuigan, J. and Rao, R., 2005. Contemporary financial management fundamentals. Mason, Ohio: Thomson/South-Western.
Weygandt, J., Kieso, D. and Kimmel, P., 2008. Managerial accounting. Hoboken, NJ: Wiley.