Tema 4: Problemes
4.2. Problemes
For projects that have passed the initial screening in stage 1, a detailed business plan must be presented, giving the business case with a rigorous assessment of strategic benefits and risks (including environmental analysis and possible competitor response, finalised capital spend and capital sources).
A project specific cost of capital should be estimated that reflects both the business risk and financial risk of the project under consideration. This assessment should be used to analyse the project's net present value and should be supported by a calculation of the project's value at risk (VaR). The NPV of the project represents our best estimate of the likely impact of the investment on the value of the firm and the VaR should show the downside of the project (for example, a 95% VaR would show the maximum downside with only a 5% risk of being exceeded).
NPV is the key statistic from the capital market perspective in that, unless we are assured that the project NPV is positive, the investment will reduce and not enhance the value of the firm. This net present value calculation should be supported by a modified internal rate of return which measures the additional economic return of the project over the firm's cost of capital where intermediate cash flows are reinvested at that cost of capital. In a highly competitive business the reinvestment assumption implicit in the MIRR is more realistic than that assumed with IRR where intermediate cash flows are assumed to be reinvested at the IRR. This may be satisfactory for near-the-money projects but is far less satisfactory for projects which offer high levels of value addition to the firm.
An accounting impact assessment including the differential rate of return on capital employed and a short term liquidity assessment. Although positive NPV projects are value enhancing, they may not do so in ways that are readily apparent in the financial reports. To manage investor expectations effectively the firm needs to be aware of the impact of the project on the firm's reported profitability and this is most accurately reflected by the differential rate of return measure. Accounting rate of return as normally calculated does not examine the impact of the project on the financial position of the firm but is restricted to the rate of return the investment offers on the average capital employed.
(b) The proposed business case concludes that this is a key strategic investment for the firm to maintain operating capacity at the Gulf Plant. The financial assessment is detailed in the Appendix to this report (excluding an assessment of impact of the project on the financial reports of the firm).
(i) The net present value of this project calculated using a discount rate of 8% gives a value of $1.965 million (Appendix 3). The volatility attaching to the net present value of $1.02 million (given) indicates that there is (Z) standard deviations between the expected net present value and zero as follows:
Z = 1.965 - 0
1.02 = 1.9265
This suggests that this project has a 97.3% probability that it will have a positive net present value or conversely a 2.7 per cent probability of a negative net present value.
The project value at risk relies upon an assessment of the number of years that the project cash flow is at risk (10 years), the annual volatility ($1.02m) and the confidence level required by the firm. The formula for the project VaR is:
Project VaR = σ t
At the 95% level σ = 1.645 giving
Project VaR = 1.645 × $1.02m × 3.162 = $5.3 million
This assumes a 95% confidence level, at 99% the project VaR is $7.51 million. This value reflects the fact that the capital invested is at risk for ten years and assumes that the volatility of the project is fairly represented by the volatility of its net present value.
(ii) Project return
The internal rate of return is given as 11.0%. The modified internal Rate of Return is calculated by using the formula provided:
PVi = PV of investment phase = 17.3955m (see appendix 1) PVr = PV of return phase = 17.3955 + NPV of 1.965 = 19.3605m
This rate suggests that the margin on the cost of capital is rather small with only a 1.162% premium for the strategic and competitive advantage implied by this project.
(iii) Project liquidity
With a present value of the recovery phase of $19.3607 million and of the investment phase of
$17.3955 million this suggests that the project will have recovery period of:
Recovery = 2 + 17.3955
19.3607 × 8 = 9.1879 years
In practice the actual recovery is shorter than this because the expected cash in flows occur earlier rather than later during the recovery phase of the project. The above calculation effectively assumes that the recovery cash flows arise evenly through the recovery period. The actual discounted payback period is just over 6 years. (Appendix 4)
The project duration of 4.461 years (Appendix 2) reveals that the project is more highly cash generative in the early years notwithstanding the two year investment phase.
In summary, the analysis confirms that this project is financially viable as it will be value adding to the firm. There is, however, substantial value at risk given the volatility of the net present value
quoted. In terms of return, the premium over the firm's hurdle is small at 1.162% and any significant deterioration in the firms cost of capital would be damaging to the value of this project. The liquidity statistics reveal that the bulk of the project's cash returns are promised in the earlier part of the recovery phase and that value invested in the project should be recovered by year six. Taking this into account acceptance is recommended to the board.
Appendix
Note. All calculations have used the discount factor tables. If formulae are used unrounded on a calculator slightly different figures would arise.
1 PV of investment/base
Time Cash flow DF PV
$m $m
0 (9.50) 1.000 (9.5000)
1 (5.75) 0.926 (5.3245)
2 (3.00) 0.857 (2.5710)
(17.3955) 2 PV and duration of recovery phase
The recovery phase duration is calculated by multiplying the present value of the cash recovered in each year by the relevant time from project commencement. The sum of the weighted years gives the recovery phase duration.
Time Cash flow DF PV @ tPV
T $m 8%
3 4.50 0.794 3.5730 10.7190
4 6.40 0.735 4.7040 18.8160
5 7.25 0.681 4.9372 24.6860
6 6.50 0.630 4.0950 24.5700
7 5.50 0.583 3.2065 22.4455
8 4.00 0.540 2.1600 17.2800
9 (2.00) 0.500 (1.0000) (9.0000)
10 (5.00) 0.463 (2.3150) (23.1500)
27.15 19.3607 86.3725
Project duration = Sum of time weighted present value of recovery phase
Present value of recovery phase = 86.3725
19.3607 = 4.461 years 3 PV of project
$m
PV investment phase (17.3955)
PV recovery phase 19.3607
1.9652
4 Discounted payback period
Time PV ($m) Cumulative PV ($m)
0 (9.5000) (9.5000) 1 (5.3245) (14.8245) 2 (2.5710) (17.3955) 3 3.5730 (13.8225) 4 4.7040 (9.1185) 5 4.9372 (4.1813) 6 4.0950 (0.0863) 7 3.2065 3.1202 8 2.1600 5.2802 9 (1.0000) 4.2802
10 (2.3150) 1.9652
(c) The proposed new investments might attract government support, which may take the form of subsidised loans for part of the investment. This makes selecting a single discount rate for the net present value evaluation difficult, as the government loan will be significantly cheaper than any other form of finance for the project.
This means that none of the existing or proposed methods of project evaluation would satisfactorily take into account this cheaper financing and may lead to a project being rejected that would actually enhance
shareholder wealth.
Adjusted present value
Adjusted present value (APV) is a more advanced method that can be used for any project appraisal exercise, but it is in the more complex cases (involving a change in capital structure and/or other complex finance problems) that it is the most useful.
(i) The first stage is to evaluate the base case NPV of operating cash flows by discounting at the ungeared cost of equity.
(ii) The present value of each individual financing side effect is then evaluated separately. The sum of the base case NPV and the PV of financing side effects is the APV.
The method has the advantage over basic net present value using WACC that it allows each different type of cash flow to be discounted at a rate specific to the risk of that cash flow. It also allows the effects of more complex financing situations to be considered.
Problems with APV
The main practical problem is to identify correctly the financing side effects and their appropriate discount rates. Theoretical weaknesses of the method stem from simplifications introduced by the Modigliani and Miller model of capital structure. For example:
It is assumed that the only effect of debt issued at market rates is the tax relief on debt interest.
The computation of an asset beta assumes that cash flows are perpetuities.
19 CD
Text references. Investment appraisal methods are covered in Chapter 5.
Top tips. You need to look carefully for the important information in this question. You are given inflation rates in both countries so your first step should be to calculate expected exchange rates using the purchasing power parity formula. The net cash flows are in real terms so need to be converted into nominal cash flows. Easy marks. The twelve marks for the calculations in part (a) are relatively easy to achieve if you have done enough practice on questions involving inflation and exchange rates and are confident with MIRR.
(a) Appraisal of alternative 2 Exchange rates
The future dollar/pound exchange rates for years 1 to 3 can be predicted using the purchasing power parity formula.
Future exchange rate $/£ = current exchange rate $/£ × [(1 + US inflation rate)/(1 + UK inflation rate)] n where n is the number of years in the future.
Thus, future exchange rate $/£ = 1.600 × [1.04/1.03] n
Discounted payback = 2 + (4.72/6.04) = 2.78 years Internal rate of return
The IRR can be found by trial discount rates and interpolation. If the discount rate is 15%, the NPV is
£(0.43) million.
Modified internal rate of return
We can find MIRR using the formula given in the formula sheet.
Year 0 1 2 3
Total nominal cash flows in £m (15.63) 5.48 6.98 7.83
9% factors 1 0.917 0.842 0.772
PV (15.63) 5.03 5.88 6.04
NPV 1.32
PV (return phase – years 1 – 3) = £16.95m PV (investment phase) = £(15.63)m
MIRR = (16.95m/15.63m)1/3 × (1 + 0.09) – 1 = 12%
(b) Project duration for Alternative 2
Present value of cash flows = NPV + initial investment = £1.32m + £15.63m = £16.95m
Year 1 2 3
PV of cash flow 5.03 5.88 6.04
% of total PV 30% 35% 36%
Year × % 1 × 30% 2 × 35% 3 × 36%
= 0.3 = 0.7 = 1.08
Duration = 0.3 + 0.7 + 1.08 = 2.08 years Significance of results
On average alternative 2 delivers value over 2.08 years. Compared with alternative one this is a good result as alternative 1 takes over one year longer to deliver value. The longer the duration, the more risky the project as there is greater uncertainty attached to future returns.
(c) Evaluation of the two alternatives Summary of the appraisal results
Alternative 1 2
NPV at 9% £1.45 m £1.32 m
IRR 10.5% 13.5%
MIRR 13.2% 12.0%
Duration 3.2 years 2.08 years
Payback 2.6 years 2.40 years
Disc. payback 3.05 years 2.78 years
All other things being equal, the project to be accepted should be the one with the higher NPV, which is Alternative 1. NPV shows the absolute amount by which the project is forecast to increase shareholders' wealth, and is theoretically sounder than the IRR and MIRR methods.
In this case the MIRR method backs up the NPV, but the IRR gives the opposite indication. This 'conflict' arises because IRR makes the wrong assumption about reinvestment rates (see (ii) above).
The duration of the alternatives shows that alternative 1 is more risky as it takes longer to recover half the present value. This is also backed up by the payback figures showing that Alternative 1 takes longer to recover the original outlay.
Before making a decision, however, there are a number of other important factors that must be taken into consideration.
Alternative 1
Alternative 1 has a high risk of lowering the firm's reputation for quality and causing confusion among the customer base. The overall effect may be to lose existing customers but not to gain many new ones.
It also removes the focus from the business. Marketing a wider range of products may be more difficult than is anticipated and may stretch resources.
Duration is longer, which might put management off, particularly if they are averse to risk.
Alternative 2
Alternative 2 represents a fundamental change in the nature of the business from a niche manufacturer to a value added distributor.
The firm may be able to add successfully its brand reputation for quality to mass market products, but this will only be possible if the US 'flat packs' are of guaranteed quality and consistency, and the varnishing and assembly work are carried out to a high standard.
The change in the nature of the firm's work may require substantial new equipment.
This alternative may also result in a loss of skilled workers, with the risk of lower quality.
However, the shorter duration of the project suggests lower financial risk to the firm, which may be a deciding factor if management are struggling to distinguish between the alternatives in other ways.
Given the similarity in the NPVs between the two projects, the decision will almost certainly depend on non-financial factors.