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NP Ltd.’s Investment in Expansion of Production Report

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Updated: Jul 19th, 2021

Executive Summary

NP Ltd. is considering an investment with a maximum budget of $48,000. So far, there are two options available, one with a $35,000 cost and another that requires a $42,000 price. This report analyses the two alternatives based on data provided by the company, such as weighted scores and projected cash flows. The simplified scoring model analysis shows negligibly small differences between the two plans. The profile approach favours proposal A strongly, possibly due to its use of a discounted value. The discounted payback period method shows a slight difference between the two notions, with proposal A paying for itself less than a year before proposal B. Lastly, the NPV method shows that neither proposal will create a return at the rate NP Ltd. wants. As such, the company should consider other opportunities before settling on either of the options. If there are no alternate options, this report indicates that the company would benefit the most from proposal A.

Introduction

  • This report is intended for NP Ltd., a manufacturing company that is currently considering an expansion in its production capabilities.
  • There are two competing proposals on the table with significantly different costs and projected cash flows.
  • As such, the purpose of this report is to use several project selection methods, both financial and otherwise, to develop a recommendation for the business.
  • The specific models employed will be the simplified scoring framework, the profile approach, the discounted payback period method and the net present value calculation.
  • It should be noted that the report will rely on the information provided by the company and use it uncritically, which can limit the accuracy and real-world applicability of the findings.
  • Moreover, the report relies on projections of the future and the theoretical performance of the proposals, which means the real situation can be considerably different.

Discussion

Simplified Scoring Model

The simplified scoring model relies on a prior examination of the proposals under consideration by some party. In it, one separates the decision into a set of critical values, weighs those aspects in order of importance and gives each proposal a set of scores depending on their expected performance in that category. The approach has the advantage of flexibility, being able to incorporate different kinds of factors (Meredith, Mantel and Shafer, 2017). It was chosen because it enabled a comprehensive analysis of the two proposals from the company’s perspective. The results of the analysis are presented below:

Simplified Scoring Model Table.
Table 1. Simplified Scoring Model Table.

As can be seen from the table, proposal B is ahead of proposal A in its total score. However, the disadvantages of the simplified scoring model should be taken into consideration before the final decision can be made. The framework relies on the fundamental assumption that the different weights represent the relative values of their associated aspects accurately, which is usually not true. Martinelli and Milosevic (2016) also highlight the tendency of proposal scores to average out to similar values. It manifests in this case, as the difference between the two proposals is too small to reach a definite conclusion.

Profile Model

The profile model limits the investigation to the two characteristics of return rate and risk. It then compares them against the minimum desired return and maximum desired risk as well as each other to make a decision based on which appears to be better. This method is appropriate because it is critical to evaluate risk as part of the consideration for both options, as risk management is closely linked with the success of any project (Basu, 2016). For this report, the model will use the assumption that both options are low-risk, but proposal A is less dangerous than proposal B. This notion is based on the Reliability criterion from table 1, where both proposals achieve high scores of 6 and 5 for A and B, respectively. The rate of return was calculated by dividing the total inflation-adjusted cash flow over the seven years by the value of the investment. This approach was chosen because it considers the rate of return, which is critical for any investment. The plot of the two proposals is presented below:

The Profile Model.
Figure 1: The Profile Model.

On the graph, the two dots represent the scores for the different proposals, and the red line is the minimum acceptable rate of return for the company. The horizontal red line represents the maximum acceptable risk level assumed for this project. Regardless, figure 1 presents a clear picture of which proposal the profile method favours. It should be noted that this trend is unusual, as risk-reward models tend not to have a single best configuration (Lock and Wagner, 2019). The calculation used inflation-adjusted return rates to improve accuracy, and the unadjusted picture may appear different. NP Ltd. should also take the fact that the profile model excludes many factors from consideration into account (Benaija and Kjiri, 2015). However, overall, proposal A appears to be significantly better than proposal B based on the framework.

Discounted Payback Period Model

The discounted payback period model is a modification of the standard approach that tries to achieve better accuracy. It uses the present value discount calculation to find the first year where the sum of the total cash flow and the original investment reaches zero or a positive value (Rout, Sahoo, Thomas and Varghese, 2017). The present value discount is based on inflation, which reduces the value of money year by year and thus lowers future income expectations. Generally, the sooner an investment can make its money back, the earlier the company will be able to begin profiting from its initiative and have the resources to move on to other projects. This aspect was the reason why the approach was selected, as the company’s purpose is to expand and continue growing further, which means other investments will be required.

Appendix B shows that proposal A will pay for itself after 6.19 years and proposal B will do so after 6.98. As such, Proposal A would be somewhat better from the company’s perspective. Moreover, like the profile model, the discounted payback period approach isolates one characteristic over the others. As such, one cannot tell if the investment will perform well after the payback period is over or whether one project or the other has a higher degree of risk (Claggett, 2018). The ability of net present value, which will be discussed next, to account for the cash flow is part of the reason why it is often considered better (Rossi, 2015). This case demonstrates these issues particularly well, as the performance of either project after the seventh year is unknown. However, additional considerations would be necessary to make the decision regardless of the result.

Net Present Value

The net present value model complements the discounted payback period model by using the same calculations to analyse the project’s cash flow. It uses adjusted cash flow to determine which proposal would ultimately yield more of a return at the end of a given period. Projects with negative overall cash flow would be discarded, and those with the highest values and, therefore, the most substantial potential profit would be accepted over the others (Behringer, 2016). This approach was selected to demonstrate the problems of Proposal B, which relies on high profits in the distant future. As can be seen in Appendix A, proposal A has a cumulative cash flow of ($7,126.02), and proposal B has ($15,973.22). Both figures are highly concerning, as they show that neither project will produce money at the rate expected by the company.

Like the profile model, the net present value calculation appears to favour proposal A, with a lower overall loss. As Bora (2015) notes, this is due to the net present value model’s dependence on early income more than that in the later years and its reliance on the discount rate. It should also be noted that the discount rate tends to be affected by factors other than inflation, such as the interest on loans, but these considerations are not relevant here because no information about such sources of money devaluation is provided (Krstevski and Mancheski, 2016). Overall, however, the negative display shown in the analysis appears to be the result of NP Ltd.’s excessive expectations regarding the rate of return. If the company has investment projects that can guarantee a 10% rate of return even when accounting for inflation, it should not approve either of the proposals in this report.

Conclusions

Of the four models used in the analysis, two favour proposal A considerably and a third dismisses both while the last one produces similar results for both.

Option B’s low return rate when inflation is taken into account is a particularly problematic aspect of the proposal, as it is close to zero and far below the figure that NP Ltd. requires.

The profile model used an inflation-discounted model for its projection. The calculation allows for highly accurate predictions if the data projections are close to reality (Hopkinson, 2016).

If they are not and especially if inflation figures are significantly lower than those expected by the company, proposal B may become considerably more attractive.

The final decision depends on NP Ltd.’s confidence in the assertion that inflation will remain near the 4% mark or above it over the next seven years.

Recommendations

NP Ltd. should consider its other investment options before choosing either option A or B.

If there are no other viable alternatives, it should reduce its return expectations or consider creating a new, better project.

Failing that, it should analyse future inflation projections to find how close they are to those in the report.

If inflation expectations are similar, NP Ltd. should implement proposal A instead of proposal B due to its significantly better prospects.

References

Basu, R. (2016). Managing projects in research and development. Abingdon, United Kingdom: Routledge.

Behringer, S. (2016). The development of the net present value (NPV) rule – religious prohibitions and its evolution. Review of Economics & Finance, 6(3), 74-87.

Benaija, K., & Kjiri, L. (2015). Hybrid approach for project portfolio selection taking account of resources management and interactions between projects. Journal of Digital Information Management, 13(6), pp. 451-461.

Bora, B. (2015). Comparison between net present value and internal rate of return. International Journal of Research in Finance and Marketing, 5(12), 61-71.

Claggett, E. T. (2018). Capital budgeting: Methods, aspects, and issues. Journal of Modern Accounting and Auditing, 14(2), 90-101.

Hopkinson, M. (2016). PM World Journal, 5(6). Web.

Krstevski, D., & Mancheski, G. (2016). Managerial accounting: Modeling customer lifetime value – an application in the telecommunication industry. European Journal of Business and Social Sciences, 5(1), 64-77.

Lock, D., & Wagner, R. (2019). The handbook of project portfolio management. Abingdon, United Kingdom: Routledge.

Martinelli, R. J., & Milosevic, D. Z. (2016). Project management toolbox (2nd ed.). Hoboken, NJ: Wiley.

Meredith, J. R., Shafer, S. M., & Mantel, S. J. (2017). Project management: A strategic managerial approach (10th ed.). Hoboken, NJ: Wiley.

Rossi, M. (2015). The use of capital budgeting techniques: An outlook from Italy. International Journal of Management Practice, 8(1), 43-56.

Rout, A., Sahoo, S. S., Thomas, S., & Varghese, S. M. (2017). Development of customized formulae for feasibility and break-even analysis of domestic solar water heater. International Journal of Renewable Energy Research (IJRER), 7(1), 386-398.

Appendices

Appendix A: Rate of Return Calculation

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Total
Inflation-Adjusted Value of Money 1.00 0.96 0.92 0.89 0.85 0.82 0.79 0.76
Proposal 1 Nominal Cash Flow ($35,000) $6,500 $6,500 $6,500 $6,500 $6,500 $6,500 $6,500 $10,500
Proposal 1 Inflation-Adjusted Cash Flow ($35,000.00) $6,250.00 $6,009.62 $5,778.48 $5,556.23 $5,342.53 $5,137.04 $4,939.47 $4,013.36
Proposal 1 Return Rate 11.47%
Proposal 2 Nominal Cash Flow ($42,000) ($4,000) $4,600 $6,500 $10,050 $9,450 $10,000 $15,500 $10,100
Proposal 2 Inflation-Adjusted Cash Flow ($42,000.00) ($3,846.15) $4,252.96 $5,778.48 $8,590.78 $7,767.21 $7,903.15 $11,778.73 $225.15
Proposal 2 Return Rate 0.54%

The rate of return is equal to the total adjusted cash flow divided by the initial investment, in this case, $4,013.36 / $35,000 = 11.47% and $225.15 / $42,000 = 0.54% for proposals A and B, respectively.

Appendix B: Discounted Payback Period Calculation

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Proposal 1 Inflation-Adjusted Cash Flow ($35,000.00) $6,250.00 $6,009.62 $5,778.48 $5,556.23 $5,342.53 $5,137.04 $4,939.47
Proposal 1 Cumulative Cash Flow ($35,000.00) ($28,750.00) ($22,740.38) ($16,961.91) ($11,405.68) ($6,063.15) ($926.11) $4,013.36
Proposal 1 Discounted Payback Period 6.19
Proposal 2 Inflation-Adjusted Cash Flow ($42,000.00) ($3,846.15) $4,252.96 $5,778.48 $8,590.78 $7,767.21 $7,903.15 $11,778.73
Proposal 2 Cumulative Cash Flow ($42,000.00) ($45,846.15) ($41,593.20) ($35,814.72) ($27,223.94) ($19,456.73) ($11,553.58) $225.15
Proposal 2 Discounted Payback Period 6.98

Appendix C: Net Present Value Calculation

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Total
Present Value of Money 1 0.88 0.77 0.67 0.59 0.52 0.46 0.40
Proposal 1 Nominal Cash Flow ($35,000) $6,500 $6,500 $6,500 $6,500 $6,500 $6,500 $6,500 $10,500
Proposal 1 Net Present Cash Flow ($35,000.00) $5,701.75 $5,001.54 $4,387.31 $3,848.52 $3,375.90 $2,961.31 $2,597.64 ($7,126.02)
Proposal 2 Nominal Cash Flow ($42,000) ($4,000) $4,600 $6,500 $10,050 $9,450 $10,000 $15,500 $10,100
Proposal 2 Adjusted Cash Flow ($42,000.00) ($3,508.77) $3,539.55 $4,387.31 $5,950.41 $4,908.03 $4,555.87 $6,194.38 ($15,973.22)
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