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A manager should carefully and comprehensively appraise a capital project before investing in it. This is based on the fact that such projects are large and require a hefty amount of capital. Besides, such projects are irreversible and a company can incur losses in case the appraisal is not properly done. Further, there are competing needs for capital. Therefore, funds should only be allocated to viable projects. The paper seeks to use the net present value and internal rate of return criteria to evaluate the viability of the New Ski Run project that Downhill Ski Tows Pty. Ltd intends to undertake.
Net present value and internal rate of return
The two criteria are often used to evaluate the viability of a project. Under the net present value (NPV) criterion a project is viable if the resulting value of the sum of present values is positive (Bierman 63). In the case of internal rate of return (IRR), a project is viable if the estimated value is greater than the discount rate or a predetermined rate (Bierman 81). The calculations shown in appendix 1 indicate that the NPV of the new ski run project is $3,443,848.45 while the IRR is 38%. It can be observed that the NPV is positive while IRR is greater than the discount rate (15%). This shows that the project will generate a positive return to the company. Therefore, it is viable and should be pursued.
The calculations are made based on a number of assumptions. The first assumption is that the investment and installation of the necessary equipment are made at the beginning of the first year (year 0). Secondly, streams of cash flows occur at the end of a financial year (Weygandt, Kieso, and Kimmel 181). Also, the calculations are based on the assumption that the project will only last for 10 years. Further, it is assumed that the salvage value of the project will be zero because it will be counterbalanced by the cost of removal.
Effect of a change on utilization rate
The capacity utilization rate has a direct impact on the revenue. The calculations of new values of NPV and IRR are presented in appendix 2. The calculations show that a decline in capacity utilization during the first two years will cause a reduction in revenue. This will cause a slight drop in NPV and IRR to $3,365,247.32 and 36% respectively. Despite the decline the project is still viable because the NPV is positive while IRR is greater than the discount rate (Vanderbeck and Mitchell 149).
Carrying out sensitivity analysis for large projects is significant. It is a process which helps in establishing the variables that are quite responsive to variations. Thus, if a project is quite sensitive to changes in a specific variable, then it should not be undertaken because the company can incur a hefty loss in a worst-case scenario. In this case, sensitivity analysis is carried out for an increase in the tax rate, discount rate, and price.
Appendix 3a shows that an increase in tax rate from 30% to 38% will result in a slight reduction in profit and cash flow after taxes. The net present value will drop to $2,955,536.99 while IRR will reduce to 33%. Therefore, an increase in taxes will cause a less than proportionate decline in profitability of the project.
Secondly, an increase in discount rate from 15% to 20% will make the net present value to decline to $2,572,486.43 while the IRR will drop to 32%. NPV is often sensitive to the discount rate. The calculations in appendix 3b show that a small increase in the discount rate leads to a large decline in NPV. Thus, the project manager should prudently come up with an appropriate discount rate (Drury 309).
The final variable is price. It has a direct effect on the revenue earned. The calculations (as shown in appendix 3c below) are based on an assumption that the price will increase by 5% every year. The increase will start in the second year. An increase in price causes the net present value to increase to $4,084,530.51 while the internal rate of return will increase to 41%. It can be observed that the increase in NPV is more than proportionate to the increase in price. Thus, the project is quite sensitive to changes in price. A decline in price is likely to have a serious impact on the profitability of the project. The management needs to carry out a comprehensive feasibility study that will ensure that the services are priced correctly (Bhimani, Horngren, Datar, and Forster 145).
The sensitivity analysis shows that the project is viable because the net present values under the three scenarios are positive while the estimated values of internal rate of return are greater than the discount rate.
Every project is exposed to several risks. These risks are experienced at different stages of the project. Therefore, project managers should identify and mitigate some of these risks. One major risk that the project will face is the low level of snow. This can result in a loss of income because the resort will experience a reduced number of visitors. As a way of mitigating the risk, the company can take a weather insurance cover to protect the business against such losses.
The risk can also be reduced through diversification. The second major risk is the safety and health of the visitors. Some of the risks that the participants encounter are external threats caused by a number of factors such as collusion with other skiers, collusion with objects such as rocks and stumps, and impact with other structures. Therefore, the business will be exposed to the risk of paying high medical bills for injuries.
The management needs to invest in preventive measures such as training participants so as to reduce the possibility of accidents. Another risk is inflation. This can affect the estimated value of expenses such as fuel, lubricants, and cables. The company is likely to make a lower profit than the forecasted estimation due to the effect of persistent increase in the price of supplies. Another risk factor is the change in weather conditions. The changes can cause avalanches and variation in terrain among others.
Adverse weather conditions have the effect of reducing the number of visitors. This will lower income levels. The final risk is tougher rules and regulation of regulatory bodies such as Occupational Safety and Health Administration (OSHA) and the National Ski Areas Association (NSAA) among others. Compliance with the regulations may be costly to the business and can reduce profits (Warren, Reeve, and Duchac 210).
In summary, the project is viable and the management should invest in it. The discussion above also indicates that the project is exposed to numerous risks. Therefore, measures should be taken so as to mitigate some of the risks. This can be achieved by taking a number of insurance covers. The management can also use other appraisal tools such as payback period, accounting rate of return, and profitability index among others to evaluate the viability of the project.
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Bhimani, Alnoor, Charles Horngren, Srikant Datar, and George Forster. Management and Cost Accounting, England: Pearson Education Limited, 2008. Print.
Bierman, Harold. An Introduction to Accounting and Managerial Finance, Singapore: World Scientific Publishing, 2010. Print.
Drury, Colin. Management and Cost Accounting, Boston: Cengage Learning, 2008. Print.
Vanderbeck, Edward, and Maria Mitchell. Principles of Cost Accounting, Boston: Cengage Learning, 2015. Print.
Warren, Carl, James Reeve, and Jonathan Duchac. Financial and Management Accounting, Boston: Cengage Learning, 2013. Print.
Weygandt, Jerry, Donald Kieso, and Paul Kimmel. Managerial Accounting: Tools for Business Decision Making, London: John Wiley & Sons Ltd, 2010. Print.