Introduction
The ProGen seed distribution project is viable because it has a net present value greater than zero. The NPV decision rule states that managers should select projects with a positive NPV. The uncertainty created by dealing in technological products has been captured by the discount rate. The 11% discount rate covers the risk brought about by uncertainty in the business environment. A positive NPV provides the income that exceeds the interest rate that investors need.
The NPV requires the use of real cash flows. Unreal values, such as depreciation, are not included in the cash flow. The salvage value of vehicles is obtained when the vehicles are sold at the end of the project. The net cash flow (NCF) is the difference between the cash inflows and outflows. The payback period is defined as the number of sessions it takes to generate an income equal to cost of project. The payback period is approximately 3 years and 8 months.
For a project that lasts five years, the payback period may appear prolonged. A project is accepted when it generates the initial investment within the set time limit. Technological products become more uncertain with more time forecast into the future. The discounted payback period incorporates the discount rate in determining whether the payback period falls within the set benchmark. The IRR is the rate of discount at which the NPV is equal to zero.
The IRR is unknown because the cash flow pattern involves more that a single change in the sign of values. The IRR can also mean the interest rate at which the net present value is equal to zero. The IRR requires a benchmark in the form of an interest rate. When the IRR exceeds the set discount rate, the project is viable. The IRR appears redundant because the NPV rule provides more information than the IRR. The NPV rule provides the discount rate as well as the monetary value generated from the project
The IRR may be used by people without a financial background because of the simplicity of the decision rule. The use of percentages makes it easier to make comparisons. The IRR appears defective when selecting mutually exclusive projects. The IRR calculation may fail to give results in some cases. The IRR is difficult to calculate manually without the assistance of a computer program.
The NPV, IRR, and Payback methods
The NPV
A positive NPV provides the amount that the project is likely to generate above the rate of return required by investors. The net present value (NPV) is the sum of the discounted net cash flows generated by a project (Graham and Smart, 2012, p. 248). Shareholders want to be rewarded by a higher rate of return for having their money invested in a riskier business. The distribution of genetically modified soya seeds’ business is surrounded by uncertainty emerging from the potential of other firms developing superior seeds in the future.
A discount rate of 11% is used to compensate the level of risk associated with the biotechnology seeds’ business. Graham and Smart (2012, p. 248) explain that the discount rate is the rate of return that an investor can obtain from the marketplace for a similar investment opportunity. The net present value considers the opportunity cost of using resources. The NPV considers the market value of resources utilized in the project. The NPV requires the use of real cash flows.
Values that do not involve transfer of cash are not included in the cash flow (Corporate finance: investment n.d., p. 24). As a result, the purchase of vehicles has been used instead of depreciation.
The NPV decision rule states that managers should select projects with a positive NPV. Projects are also acceptable when the NPV is equal to zero because it has taken care of the rate of return required by investors (Graham and Smart, 2012, p. 248). The ProGen project has an NPV of £1,087,530 (see Appendix A). It shows that the project exceeds the returns required by shareholders for undertaking risk by investing in the project.
Explanations on the calculations
Depreciation does not represent a real transfer of cash from the project to an outsider. As a result, the purchase cost of the vehicles has been used in the first year and the salvage value at the end of the project’s life. The salvage value of vehicles is obtained when the vehicles are sold at the end of the project. Depreciation would be calculated by deducting the salvage value from the cost and then dividing the difference by five years. It would be £106,000 instead of £130,000.
The market value has been used for the rent of offices because the net present value considers the feasibility of the project in market conditions (Graham and Smart, 2012, p. 248). Indirect benefits have been left out because they do not represent real cash flows. However, the indirect benefits may assist the management to make the final economic decision (benefits-cost analysis). A working capital of £1.5 million is received in Year 0 and repaid in Year 5 without any interest as shown in Appendix A. All other costs are similar to the ones displayed in the exhibit.
The cash inflow is the sum of all values that are generated by the project. The items include sales, sale of vehicles, indirect benefits, and the receipt of working capital. The cash outflow is the sum of all values that involve an expenditure or payment to an outsider. The net cash flow (NCF) is the difference between the cash inflows and outflows. It represents the amount of cash that the project keeps at the end of the annual operations. The net present value is the sum of the discounted net cash flows.
The internal rate of return (IRR)
The IRR of an investment is the rate of discount at which the investment cash inflows and outflows are equal. The IRR can also mean the interest rate at which the net present value is equal to zero. Graham and Smart (2012, p. 254) explain that the IRR is “the compounded annual rate of return on the project given its upfront cost and subsequent cash flows”. The statement is important because the calculation of the IRR fails when the pattern of the stream of income changes.
The calculation requires an initial cost or costs followed by a stream of positive cash flows for one to obtain an answer in the Excel program. Excel does not give an IRR when the negative sign changes pattern among positive values (Corporate finance: investment n.d., p. 31). In the ProGen project, Excel does not provide an IRR when the positive stream of £1,500,000 working capital is included (see Appendix B). However, it provides an IRR of 10% when the working capital inflow is excluded.
The IRR requires a benchmark in the form of an interest rate. When the IRR exceeds the set discount rate, the project is viable. Graham and Smart (2012, p. 255) emphasize that the discount rate used for the NPV calculation should be the same as the one set as a benchmark for the IRR.
The IRR is impossible to obtain using Excel when the pattern of positives and negatives is intermingled. The calculation indicates that there are multiple IRRs when the pattern changes (Corporate finance: investment n.d., p. 32). Online IRR calculators also indicate that when the initial amount is positive, IRR is impossible to calculate. It becomes difficult to evaluate the project using the IRR.
Calculations
The IRR is calculated using the net cash flows. Select IRR from the formula bar. Select the range of values to be considered in the NCF row and click OK. The IRR cannot be obtained using the arrangement.
Payback and discounted payback periods
The payback period method is appropriate for the ProGen project because it relies on biotechnology. Moles et al. (2011, p. 377) defines the payback period as the number of years required to recover the amount of money used in the initial investment. Technological products become more uncertain with more time forecast into the future.
New entrants and new products may be developed that reduce the current product’s profitability. The firm will prefer the project if it generates the investment amount earlier than the cutoff point. A project is accepted when it generates the initial investment within the set time limit (Moles et al. 2011, p. 377). A firm may prefer a project that covers the initial investment earlier when it has financial constraints in other sections of its operations. A firm may also prefer shorter payment periods to repay debts or reinvest in other business opportunities (Graham & Smart 2012, p. 244).
During the year it turns positive, the period is a fraction of a year. It is obtained by dividing the remaining amount by the net cash flow in the year that the cumulative cash flow turns positive (Moles et al. 2011, p. 377). The discounted payback period incorporates the discount rate in determining whether the payback period falls within the set benchmark. The discount rate used is 11%. The discounted payback period tries to address the weakness of the simple payback period by accounting for the time value of money (Moles et al. 2011, p. 380).
Under the simple payback period, the initial investment is recovered after 3 years and 243 days (see Appendix C). Under the discounted payback period, the initial investment is recollected for a period of 3 years and 250 days (3.685 years). The discounted payback period is slightly longer than the simple payback period because the values of net cash flows are reduced under the discounted payback period. If the benchmark were 3 years, the project would be unviable.
If the benchmark were 4 years, the project is feasible. Using intuition, it would be unlikely to have only a single year as the year of profitability. Graham & Smart (2012, p. 244) discuss that projects that take longer before covering cost of investment are riskier. The external environment is likely to change in the long run creating large variations between estimates and actual values generated from operations.
Calculations
The payback period is obtained using the sum of NCFs known as cumulative NCF. The values are added horizontally. When the figure turns positive on the cumulative NCF, the payback period if found at that point. The discounted payback period is obtained by multiplying the NCF by the discounting factor. The discounted NCF are added horizontally before finding the payback period at the point where the discounted NCFs turn positive.
The IRR rule is redundant as an investment criterion because the net present values (NPV) rule always dominates it
The IRR appears redundant because the NPV rule provides more information than the IRR. The NPV may tend to show the rate of return that the investment may be higher or below the required rate of return. Graham & Smart (2012, p. 248) explain that the NPV rule works according to the objective of maximizing shareholder wealth.
The IRR does not indicate the value that shareholders would obtain above the discount rate. The NPV rule provides the discount rate as well as the monetary value generated from a project. Managers may prefer the NPV because it shows the creation of wealth for shareholders.
The IRR may be used by people without a financial background because of the simplicity of the decision rule. The manager sets a discount rate as a benchmark, and compares it with the generated IRR. If the IRR is higher than the benchmark, the project is feasible. The use of percentages makes it easier to make comparisons (Corporate finance: investment n.d., p. 36).
The discount rate is an estimate of the risk posed by the business environment. Managers with a financial background may prefer the NPV because of the clarity that it provides to the decision making process. The NPV allows managers to use multiple discount rates and test the changes that are likely to occur under different circumstances. The NPV profile may be used to show many possible outcomes (Albrecht 2008, p. 1142). The IRR provides a single discount rate under which all other factors are ranked.
The IRR may not be calculated manually without the assistance of a computer program. The calculations behind the generation of the IRR are difficult to understand. The NPV is easy to understand. For some people, the NPV is cumbersome because of the need to generate some figures and components manually.
The IRR appears defective when selecting mutually exclusive projects. Graham & Smart (2012, p. 262) elaborate that selecting a project with the highest IRR may not always be the best decision with maximizing shareholder value. The IRR fails to take into account the size of the project (Corporate finance: investment n.d., p. 34). The NPV provides a perfect rule when making a decision on mutually exclusive projects. The profitability index improves the ability of the NPV rule in selecting among projects with positive NPVs. The profitability index is obtained by dividing the NPV by the initial investment (Albrecht et al. 2008, p. 1142).
Managers can select projects with the highest profitability index. As a result, the NPV checks both the discount rate and maximization of shareholders’ wealth. Shareholders’ wealth is checked through a positive NPV and the rate of return through the profitability index. Managers will prefer the NPV because it seems to do what the IRR examines as well as maximizing shareholders’ wealth.
The IRR calculation may fail to give results in some cases. Graham and Smart (2012, p. 261) discuss the failure of the IRR when there is more than one change in the sign of the values. In some cases, the IRR calculator will indicate that there is an error in calculation because there is no single IRR (Corporate finance: investment n.d., p. 32). The IRR may give different results for projects with the same NPV but different patterns in the stream of cash flows (Corporate finance: investment n.d., p. 35).
Conclusion
The ProGen project should be implemented because it presents a positive NPV. The payback period also shows that the project has more than a year of safety margin to recover the project cost. The payback period and the IRR require managers to set the limit for which the outcome may be acceptable. The required rate of return is needed for the IRR and an optimal time for the payback period to give guidance in making decisions. Technological products become more uncertain with more time forecast into the future.
The payback period is relevant in such a situation. The payback period may be used when the firm needs early returns to invest in new projects or cover project operations. The IRR may not be applicable in this case because the cash flows have changed patterns of positive and negative values. The IRR is redundant because the NPV provides part of the information examined by the IRR as well as the monetary values. The discount rates ensure that resources are used efficiently.
Value creation is also important to shareholders. The IRR fails to incorporate the value created for shareholders. The IRR cannot be used accurately to rank mutually exclusive projects. The IRR may be used by people without a financial background because of the simplicity of the decision rule.
Reference List
Albrecht, W, Stice, J, Stice, E & Swain, M 2008, Accounting concepts & applications, Thomson/ South-Western, Mason, OH.
Corporate finance: investment n.d. Web.
Graham, J & Smart, S 2012, Introduction to corporate finance, 3rd edn, South-Western Cengage Learning, Mason, OH.
Moles, P, Parrino, R and Kidwell, D 2011, Fundamentals of corporate finance, Wiley, Hoboken, NJ.