Introduction
In any business undertaking, selection of a good project is a vital step towards success. Many firms make big losses as a result of investing in projects that are not viable. In this regard, it is advisable that before any project is pursued, proper evaluation is done to ensure that only profitable investments are undertaken. There are many ways to evaluate investment projects. In most cases, companies assess several proposals with the intention of selecting the most profitable one.
However, sometimes a firm may evaluate a single project to determine whether it meets the predetermined short term and long term goals or not. In this paper, two investment projects are analysed using various methods. The aim is to help Mr John Black (Assistant Production Manager for Scientific Robotics Equipment Corporation) select one project that will be most profitable to his company.
Weighted Average Cost of Capital
Weighted average cost of capital (WACC) comprises of expenses that a company incurs as a result of interest on its sources of funding (Murray & Tao 32-37). WACC = E/V * Re + D/V * Rd (1-tc/100), where E is the equity value of the company, D is the debt value of the company, V is the total value of the company, Re is the required rate of return on equity, Rd is the required rate of return on debt and Tc is the income tax of the company.
From the available information, kd = 0.058, kp = 0.09, ke = 0.12, wd = 0.25, wp = 0.15, and we = 0.60. In this regard, the WACC formula can be changed to WACC = wdrd(1-t) + wpkp + weke, where wd = D/V is the percentage of capital financed by debt and We = E/V is the percentage of capital financed by equity. Therefore, WACC = 0.25*0.058(1-0.4) + 0.15*0.09 + 0.6*0.12 = 0.0942 = 9.42%. In this case, 9.42% implies that for every one dollar SREC gets from investors, $1.0942 is paid back. The weighted average cost of capital is important because it enables companies to assess the cost of funding their projects. It should be noted that lower WACC means the company can cheaply fund its projects (Jan et al. 7).
Net Present Value (NPV)
NPV= -II + [OCF/ (1+R(r))t] + [TCF/(1+R(r))n], where II is the initial investment, OFC is the operating cash flow in year t, n is the life span of the project in years, and R(r) is the project required rate of return. Initial investment is obtained by taking total project costs minus investment tax credit plus income from sale of old assets plus or minus tax effects. For SREC, the cost of alternative one is: $380,000 for machine acquisition plus $12,000 for installation plus $8,000 for transportation.
The total amount obtained is $400,000. Therefore, the initial investment for project one is 400,000 – 15000 = $385,000. In this case, $15,000 is the amount obtained from disposal of old items.
The following table is used to calculate the present value of the future cash flows for project one. The first column displays years and the second column displays discount factors obtained by 1/(1+r)t, where r is the desired rate of return and t is the year. The column for net cash flow is obtained by subtracting cash revenues from operating costs. The column for present value is obtained by multiplying net cash flow by discount factor.
From the above table, the present value of future cash flow for project one is $380, 910. Therefore, the net present value = -II + present value of future cash flow = -$385,000 + 380910 = $-4090. It can be noted that the obtained net present value is negative. A negative NPV indicates that the project is not profitable. Therefore, alternative one should be rejected even without considering alternative two.
For alternative two, the initial investment is $476,000 for machine acquisition plus $16,000 for installation plus $8,000 for transportation minus $15,000 for disposed items. The total amount obtained is $485,000.
The present value for option two is $769,868.1. Therefore, the net present value, NPV = -485,000+769,868.1 = 284,868.10. Since the net present value is positive, project two is profitable. It is also obvious that option two is much far better than option one in terms of profitability.
Payback method
Payback method is used to determine the time it takes to recover the total amount invested in a particular project. Payback period is calculated by subtracting cash inflows from the initial investment until zero is obtained. For SREC, the initial investment for option one is $390,000, obtained by adding the initial investment used in question one ($385,000) to the extra current assets required. The following table is used to calculate the alternative one payback period.
From the total of $390,000, $310,000 is recovered within the first three years. The net cash flow for the fourth year is $90,000. Therefore, the remaining $80,000 is recovered within 80,000/90,000 of a year = 0.889. In this regard, the total initial investment for option one would be recovered after 3.889 years.
For option two, the initial investment is $490,000.
From the total of $490,000, $285,000 is recovered within the first three years. The net cash flow for the fourth year is $395,000. Therefore, the remaining $205,000 is recovered within 205,000/395,000 of a year = 0.722. In this regard, the total initial investment for option two will be recovered within 3.722 years. Therefore, the payback method reveals that the amount invested in option two would be recovered earlier than the amount put in option one. These results indicate that option two is better. It should be noted that in this case, both the payback and NPV methods favour the same option.
Average Accounting Rate of Return (AAR)
AAR is a measure of profitability that compares invested amount to net earnings from the investment. AAR = Average net income/Average investment (Wen-Yau 446-449).
In the case of SREC, for alternative one, average depreciation = 385,000 / 5 = 77,000. The average accounting income is, (110,000 – 77,000 + 105,000 – 77,000 + 95,000 – 77,000 + 90,000 – 77,000 + 90,000 -77,000) / 5 = 105,000. The average investment is 385,000 / 2 = 192,500. Note that $5,000 is invested in the project in form of additional current assets and recovered at the end of the project. Therefore, AAR = 105,000 / 192,500 = 0.5454 = 54.54%.
For alternative two, the annual depreciation = 485,000/5 = 97,000. The average accounting income is, (-25,000 – 97,000 + 0 – 97,000 + 310,000 – 97,000 + 395,000 – 97,000 + 440,000 – 97,000) / 5 = 127,000. The average investment is 485,000 / 2 = 242,500. Therefore, AAR = 127,000 / 242500 = 0.5237 = 52.37%. The AAR for the first project is greater than the second project; implying that the first project is better than the second project. It should be noted that unlike payback and NPV methods that favoured project two, AAR favours project one. In this regard, the difference between NPV and AAR has been caused by failure to account for time value of money in AAR.
Profitability Index
Profitability index measures the rate of return on investment. The figure is obtained by dividing the present value of future cash flow by the initial investment (Arnold 37-41). Profitability index that is greater than one implies the project is profitable.
For SREC, profitability index for alternative one is: PI = Present value of future cash flow / Initial investment. Present value of future cash flow is 380,910 and the initial investment is 385,000. Therefore, PI = 380,910 / 385,000 = 0.989. Since the PI is less than 1, option one is not a profitable project.
For option two, the present value of future cash flow is 769,868.1 and the initial investment is 485,000. Therefore, option two PI = 769,868.1/485,000 = 1.587. Option two is profitable because its profitability index is greater than 1. PI = 1.587 means that for every one dollar invested, the investor gets $1.587.
Appropriate Method
To decide the most appropriate method for selecting the best investment option, John needs to look at the merits and demerits of various methods in relation to desired projects. In this regard, the advantages and disadvantages of Net Present Value (NPV), Payback and Average Accounting rate of Return (AAR) will be analysed.
Advantages of NPV
NPV is the most used method in determining suitability of projects because of its accuracy. The first advantage of NPV is that it takes into account the time value of money. Firms that fail to consider time value of money can easily make loses without knowing. For example, to put this into perspective, one hundred dollars today is not equivalent to one hundred dollars after one year even in the absence of inflation.
NPV method is also preferred because it takes into account profitability and risks involved in investment projects. The method helps investors avoid projects that have high risks and low returns. In this regard, it is believed that high risk projects should yield more returns. For example, it does not make sense to break into a bank and come out with one hundred dollars but it makes sense to get the same amount from pickpocketing someone.
NPV method is accurate because it takes into account cash flows before and after the project life span. For example a firm may reclaim invested money by disposing some items after the project. Equivalently, firms can also make money by disposing old items that are rendered useless as a result of project implementation.
NPV disadvantages
Calculation of NPV is so involving. In addition, it is sometimes hard to accurately determine suitable discount rates. Poor choice of discount rates can lead to rejection of good projects or acceptance of bad ones.
Advantages of payback method
Because it favours short term alternatives, payback method helps to avoid uncertainties in late cash flows for long term projects. The method also helps to keep firms liquid because it is concerned about short term returns. Lastly, payback method is easy to understand, use and report the findings.
Disadvantages of payback
One of the disadvantages of payback method is the assumption that a certain amount of money today is equal to the same amount in future (Murray & Tao 41). In this regard, failure to consider the time value of money introduces some inaccuracy in the process. In this regard, a project can bring profits during early stages but end up as a loss in general. In the instances where only one project is being assessed, the payback method requires an arbitrary cut-off point. In this regard, the point may not be accurately determined. In addition, the method ignores cash flows after the cut-off point. As a result, the method is also biased against long term projects that may bring permanent changes. In general, payback method has more disadvantages than advantages (Ross, Randolph, and Jaffe 23).
Advantages of Average Accounting Rate of Return
Accounting rate of return is easy to understand, use and report the findings. The method is mostly used by stakeholders to assess management teams because it focuses on net operating income.
Disadvantages of AAR
Like payback method, AAR is also based on assumption that a given amount of money today is equal to the same amount in future (Murray & Tao 52). In addition, the method does not give priority to cash flow. In this regard, projects that generate faster cash flow and facilitate further investment may be rejected if AAR method is used.
After looking at the advantages and disadvantages of NPV, Payback and AAR methods, the next step is to select the most appropriate approach for John Black. In this regard, accuracy and reliability should be the guiding factors.
From the available options, the approach that has more advantages and less disadvantages is NPV. The complexity of the process can be taken care of by John’s high competence and experience in project evaluation. Another problem associated with NPV is the difficulty in determining the required rate of return. This problem is solved because the calculated Weighted Average Cost of Capital is used as the desired rate of return.
In addition, NPV is the only approach that takes into account the time value of money. John should use NPV to select the best project for SREC. Based on my calculations, NPV = 284,868.10 will lead him to alternative two. The first alternative has NPV = $-4090. In this regard, alternative one ought to be rejected even in the absence of alternative two because it has a negative NPV. It should be noted that all answers obtained using different methods except AAR indicate that project two is better than project one.
Other Considerations
There are several considerations that John should think about before making the final decision. After finishing the evaluation process, he is supposed to consider the likely response from other stakeholders. A project can only be fruitful if it is appreciated and supported by people who are expected to participate in its implementation. In this regard, consideration should be given to other managers who will be working on the project with him and members of staff who will be performing specific duties. Some of the factors to consider include whether employees would require some training to work on the project or not.
John should also consider the priorities of the company. Companies that value liquidity may not prefer projects that take long time to start yielding returns. In addition, the company’s financial needs should be considered. Sometimes a firm may invest all the money in a project in anticipation that returns will start flowing in after the project starts running. Projects that take long before starting to pay may not be appropriate in such situations.
John should also think about the chances of the project failing. High return projects are also known to be risky. In this regard, it has to be noted that the future cash flows are mere estimates that can change for various reasons. Therefore, John should assess the likely consequences if the project backfires. It is always good to find escape routes in advance when dealing with risky ventures. John should have answers to such questions before forwarding his selected project.
NPV project evaluation process does not consider non-monetary factors. There is need to determine the general impact of the project on the company beyond financial estimates. Factors such as customer satisfaction should be considered for the sake of sustainability. In general, John should be prepared to answer any questions that may be asked by people who did not participate in the evaluation process.
John’s Worries
John is afraid of selecting alternative two because of its projected poor performance in the first two years. He is targeting the position of production director that is expected to become vacant as a result of the impending retirement of the current position holder. Although John has a right to think about his ambitions, he also has an obligation to correctly perform duties entrusted on him. Clearly, he is faced with conflicting interests in that company goals are competing with his personal objectives. Under such circumstances, any officer would be expected to put a side his or her ambitions and serve the company or resign to pursue personal interests.
John owes the company a duty of care in performance of his tasks. It is not only un-ethical but also illegal for a company officer to give misleading information that can lead to massive loses. If discovered, John is likely to face a civil case. He may also be required to compensate the company any losses incurred as a result of the project.
My advice to Black is that it will be more detrimental for him to select a wrong project. Although he may be promoted as a result of the board’s ignorance of his project selection, things are likely to change when the truth finally comes out. It will be more embarrassing to be promoted and later dismissed on account of incompetence and blackmail. Therefore, John should remain calm and select a project that will bring the best returns to the company.
He should explain all the merits and demerits of the selected project to his seniors and colleagues. He should make it clear that the selected project will require some patience because returns will not be realized in the first two years. Since alternative two is the best choice, John should make it known that alternative one would lead to direct losses. Hopefully, he will not be evaluated based on an on-going project but rather his past performance. Furthermore, it is better to lose one chance and remain around to be considered next time than force his way and lose everything including his career.
Conclusion
From the analysis, SREC has a WACC of 9.42%. Using the Net Present Value method, the first project NPV = $-4090 and the second project NPV = $284,868.10. Therefore, the second project is much far better than the first one. Using the payback method, project one PB period = 3.889 years and project two PB period = 3.722 years. Therefore, project two is slightly better than project one. Using the Average Accounting Rate of Return, project one AAR = 54.54% and project two AAR = 52.37%; implying that project one is better than two. In this regard, NPV is the method of choice and it favours project two. Therefore, John should select project two.
Works Cited
Arnold, G. Essentials of corporate financial management. London: Pearson Education, 2007. Print.
Jan, Williams et al. Financial and Managerial Accounting, New York: McGraw-Hill/Irwin, 2012. Print.
Murray, Z. Frank & Tao Shen. Investment, Q, and the Weighted Average Cost of Capital. Minneapolis: University of Minnesota. 2012. Web.
Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe. Corporate Finance. Boston: McGraw-Hill/Irwin. 2008. Print.
Wen-Yau, Liang. “The analytic hierarchy process in project evaluation: An R&D case study in Taiwan”, Benchmarking: An International Journal, 10.5 (2003): 445-456. Print.