2009

15/12/2009 MBA1 GROUP D 0030ROMR0209 ANH NGUYEN KIM NGOC

CAPITAL BUDGET DECISION ASSIGNMENT

This report concentrates on analysis and evaluate the efficiency of the different projects of Firmex Corporation in aim to select the most profitable project for the strategic investment of company

ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

INTRODUCTION
Financial Project Management (FPM) is a proven process that keeps project managers in control of changes to their financial systems whilst minimising the time to them. It does this by focusing involvement of the manager on the basis of managerial decision making process. The managerial decision making is both an art and a science because a combination of quality (subjective) and quantitative (objective) factors enter the picture. Such qualitative factors as public image, social responsibility, competitive reaction, management intuitions and employee attitudes often have an important bearing on a decision. At the same time, management will attempt to structure a decision-making situation in quantitative terms whenever possible so a choice can be made on a systematic basis. Based on the quantitative information that provided by the managerial accounting system, the decision-making process follows of four steps: 1. Definition of the problem 2. Selecting of alternative courses of action
3. Obtaining relevant information

4. Making a decision To get a precise decision of selecting pursuing a valuable project, the project managers have many various tools to fairly evaluate and compare the profits and achievements of the different projects before making the final decision. Capital budgeting, which involves the planning and financing of capital investments such as the replacement of equipment, expansion of production facilities and introduction of a new product line , is one of the important tool of managerial decision making. Capital budgeting decisions are critical to the long-term profitability of a business since they will determine its capacity to do business. (Sources: P.1288, Accounting in Australia, The 3rd Edition, Hogget &Edwards). Using the discounted cash flows method of capital budgeting decision, this report is focusing on comparing the costs or initial costs outlay of two different projects of Firmex Corporation (PLC) with the present value of net cash flows expected from them in the three years period. It is aware of using two popular techniques of this approach include calculation of the net present value (NPV) and the internal rate of return (IRR). In addition, the report is also considering the profitability index (PI) of each project in order to clearly identify the amount
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Strategic Financial Management Assignment

of value created per unit of investment, thus assure to the prior choosing of investment in the project which creates the most efficient value.

REPORT
Firmex Corporation (PLC) is considerably undertaking one of two potential projects which are strategically important to the company. The companys cost of capital for both projects is 10% and the project length is similar (3 years) while there are the differences of initial cost and the net cash flow expected each year for each project that diagrammed as below:

The expected cash flow in 3 year

800 600 400

800

Project A $200.00

Project B $150.00

Initial
200

Cash ($)

200 0 -200 -400 -600 -800

cost
50 100

150

1.

Net
Year
1 2

-800

present value (NPV) of projects

Cash flow (Project A)

Cash flow (Project B)

Net

present

value (NPV) is

defined as the total present value (PV) of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. It is one of the most efficient financial tools to evaluate if an investment or project worthwhile is. Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV formula is

CFt n NPV = t = 0 (1 + k) t
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Strategic Financial Management Assignment

With a particular project, if kt is a positive value, the project is in the status of discounted cash inflow in the time of t. If kt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations. If... >0 NPV <0 It means... add value to the firm The investment would subtract value from the firm We should be indifferent in the decision whether to accept or NPV =0 The investment would reject the project. This project adds no monetary value. neither gain nor lose value for the firm Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation. Source: From Wikipedia, the free encyclopedia Based on the theory basis of NPV and PV, we apply the formula of NPV to calculate the results of the given information of both projects of Firmex Corporation as below: The project should be rejected Then... The project may be accepted

NPV The investment would

ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

a/ Project A Present value of $1 at 10% 1 0.9091 0.826 0.751 41.82

Year Initial cost 1 2 3 Total NPV

Expected net cash flow -200 200 800 -800

PV

-200 181.82 660.8 -600.8 241.82

NPV (A) = 41.82 > 0 The investment for project A can add more value to firm Project A maybe is accepted b/ Project B Present value of $1 at 10% 1 0.9091 0.826 0.751 90.705

Year Initial cost 1 2 3 Total NPV

Expected net cash flow -150 50 100 150

PV

-150 45.455 82.6 112.65 240.705

NPV = 90.705 > 0 The investment for project B can add more value to firm
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Strategic Financial Management Assignment

Project B maybe is accepted c/ Conclusion Calculation and analysis of NPV of both project A and project B showed both of them can create the new values to Firmex Corporation (PLC). The principle issue is capital of Firmex Corporation cannot afford to invest to both project at the same time. Hence, this is the core point for the manager to carry out the decision making process in order to select only project with the highest value and the most efficient capital budget. This matter is going to seriously discuss at the last part of the report.

2. Profitability index (PI) of both projects

The profit index (PI) is one investment ranking tool, also known as benefit/cost ratio. To put in mathematical terms, the formula is: Profitability Index = PV of future cash flow/ PV of Initial Cost

The profitability Index (PI) also follows the specified rules to evaluate if a project should be accepted. The measurement of PI is based on value of 1 Negative (-) Positive (+)

Bad investment

Good investment

In addition, the Profitability Index (PI) and Net present value (NPV) have been existed a linear relationship which is made up as follow: - If Profitability Index > 1, NPV is Positive (+) - If Profitability Index < 1, NPV is Negative (-) Applying formula of PI in case of Firmex Corporation (PLC), we obtain the PV results of both projects in the below table. a/ Project A

ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment Present value of $1 at 10% 1 0.9091 0.826 0.751 41.82 1.2091

Year Initial cost 1 2 3 NPV PI

Expected net cash flow -200 200 800 -800

PV

-200 181.82 660.8 -600.8

PI (A) = 1.2091 > 1 For every $1 invested in this project, the total value created is $1.2091. Therefore, we have a net profit of 1.2091 - 1 = $0.2091 per every dollar invested. Good investment The investment for project A may be taken up b/ Project B Present value of $1 at 10% 1 0.9091 0.826 0.751 90.705 1.6047

Year Initial cost 1 2 3 NPV PI

Expected net cash flow -150 50 100 150

PV

-150 45.455 82.6 112.65

ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

PI (B) = 1.6047 > 1 For every $1 invested in this project, the total value created is $1.6047. Therefore, we have a net profit of 1.6047 - 1 = $0.6047 per every dollar invested. Good investment The investment for project B may be taken up c/ Conclusion Profitability index of both projects are positive. That means both project have chances to attain the profit for Firmex. However, profitability index of project B > profitability index of project A. It reflects the higher profit value of project B which Firmex should take up.

3. Internal rate of return (IRR) of both project

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is defined as the interest rate that will discount the future cash flow so their present value is exactly equal to the cost of investment. Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment which IRR exceeds its cost of capital add value for the company. Calculation formula of IRR is given by a collection of pairs (time, cash flow/ n, NPV, the internal rate of return (IRR) is given by r in:

Cn)

where n is a positive integer, the total number of periods N, and the net present value

ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

In case of Firmex Corporation, using the Excel software to calculate IRR of both projects based on the expected cash flow, we get the follow outcomes a/ Project A Expected net cash flow -200 200 800 -800 IRR Guess 10% 70% 0% 100%

Year Initial cost 1 2 3

There is existence of multi IRRs in the project A when a cash outflow of $800 appears at the end of the three years period. The outcomes of calculation reflect two IRRs with the value of 0% and 100% which produce the confusion and impossibility to use the IRR decision rule to implement. It requires another method to evaluate if project A is worth to invest. In this case, we use NPV and diagram of NPV, which will be mentioned in the next part of the report, for making investment decision. b/ Project B Expected net cash flow -150 50 100 150 IRR Guess 10% 70% 36% 36%

Year Initial cost 1 2 3

The IRR value of project B equals 36% IRR (B) = 36% > cost of capital = 10% Add value to Firmex Corporation Project B may be accepted.

CONCLUSION
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ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

Which project should be invested by Firmex Corporation (PLC)?

During calculation process of the different financial indicators, I got the outcomes of NPVs, PIs and IRRs of both projects of Firmex Corporation. In this part, I concentrate on selecting the most appropriate evaluation technique among the three above indicators and comparing the pairs of the indicators to obtain the precious decision. First of all, I want to mention about the evaluation technique I decide to undertake to use for my decision making purpose. From the expected cash flows of the projects, I have seen the project A has multiple sign changes in the series of cash flows (- + + -) which generated multiple IRRs for that single project. In this case, it is not even clear whether a high or low IRR is better, when it showed rate of 0% as well as 100%. For this reason, I decide to select evaluation technique of NPV for making investment decision instead of using the IRR technique. The diagram presents the changes of the NPV values that remain the "more accurate" reflection of values to the business of Firmex Corporation. At the present value of 10%, we got NPV (B) = 90.705 > NPV (A) = 41.82. That means project B add more value to Firmex.

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ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

In addition, the PI indicator of project B is more profitable than project A as well, with profit of $0.6047 per every dollar invested much more $0.3956 profit per every dollar invested than project A. At last, the IRR indicator of project B equals 36% which higher than the 10% cost of capital of Firmex. It shows project B attains the worthwhile qualifications to be invested by Firmex Corporation.

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ANH NGUYEN KIM NGOC

Strategic Financial Management Assignment

REFERENCE
BOOKS Hoggett & Edwards (1996). Accounting in Autralia (3th edition ed.). Capital Budgeting, p.1285, p.1288 ONLINE REFERENCES Wikipedia: The free encyclopedia. Profitability Index. Available at: http://en.wikipedia.org/wiki/Profitability_index [accessed 2th December, 2009]. Finance Scholar Online. Profitability Index Investment Ranking Tool. Available at: www.financescholar.com/profitabilityindex.html+profitability+index&cd=3&hl=en&ct=clnk &gl=uk [accessed 14 December 2009]. FAO Corporate Document Repository. Chapter 6 Investment decisions Capital Budgeting. Available at: www.fao.org/docrep/w4343e/w4343e07.htm+npv+vs+irr&cd=2&hl=en&ct=clnk&gl=uk [accessed December 13, 2009] Experiments in Finance. How to calculate an internal rate of return (IRR), and when not to use it. Corporate Finance. Available at: http://www.thetimes100.co.uk [accessed December 10th , 2009]

BIBLIOGRAPHY
Jeff Madura (2006). International Finacial Management (8th edition) Ray Proctor (2006). Managerial Accounting for business decisions (1st edition). Financial Times: Prentice Hall Andrew Fight (2007). Introduction to project finance (1st edition). Essential capital markets Michael Brett (2003). How to figure out company accounts. How to read the financial pages

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