Financial Management

Introduction NPV (Net Present Value) is the total difference between all the present values of cash inflows and outflows. (Khan, 1993) The value of money tends to fluctuate over certain period. $1000 dollars today is worth much more than $1000 dollars in a couple of year’s time. An investor can decide to spend money or invest wisely in interest generating ventures. The process of evaluating the current present value of the future value is known as capitalization. The opposite process is the discounting. For example in lotteries. Present values and future values are beneficial in analyzing the time value of money. (Vance, 2003) XYZ Incremental Cash flow 1st yr 2nd yr 3rd yr 4th yr 5th yr 6th yr 7th yr 8th yr Total Income/B C/fwd -1722500 -1442500 -1162500 -882500 -602500 -22500 557500 942375 Sales 950000 1500000 1500000 1500000 1500000 1500000 1500000 1500000 11450000 Total income -222500 57500 337500 617500 897500 1477500 2057500 5222500 Costs 0 Direct costs 427500 675000 675000 675000 675000 675000 675000 675000 5152500 Indirect Costs 95000 95000 95000 95000 95000 95000 95000 95000 760000 0 New Plant 1500000 1500000 Depreciation 300000 300000 300000 300000 300000 0 0 0 1500000 Net receivables 200000 200000 Cost of Capt 10% 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 1200000 Tax (35%) 0 0 0 0 0 0 0 195125 195125 Total Costs 2672500 1220000 1220000 1220000 1220000 920000 920000 1115125 10507625 Balance C/fwd -1722500 -1442500 -1162500 -882500 -602500 -22500 557500 942375 The total income is obtained by adding the total sales. The total cost of sales and the expenses is arrived at by adding all the costs. These are; direct and indirect costs, depreciation, cost of the new investment, the cost of capital and the taxation in year 8. This is because the deficits that the company incurred are not subject to taxation. The payback period from the table is seven years. The income generated is incremental and also the costs. To arrive at the payback period, the balances have to be brought forward and carried forward to calculate the ultimate payback period as illustrated on the incremental cash flow. The total income for the first year = 950,000. The income for the next six years = 6 * 1500,000 =9,000,000 This figure is added back to the income realized in the first year = 9,000,000 + 950,000 = 9,950,000. The total expenses for project in the first seven years = Direct Expenses = 45% of 950,000 = 427,500 + 45% of 1,500,000 * 6years = 427,500 + 4050,000 = 4477500 Add indirect costs 95000 * 7months= 665,000 Add Additional plant = 1,500,000 Add Depreciation = 1,500,000 Add cost of Capital 10% of total expenses = 10% of 1,500,000 = 150,000 Total cost = 4477500 + 665,000 + 1,500,000 + 150,000 = 6,792,500 These figures are recurrent and they are earned after the seventh year as per the incremental cash flow. The NPV of the project is calculated by the following formular, PV = FV/(1+r)n PV = Present value FV = Future value r = interest rate n = Number of years NPV = PV – Total invest FV = Total income 11450000 IRR 1.080% NPV = -506.73 Total Investment 10507625 Formular For calculating NPV Investment FV Years IRR PV NPV 10507625 11450000 8 1.0800% 10507118 -506.73 PV = FV/ (1+r) ^n PV = 11450000/ (1+0.0108) ^8 PV = 10507118 NPV = PV – Investment NPV = 10507118 – 10507625 = -506.73 NPV = -506.73 Do you think the project should be accepted? Why? The project should be accepted. Though it takes a long period to breakeven. It eventually starts to generate profits in the seventh year after paying all the incremental costs. Its NPV is also -507. Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years. The company will definitely reject the project as its life begins after the seventh year. The initial years the company operates at a deficit. In the first year it has a deficit of 1,722,500 followed by (1,442,500), (1,162,500), (882,500), (602,500), (22,500) for the year 2, 3, 4, 5 and 6 respectively. If the project required additional investment in land and building, how would this affect your decision? Explain. I would certainly reject the project. The cost of land and building will certainly increase the costs of the project. Land and building are fixed capital expenses which require large capital. It takes seven years to breakeven without the cost of land and buildings. If they are included the project will not be economically viable as it may require even a longer period to breakeven. The additional capital requirement for this project will lead to its disqualification as it has a very long life. At seven years, its already long enough, extra and additional time will result in losses for the company as most of the projects are funded by loans and the chargeable interests are calculated in accordance with the payment period. The longer the project the more costly it will eventually become. References. Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. Vance, D. (2003). Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill.