The report provides an analysis of different investment appraisal methods from which the project is evaluated. The calculation of NPV (Net Present Value) is done for a project, which is about installing wind turbines to generate electricity and then sell it. Methods used to calculate this NPV has been in the appendix, before properly analyzing the questions. Furthermore the importance of some other methods is explained with respected to NPV, which are ARR (Accounting Rate of Return), Payback Period (PBP), IRR (Internal Rate of Return). Apart from the importance, the report also discuss about their drawback and why NPV can be stated as the most vital one. Some limitations of the reports are that no proper analysis of discount rate was done as it was given in the question, no external factors could be described as they are ignored by these investment appraisal methods.
To start with the report, we must know what actually investment appraisal is. Investment appraisal is the way in which we assess that whether a certain project is acceptable or not. This consists of various techniques or methods, which are used to calculate whether a project is worth it. We must also know that why companies invest. They invest because of many reasons; companies can use these investment returns to finance different expense they incur. For example, to plant and equipment, to increase their efficiency, productivity, and to diversify, are the reasons of investments by several companies.
Whether should we accept this Project or not?
After calculating the Net Present Value of this Project, which turns out to be negative with very big amount, the project should be rejected. The NPV of this project is -41,143,312. The overall revenue generated from this Wind Turbine Project is less than the overall cash Outflow of this project. Moreover, applying the Cost of Capital as the discount rate, we have the outflows exceeding the inflows of the project. According to Zavrl, the project with negative NPV should be rejected, as it will result in the depletion of company’s reserve as well as their net profits (Pettinger, 2000).
How sensitive the NPV is to these changes?
If the maintenance cost is 10% higher
If we increase the maintenance cost by 10%, which means if we divide the £15 million then our maintenance cost will be £16.5 million, which increase our negative NPV or in other words it will worsen the situation. The exact NPV after the change is -52,552,431 that we all can see that it has increased its negative value. Now if you see the sensitivity, the NPV has increase by £ (11)-(12) million, which is almost 27.73% increase of negative value.
If the maintenance cost is 10% lower
If we choose to do the opposite of what we have done in part (a), then our negative NPV will be reduced because the maintenance cost is reduced by 10% however the sensitivity remains the same. Now the overall NPV has reduced by almost -27.73% due the decrease in this specific cost (Juhaisz, 2011).
If the electricity generating capacity of each turbine increases by 10%
If the electricity generating capacity increases, then the overall revenue will increase which will result in increased cash inflows. We have increased the capacity by multiplying the percentage with 15, which is the generating capacity of the turbine per day. Now it is 16.5. The current NPV is -6,365,852
The sensitivity is measured through the percentage change we have in our NPV, which is almost negative 84.52%. This shows that increasing the capacity of the turbines decreases the negative NPV by a very big number.
If the electricity generating capacity of each turbine decreases by 10%
If the generating capacity decreases then the NPV of the project will increase towards the negative side more because of the fact that revenue is directly related with the generating capacity of the turbines. The NPV from applying this condition is now -75,920,772 and there is 84.52% positive change.
If the prices were £110 per megawatt over all the useful life of this project
This is the only scenario in which the NPV is getting positive. It clearly shows that the price of the electricity is one of the main factors affecting the net present value. To elaborate the price, it is constant over the project’s useful life, £110, and now the answer is 51,182,508. The NPV shows that only the change in price has a drastic affect on the results. Eventually it has a decreasing or I should say a positive effect of almost 200%.
Why NPV is the most appropriate method of investment appraisal?
Various methods come under this investment appraisal, such as, Payback Period (PBP), Accounting Rate of Return (ARR), Net Present Value (NPV) or Internal Rate of Return (IRR). The first one Payback Period, tells us in how much time the company will get its money or initial investment back. The problem associated with this method is that it only tells about the time and nothing else. It also does not consider time value of money which means that the future net cash flows are not considered according to their time. Thus, time value of money cannot be estimated or known. Furthermore, it does not consider the cash flows after the payback period. The third method, Net Present Value, calculates the net cash flow of the project, considering the time value of money (Baum, 2008).
The net present value (NPV) method is based on the discounting of expected future cash flows of an investment project. More specifically, it states that the present value of the project’s inflows (or benefits) must exceed the present value of its outflows (or costs), if a project is to be selected. The cash flow stream includes all the payments and receipts associated with the investment project during its economic life, and it should be discounted at the opportunity cost of capital, which should reflect the risk of the project and the financing mix (Damodaran, 2001).
It means that the method is way better than the payback period as it does not considers the time value of money. Moreover, this method also tells us about the project whether it was useful or not. It means that whether the project has generated cash flow more than its costs or not. The method ARR tells us the return on capital employed, which means that it considers the profit of the project and not the cash flows. So this justifies, that it includes depreciation in its formula which means that it can be affected by the change in depreciation policy. The company has for example, straight-line or reducing-balance method. So to enlist its disadvantages the Accounting rate of return does not consider the net cash flow of the project as well as the time value of money. Both of these are the most important factor in assessing a new project and Net Present Value takes both these factors into consideration. Another method, which is widely used by investors and analysts, is IRR (Internal Rate of Return). “The Internal Rate of Return (IRR) corresponds to the rate for which the present value of the investment’s money in-flows are equal to the present value of the money out-flows. Unlike the previously mentioned techniques, Internal Rate of Return (IRR) takes the time value of money into consideration by introducing a discount factor (Pettinger, 2000). This method tells us the discount rate at which the Net Present Value is zero. In simple words, it tells us about the percentage in which the project is going to manage; cash inflow equals to cash outflow; consider their appropriate time value of money. However, the drawback associated with this method is that it ignores the size of the projects, which means that both the projects might have same IRR but have different cash flow over a certain period. Furthermore, IRR should not be used to make a choice between two mutually exclusive projects. So, the Net Present Value method is the best method to find out whether the project should be accepted or rejected (Pettinger, 2000).
Why managers accept negative NPV?
As discussed earlier, NPV (Net Present Value) is the discounted net cash flow earned, and by net cash flow it means cash inflow minus cash outflow. Among many methods used to analyze a project such as, ARR (Accounting Rate of Return), Payback Period (PBP), Discounted Payback Period, IRR (Internal Rate of Return), net present value is sometimes stated the best appraisal method. Moreover, any project with a negative NPV (Net Present Value) should be rejected and if the project has zero or positive NPV, then it should be accepted (Langdon, 2002).
Nevertheless in many occasions, the managers of the organization accept the negative NPV due to several reasons. One of the reasons is that the project might be a “Pet Project”. The word pet project means that it might have some political influence on it. These projects are undertaken due to the influence of company’s executive or a politician, which doesn’t add value to the company. An example can be a power plant installed in a rural area, which is beneficial for the inhabitants of the area however it is a complete loss for the company, by an executive or a politician to attract votes or increase the employment of the area which has nothing to do with company’s revenue.
Another reason, why managers accept a project with negative net present value, is that the project might be a supporting project, which means that the project’s output is essential for another project (Langdon, 2002). For example, many of textile industry in Pakistan due to energy crisis have to execute some power providing projects. So despite of having a negative net present value of the project, the managers or the directors will have to install this project because it will provide them electricity; hence, it will increase their utilization capacity.
Moreover, the manager may accept it for the competition. For example, Google have its play store and operating system in mobile phone. Now another company for example Samsung launches a phone which supports these two systems. Then in order to cater its market, Google will need a phone which will support its system. So, if it has negative net present value, it has to be accepted in any case. Sometimes for the sake of competition, companies have to accept projects with a negative NPV in order to create hindrance for their competitor’s business.
Furthermore, a reason can be the government regulations or government pressure. Some companies accept negative NPV due to the intense pressure from the government. A good example of this can be the environment friendly techniques used by different organizations. For example, sometimes to reduce unemployment government pressurizes some companies to recruit more workers in certain projects, which in fact will decrease a project net present value. Sometimes the shareholders expect that cash flow of the project will increase more than the expected one, so they accept some negative NPV projects.
Why managers decide to use more than one investment appraisal techniques?
Managers use more than one appraisal methods for their project because each technique has its own importance (Anon, 2016). As previously discussed, the appraisal methods are ARR, Payback period, NPV and IRR. Each of them has its own importance and that is why a manager should not rely on just one of these techniques. In the previous question the advantages of net present value were discussed. However, it has some disadvantages too, which can be the reason of why a company should use more than one appraisal methods. The disadvantage lies in the sensitivity of the discount rate, used to find out the discounted cash flow from the net present value. This discount rate varies from time to time. For example a ten-year project can have different discount rates in each year. Another problem is with the calculation of the discount rate; analysts can have their individual and different analysis, which will result in different discount rate calculations. For example, Google wants to initiate a project and Google’s analysts state that a 7% discount rate should be used to calculate the net present value, but on the other hand, Microsoft wants to initiate the same project and their analysts state that 9% discount rate should be used. A difference in analyzing the discount rate will either decrease the NPV or increase it (Anon, 2016). Another problem with NPV is that it does not state the opportunity cost that appears with initiating the project. Moreover it does not incorporate any external favorable factor which a company can experience in future.
Everything has their own pros and cons, so it is necessary to use more than one method to experience advantages of all techniques and to get a clearer picture of the projected net cash flows of the project (Anon, 2016). ARR and Payback period are easy to calculate; hence, managers use it. However, these techniques do not show a deeper picture of the project, which makes the managers to use other methods too. The disadvantages associated with these methods are that the ARR only tells the profit of the project but not the cash flow of the project. And the depreciation as explained before can give different ARRs based on the depreciation policy of the company; the payback on the other hand does not consider time value of money (Lere, 1980).
Another method which is widely used, the IRR (Internal Rate of Return), has its own advantages and disadvantages which makes managers to not only rely on this technique as well. The advantage of this technique is that it gives the managers a discount rate in which the project will break even after its beneficial life. The disadvantage is that two different projects can have same IRR but the size of those projects can be different. Just like in any investment you don’t want your whole money to be spent on a single project so you choose a portfolio. Same is the case with appraisal method; by choosing a mix of appraisal method you get a better and justified view of your project (Lere, 1980).
To conclude, managers should choose diversity to get a broader view of their project. With a broader view of their project, they will be able to make good decisions which will be based on the results, derived from various investment appraisal techniques. However, in many situations, the expected results are not achieved in reality.
Anon, (2016).determinants of the use of capital investment appraisal methods. [online] Available at: http://repositorium.sdum.uminho.pt/bitstream/1822/17961/1/afonso_cunha_EABR.pdf [Accessed 15 Mar. 2016].
Baum, A. and Crosby, N. (2008). Property investment appraisal. Oxford: Blackwell Pub.
Juhaisz, L. (2011). NET PRESENT VALUE VERSUS INTERNAL RATE OF RETURN.Economics & Sociology, 4(1), pp.46-53.
Langdon, K. (2002). Investment appraisal. Oxford, England: Capstone Pub.
Lere, J. (1980). DETERMINISTIC NET PRESENT VALUE AS AN APPROXIMATION OF EXPECTED NET PRESENT VALUE.Journal of Business Finance & Accounting, 7(2), pp.245-259.
Pettinger, R. (2000). Investment appraisal. New York, N.Y.: St. Martin’s Press.
Zavrl, D. (n.d.). Investment decision making.
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