Coursework Assignment

Strategic Financial Management

MEX Corporation (PLC):

The data shown in the above table are for two mutually exclusive project
opportunities that a company called MEX Corporation is considering
undertaking.

Both projects are assumed to be strategically important to the company.

Assume further the company’s cost of capital is 10 per cent.

1. Calculate the NPV of both projects.

2. Calculate the IRR for both projects

Which project should MEX invest in?

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INDEX

CONTENT PAGE NUMBER

INTRODUCTION 2
NET PRESENT VALUE 3
INTERNAL RATE OF RETURN 5
PROFITABILITY INDEX 7
CONCLUSION 8
REFERENCES 9

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INTRODUCTION

Investment appraisal is very vital in every business. There are

different types of investment appraisal methods such as Net present value
(NPV), Internal rate of return (IRR), and Profitability index (PI). These methods
(NPV, IRR, PI) considers the time value of money and are called the Discounted
cash flow techniques. It measures the cash inflows and outflows of a project as
if they occurred at a single point in time so that they can be compared in an
appropriate way. These are the best methods to use for long-run decisions.
Since, IRR and NPV incorporate all the cash flows and time value of money,
these criteria can be used to reflect capital investment proposal’s strategic
orientation.

In the given case, MEX Corporation is considering undertaking two

projects. The two projects will be evaluated using the discounted cash flow
methods to decide on, which project is to be selected.

NET PRESENT VALUE (NPV)

The Net Present Value analyzes the profitability of a project by

discounting all expected future cash inflows and outflows to the present point
in time, using the discount rate (Horngren, et al.,1997). Discount rate is the

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minimum acceptable rate of return on an investment. It is the return that the
organization could expect to receive elsewhere for an investment of
comparable risk.

NPV is a better method of appraising investment opportunities

than Accounting rate of return (ARR) and Payback Period (PP), because it takes
account of the time value of money and also includes all the relevant cash
flows irrespective of when they are expected to occur (McLaney and Atrill,
2002).

Project A

Company’s cost of capital-10%

Discount Factor = 1 / (1+r)n , where ‘ r ’ is the cost of capital.

Discounted cash flows for Project A

Year Cash Flow Amount ($) Discount Factor Present Value ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash Flow 200 0.909 181.8
2 Net Cash Flow 800 0.826 660.8
3 Net Cash Flow (800) 0.751 (600.8)

NPV = ($200) + $181.8 + $660.8 + ($600.8) = $41.8

Project B

Company’s cost of capital-10%

Discounted cash flows for Project B

Year Cash Flow Amount ($) Discount Factor Present Value ($)
0 Initial Cost (150) 1.000 (150)
1 Net Cash Flow 50 0.909 45.45
2 Net Cash Flow 100 0.826 82.60
3 Net Cash Flow 150 0.751 112.65

NPV = ($150) + $45.45 + $82.60 + $112.65 = $90.7

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Appraisal using NPV

NPV is positive when the discounted cash inflows exceed the

discounted cash outflows, and so a proposal is acceptable if it has a positive
NPV. When evaluating two or more mutually exclusive proposals, the one with
the highest positive NPV should be accepted.

In the given case, NPV of ‘Project B’ is much higher than that of

‘Project A’. So, Project B is preferable.

INTERNAL RATE OF RETURN (IRR)

Internal rate of return is another discounted cash flow technique.

It is the discount rate at which the present value of expected cash inflows from
a project equals the present value of expected cash outflows of the project.
That is, IRR is the discount rate yielding a zero NPV (Upchurch, 1998).

Project A

NPV of Project A at 0% discount rate

Year Cash Flow Amount ($) Discount Factor Present Value ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash Flow 200 1.000 200
2 Net Cash Flow 800 1.000 800
3 Net Cash Flow (800) 1.000 (800)
NPV = $0

At 0% discount rate, NPV of Project A is zero.

At 10% discount rate, NPV of Project A is $41.8

So, IRR of Project A = 0%

NPV of Project A at 101% discount rate

Year Cash Flow Amount ($) Discount Factor Present Value ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash Flow 200 0.497 99.50
2 Net Cash Flow 800 0.247 198.0
3 Net Cash Flow (800) 0.123 (98.48)
NPV = ($0.98)

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At 101% discount rate, NPV of Project A = ($0.98)

IRR of Project A=10% + [{$41.8÷ ($41.8 + $0.98)} × (101% − 10%)] = 99%

So, IRR of Project A = 99%

Project B

NPV of Project B at 40% discount rate

Year Cash Flow Amount ($) Discount Factor Present Value ($)
0 Initial Cost (150) 1.000 (150)
1 Net Cash Flow 50 0.714 35.7
2 Net Cash Flow 100 0.510 51.0
3 Net Cash Flow 150 0.364 54.6
NPV = ($8.7)

At 10% discount rate, NPV of Project B is $90.7.

At 40% discount rate, NPV of Project B is ($8.7).

Therefore, the project’s IRR will be between 10% and 40%.

IRR = 10% + [{$90.7 ÷ ($90.7 + $8.7)} × (40% − 10%)] = 37.37%

So, IRR of Project B is 37.37%.

Appraisal using IRR

A project is accepted only if the internal rate of return exceeds

the company’s cost of capital. If it is less than the cost of capital, the project
should be rejected. While evaluating two competing projects, the one with the
higher IRR should be selected.

In the given case, we will get two IRR values for ‘Project A’, and
so this project cannot be evaluated using IRR. Whereas, the IRR of ‘Project B’ is
much higher than the company’s cost of capital, and therefore it can be
selected.

PROFITABILITY INDEX

Profitability index is the total present value of future net cash

flows of a project divided by the total present value of the net initial
investment (Horngren, 1997). It measures the cash flow return per dollar
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invested. It is very useful in choosing among projects when the investment
funds are limited, because it can identify the projects that will generate the
most money from the limited capital available.

Project A

Initial investment = $200

NPV = $41.8

Total present value of future net cash flows = NPV + Initial investment = $241.8

Profitability index = $241.8 ÷ $200 = 1.209

Project B

Initial investment = $150

NPV = $90.7

Total present value of future net cash flows = $240.7

Profitability index = $240.7 ÷ $150 = 1.604

Appraisal using PI

For a project to be selected, profitability index should be greater

than 1. While assessing two mutually exclusive projects, it is better to select
the project, with the higher profitability index, because higher the value more
will be the cash flow to the investment. In the given case, profitability index of
‘Project B’ is higher than that of ‘Project A’, and so ‘Project B’ should be
selected.

COMPARISON OF PROJECT ‘ A ’ AND PROJECT ‘ B ’

PROJECT NPV PI IRR

A $41.8 1.209 0% & 99%
B $90.7 1.604 37.37%

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CONCLUSION

NPV is the technically superior criteria, because IRR is calculated

by trial and error method, and so the results are less precise. Also, IRR do not
consider the size of the investment required and the gain/loss which will result
from undertaking or not undertaking a project. It is therefore difficult to use
IRR for comparing competing proposals, and there is a possibility that both
NPV and IRR will give conflicting indications. IRR is also unable to cope with a
change in the cost of capital during the life of a project. But, NPV can
accommodate such a change. Another problem with IRR is that some projects
may have more than one IRR, which makes it a meaningless criterion while
evaluating that project.

In the given case, Project ‘ A ‘ has got two IRR values. So, IRR
cannot be used for evaluating this project. The other two criteria, NPV and
profitability index are higher for Project ‘ B ‘. IRR for Project ‘ B ‘ is also higher
than the company’s cost of capital.

So, MEX should invest in Project ‘ B ‘.

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REFERENCES

Horngren et al. (1997) Cost Accounting-A Managerial Emphasis, 9th edition,

New jersey: Prentice Hall, p.783-788.

McLaney, E & Atrill, P (2002) Accounting-An Introduction, 2nd edition, London:

Prentice Hall, p.433-441.

Upchurch, A (1998) Management Accounting-Principles and Practice, London:

Financial Times management, p.329-339.