Coursework Assignment

Strategic Financial Management

FIRMEX Corporation (PLC):

The data shown in the above table are for two mutually
exclusive project opportunities that a company called FIRMEX 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 Profitability Index for both projects.

3. Calculate the IRR for both projects

Which project should FIRMEX investment 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 Accounting rate of return (ARR), Payback
period (PP), Net present value (NPV), Internal rate of return
(IRR), and Profitability index (PI).

Time is a very essential feature of investment

decisions. ARR and PP do not take into consideration the time
value of money, and do not give an indication of the amount of
capital investment required. The remaining three 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, FIRMEX 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.

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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 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

Ye Cash Flow Amount Discount Present Value

ar ($) Factor ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash 200 0.909 181.8
Flow
2 Net Cash 800 0.826 660.8

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 Flow
3 Net Cash (800) 0.751 (600.8)
Flow

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

Project B

Company’s cost of capital-10%

Discounted cash flows for Project B

Ye Cash Flow Amount Discount Present Value

ar ($) Factor ($)
0 Initial Cost (150) 1.000 (150)
1 Net Cash 50 0.909 45.45
Flow
2 Net Cash 100 0.826 82.60
Flow
3 Net Cash 150 0.751 112.65
Flow

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

Appraisal using NPV

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 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

Ye Cash Flow Amount Discount Present Value

ar ($) Factor ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash 200 1.000 200
Flow

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2 Net Cash 800 1.000 800
Flow
3 Net Cash (800) 1.000 (800)
Flow

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

Ye Cash Flow Amount Discount Present Value

ar ($) Factor ($)
0 Initial Cost (200) 1.000 (200)
1 Net Cash 200 0.497 99.50
Flow
2 Net Cash 800 0.247 198.0
Flow
3 Net Cash (800) 0.123 (98.48)
Flow

NPV = ($0.98)

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

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NPV of Project B at 40% discount rate

Ye Cash Flow Amount Discount Present Value

ar ($) Factor ($)
0 Initial Cost (150) 1.000 (150)
1 Net Cash 50 0.714 35.7
Flow
2 Net Cash 100 0.510 51.0
Flow
3 Net Cash 150 0.364 54.6
Flow
N
PV = ($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.

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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 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

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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%
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, FIRMEX 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.

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