The Dilemma at Day Pro
The Dilemma at Day Pro
1.The payback period can be defined as the length of time it takes before the cumulated stream of forecasted cash flows equal the initial investment (Arnold 2007). By looking at Appendicle A1.0 and A1.1 we can see that the "Epoxy Resin" project has a payback period of 1.5 years while Synthetic Resin has a longer payback period of 2.5 years. On the basis of this methodology we will choose to invest in Epoxy Resin.
Though it is important to understand that payback period cannot be used as a measure of probability, as it does not take into account the cash flows after the payback period, thus making it ineffective. Another drawback to payback period is that it simply ignores the time value of money (Today’s value of a payment is worth less in the future). Also we have to take into account that there is no comparison between future cash flows with primary investment and their present value when it has been discounted, secondly, it has a serious theoretical flaw the most significant being is that it ignores shareholder wealth maximization objective (Mclaney 2003)
One school of thought suggests that Payback period only demonstrates the financial feasibility of the projects technology (Attaran, 1996) and not its profitability. In this situation Tim is looking to determine which project brings maximum wealth to Day Pro, and Payback period cannot do this because it cannot measure wealth.
2.Discounted payback is very similar to the previously discussed payback method but the underlying difference is that it takes into account the time value of money. Appendicle B 1.0 and B 1.1 suggest that Epoxy Resin is the most viable project based on the discounted payback method.
This still should not be used as a deciding factor as it simply ignores all cash flows after the payback period. Gowthrope ( 2008) stated that the weakness of discounted payback is that it provides little useful information. Thus it may lead to the rejection of good wealth creating projects. Another fundamental flaw of discounted payback method is that it can easily ignore the latent energy of the product because it requires an arbitrary cut off value (Arnold 2007).
Payback period drawbacks are not significant where it is to be used to asses relatively short term, lower value projects (Chadwick 2007). In this situation it is vital for Tim to weigh the cost and the benefits of the two proposals and the payback methods cannot simply do this to an extent in which it can maximize the company’s wealth.
3.Accounting rate of return is the ratio of profit before interest and taxation to the percentage of capital employed at the end of a period. Variations include using profit after interest and taxation, equity, capital employed and average capital for the period. (BNET 2005).
The main purpose of ARR is to compare project’s average annual profit with the capital invested. ARR’s weakness is that it does not consider the time of cash flows and the standard of investments. Another flaw with ARR is that it uses profits which ignore the time value of money, but not cash flows. (Investopedia 2008)
Looking at Appendicle C 1.0 we can see that ARR for Synthetic Resin is 64% and 45% for Epoxy Resin. Since the acceptable ARR for both projects is 40% it may be difficult for Tim to make the right decision as both will be generating wealth.
4.The IRR is the discount rate in which NPV becomes zero. The IRR method is compared against a single required rate of return and cannot handle variable rates. (P131, Pike & Neale). The weakness of IRR is that it ignores the scale of the project. (P131, Pike & Neale) In another word, the IRR is just a rate; we cannot compare how much profit the shareholders can get from the case of mutually exclusive projects. The IRR for Synthetic project is 36.99%, and the Epoxy project is 43.16%. The NVP for Synthetic project is 903021, and the Epoxy project is 562214, so even though Synthetic project has a lower IRR than Epoxy Resin project, NPV contradicts this and thus we must analyze this even further.
IRR could be misleading in deciding the mutually exclusive projects but we still must take it into consideration as it can consolidate our decision if it has no conflict with NPV.
5.NPV is a very strong tool that can be used to determine the potential wealth generated from a project; this is done by accumulating the sum of all the cash flows and discounting them with the relevant discount factor (E1.0 & E1.3). What makes NPV a powerful tool is that it address the fact that £1 today is worth in the future.
The rule is that all positive NPV investments enhance shareholders wealth, the greater the NPV, the greater the shareholders wealth is enhanced. (Eddie M. 2003) Looking at Appendices E1.0 we can see that Synthetic Resin has a higher NPV and so we should choose to accept this project as it generates more wealth. Though there is a raking conflict that exists between NPV and IRR and we must use the crossover point to resolve this dilemma.
The crossover point helps us dispute the IRR and NPV raking conflicts. Since we can only choose one project as they are mutually exclusive and the NPV method tells us to accept the Synthetic Resin project while IRR tells us to pick Epoxy Resin we can use the crossover point to come to decisive conclusion. Firstly the reason that this occurs is because of the reinvestment rate assumption, meaning that IRR and NPV’s assumption is based on the fact that cash flows will be reinvested at a given rate regardless what is done with the cash flows, and inherently NPV assumes that projects can be reinvested at the cost of capital while IRR assumes reinvestment at the IRR rate. (Dryden Press 1996)
Mathematically speaking, conflict will occur when the discount rate is set below the crossover point which in this case is 29.17%. (Baker 2006)
6.For the mutually exclusive projects MIRR is predominantly more accurate. MIRR is the rate of return which, when the initial outlay is compared with the terminal value of the project’s net cash flows reinvested at the cost of capital, gives an NPV of zero. (Pike & Neale, p138) IRR is based on the cash flow in batches, the cash flow can be used to reinvest with same IRR. Though some investors would choose to save the cash flow returns in their bank, or have a higher return from another investment.
Now, the IRR for Synthetic project is 36.99%, and the Epoxy project is 43.16%. Assume that the return cash flow is saved in bank with an interest rate of 5% (Refer to Appendices F1.0 example 1) would produce an MIRR of 19.29%. Now also assume that the manager finds an investment rate of return 50% which is higher than both of the projects before he gets the return cash flow would then give us an MIRR of 47.38% (Refer to Appendices F1.0 example 2).
MIRR considers the return rate of re-investment is also the same rate with the return rate. On the other hand, in a realistic environment, the re-invest rate can be higher or lower than the original return rate. We must also consider the total amount of return in the project and the return rate of the re-investment. In this case, if the re-investment rate is low, the manager should accept Synthetic project. If the re-investment rate is higher than the original rate, the manager should accept Epoxy project.
7. Profitability index (P.I) is another way for showing the value of cash flows. The values which we have worked out for project A and B (Appendices G1.0) indicates the value of wealth generated per £1, for example in our situation Project A has a P.I of 1.903 so that means for every £1 invested £1.903 of wealth is generated. There is two general rules about the P.I value given, if the value is greater than 1 then the project is favourable and wealth generating, and should be accepted or considered, and if the value of the P.I is less than 1 then it indicates that it is non wealth created and should be rejected.
By using profitability index it may be easier to decide which project to accept, as it is much simpler to compare both ratios given from each investment projects. By ranking them we can see project A is the better wealth creating of the two projects, as it has the highest P.I value. However with both projects project a positive NPV and profitability index, and does not lead to a clear cut decision for Day pro, but favours project A to be accepted. Also to take into account a major problem with selecting Profitability index as a deciding method is that the profitability index uses discount rate, without knowing the riskiness of the project the NPV values will change (McLean 1997).
8.NPV is very sensitive to changes in cash flows during initial periods. A higher cash flow in the opening periods in conjunction with a low discount rate leads to a higher NPV.
If we use the previous NPV calculations which use a discount rate of 10% we can see that Synthetic resin has a higher NPV then Epoxy Resin, but if we introduce a discount rate of 40% the Epoxy Resin projects a higher NPV and the Synthetic Resin project shows a negative NPV (-£64,348).
Line Graph showing correlation between discount rates and NPV in relation to initial period cash flows.
Calculations can be seen in appendix H1.0
We can see that a discount rate higher than 29.17% would cause Epoxy Resin to have a higher NPV than Synthetic Resin. The reason for this is the Synthetic Resin project has a lower rate of profit during the first three years (including the initial investment) compared to the Epoxy Resin project, combined with a higher discount rate (30%) would further reduce the NPV of the Synthetic Resin project thus Epoxy Resin will appear to have a higher NPV. (Baker 2006)
We can now see that the NPV value has increased due to the Profits appearing earlier. The reason for all of this is simply because the time "value of money", the £700,000 cash flow for the Synthetic Resin project in year seven would not have the same value as it does today, thus reducing the projects appeal and having a negative impact on the projects financial incentive.
9. This situation can impact almost all of what we have analyzed. For one the payback period, one of the first things we looked at, when we look at payback period, we look at the initial outlay and cash flow, Synthetic resin is likely to incur additional cost due to its extensive development this could mean that its initial outlay will be greater than expected, thus the figures that we have now may not be accurate. Right now payback period is 2.5 years, let’s assume that initial outlay increases to £1,500,000 this would then increase payback period to 3.61 years. And like wise for epoxy, its initial outlay maybe lower because it’s ready straight away, so the return can be shorter than expected.
The Discount rate which is being used also effects the true value of each project, Epoxy being ready of the shelf, could imply that there is less risk involved, and at the current 10% this could mean that it’s too high, which makes it favorable, alternatively the synthetic resin with its required of development means that it has a greater risk, and at only 10% can be seen to be too low.
The extensive development has no specific mention on time required, it could be anything from 1month to 3 years, and this will have implications on the cash flow for synthetic resin, for example they receive no money in years1 to 3 but start from year 4(Appendicle I1.1). This would then make Epoxy Resin instead.
10. This sensitivity analysis will determine how sensitive our NPV is to two key variables "Discount Rate" and "Initial outlay". From the tables below we can see that discount rate
effects NPV at a greater degree.
It is evident that NPV is highly sensitive to the discount rate. If we take these "What if scenarios" to the extreme and determine our boundaries and best case scenarios, we will be able to see what is the maximum initial investment and discount rate that we can cope with. Using the same line chart that we used to show the break-even NPV (Crossover Point)
We can see that anything higher than 36.63% for Synthetic Resin and 42.91% discount rates will predominantly cause a negative NPV. We can also see that from our sensitivity analysis that a 5% increase in the NPV leads to an 22.59% decrease in the NPV while a 5% decrease leads to a 34.14% increase in the NPV with similar results for the ER leads us to a conclusion that a favorable change in the discount rate leads to a higher rate of wealth.
The sensitivity analysis provided us with evidence that a slight change in the initial investment did not make major changes; this diagram will illustrate the extremes and the lows.
Correlation between NPV and Initial outlay
Excel Calculations can be found in Appendices J1.1
The worst case scenario would be an initial outlay higher then £1,903,021.40 (Appendices J1.1) for the SR project would produce a negative NPV and an initial outlay higher then £1,362,214.45 for the ER project would produce a negative NPV.
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