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The Drillago company
Budget analysis techniques are very important particularly when evaluating the need to proceed with a project or not. Some of the technique used are the IRR, where the investors would note the interest return rate of their project. Secondly, the net present value is useful when noting down the value of an investment at the present moment. This requires that the future cash inflows be converted back into present value. Others include the payback period, which is important for investors who have set the time limits for their investments plans. Therefore, this exercise aims at evaluating the evaluation techniques to note their importance when making decisions on whether to invest on a project or not. The three techniques are used in assessing the importance of analyzing the business before investing on it. Thus, critical decisions are therefore made in the end.
Calculate the projects net present value (NPV), is the project acceptable under the NPV technique? Explain.
Calculation and Discussion;
The project NPV is calculate using the below formulas and method, but first we need to find the total present value;
PV=C1/ (1+r) ^n
Therefore, the NPV would be calculated using the cash flows for the 10 year period.
Year cash inflows PV=C1(1+r)n
0 -15,000,000 1 600,000 530973.45 476190.48
2 1,000,000 783146.68 629881.58
3 1,000,000 693050.16 499906.02
4 2,000,000 1226637.46 793501.62
5 3,000,000 1628279.81 944644.78
6 3,500,000 1681114.85 874671.09
7 4,000,000 1700242.58 793352.47
8 6,000,000 2256959.17 944467.22
9 8,000,000 2663078.67 999436.21
10 12,000,000 3535060.18 1189805.01
? PV 16698543.00 8145856.48
NPV = 16698543.00- 15,000,000
=1698543.00 = 8145856.48- 15,000,000
The net present value is obtained by subtracting the present value of the cash flow accumulated for the next 10 years to the initial investment. The initial investment is given as 15 million dollars which implies that the value is supposed to be positive if the investment is showing good results. Meanwhile, a negative NPV shows that the investment is not worth the risk. The rate given at 13% reflects the ability of the business to generate income. Based on the calculation of the project NPV was obtained from the subtraction of the net cash inflows minus the investment
That is = 16698543.00- 15,000,000 = the resultant value is 1698543.00. This is a positive value which implies that the NPV is a profit. Therefore the project is worth investing on and is acceptable. It is acceptable under the NPV technique. The only unacceptable projects are the ones which do not have their NPV exceeding below the 0 mark. So as per the result of net present value, this project is accepted.
Calculate the projects internal rate of return (IRR). Is the project acceptable under the IRR technique? Explain.
The project internal rate of return is calculated using the following formula;
IRR= 0.13 + 1,698,543/ ((1,698,543 – (-6854143.523))* (0.26-0.13)
= 0.13 + 1,698,543/ 8,552,686.52 * (0.13)
= 0.13 + 0.198597598 * (0.13)
= 0.13 + 0.025817688
As per the result of IRR, this project is accepted because the result is 15% which is more than 13%. From the projects evaluation techniques, the best way to select the best project is through the IRR. Large IRR implies that the project return rate is worth the investment. From the calculation using the formula of IRR, the value is found to be 15.58%. The value is higher compared to the 13% set for the project investment. According to the project report, the IRR technique is acceptable since it give a higher value compared to the discounted rate. The IRR technique only allows the projects whose rate of return are less than the discounted rates. Therefore, the project can be affirmatively said that it is just and acceptable based on the IRR.
In this case, did the two methods produce the same results? Generally, is there a preference between NPV and IRR techniques? Explain.
In both the results, that are the NPV and IRR, the project seemed acceptable based on the reports produced. The NPV of the project gave a positive result. Hence, both of the projects are acceptable. Meanwhile, both techniques cannot be used to evaluate the project’s acceptability. One measure is always used in preference to the other. The NPV is easily predictable based on the discounted rate provided. Meanwhile the IRR cannot be used since any project is likely to contain many discount rates. It would be inappropriate to use one discount rate over ten year when the market demands are always fluctuating unpredictably.
The NPV is appropriate and mostly preferred since it can be used to evaluate many projects based on its flexible nature of accepting multiple discount rates. Over the 10 year period, the preferred way of evaluating a project is using the NPV since it can accommodate the multiple discount rates. In the event that the market environment changes such that the IRR is different, the calculation of the NPV would not be affected. That is, in the event that the rate changes on yearly basis, the NPV still uses the same formula to calculate it but the IRR maybe not.
Calculate the payback periods for the project, if the firm usually accepts the projects that have payback periods between 1 and 7 years, is this project acceptable?
In order to calculate the payback period, it would be necessary to note the amount of time it would take for the project to return its investments.
Payback period Year cash inflows Cumulative
1 600,000 600,000
2 1,000,000 1,600,000
3 1,000,000 2,600,000
4 2,000,000 4,600,000
5 3,000,000 7,600,000
6 3,500,000 11,100,000
7 4,000,000 Remains:
15,000,000 – 11,100,000 = 3,900,000
Therefore payback period = 6 + (3,900,000/4,000,000)
= 6+ 0.975
= 6.975 years
The projects is accepted because the payback period results showed that the project need 6.975 years to recover the initial investment which in the acceptance range that firm accept ( between 1 and 7 years).However, the year through which the 15 million is recovered in the end of 6th year of investment. According to the firms policies, the payback period should lie between the 1st and 7th year. This implies that the project would be viable based on the year of set by the firm. Therefore, the project is acceptable due to the success to meet the payback period. Payback period is one of the measures that are useful in evaluating the feasibility of the project.
After the successful completion of the calculations process, the decision was made to finally go ahead and accept this project. The first phase involved assessing through the NPV where it passed. The second phase involves passing it through the IRR technique where it also passed. The third phase (payback technique) passed after success to meet the payback period. Therefore, the project is acceptable. In addition, the comparison between the IRR and the NPV are very useful where the NPV is preferred over IRR due to its flexibility. Through NPV people can perform multiple discount rates. Therefore, the evaluation techniques are very important in decision making.
Case 2 – Encore InternationalIntroduction
The Encore firm is an example of the business that performs but requires some intervention in assessing its potentiality. One of the reasons that require the analysis of the businesses based on the success history to predict its future. The P/E ratios are particularly used in noting the position of the business in terms of share value ratio. In addition, the parameters such as the return rate, the book value, stock value are discussed to assess their importance in the prediction of the business performance. The Encore presents very clear programs following its success of making up to 300 million dollars net worth. The business dreams to have their assets expanded and check the stability in the market. The analysis begins with noting the relevant ratios that help in determining the position of the business. Meanwhile, the company assesses the relevance of return rate in its business performance.
What is the firm’s current book value per share?
The current book value per share is calculated using the below formula;
Book Value per Share =Book value of common stock equityTotal common shares outstanding = 60,000,0002,500,000 = $24
This value also represents the stock value of Encore which the company aims at increasing the value.
What is the firm’s current P/E ratio?
The firms’ current P/E ratio is calculated using the below formula;
Current Price to Earnings Ratio= Price per share of common stockEarnings per Share(EPS) =$40$6.25 =6.4
(1) What is the current required return for Encore stocks?
It is easy to find the current required return using the below formula;
Dt = D0 * (1+g)tD12 = 4.00 *(1+ 0.08)12
= 4.00 * (1.08)12
= 4.00 * 2.5181
= $ 10.07
P2= D2 / (R- g)
= 10.07 / 0.10 – 0.08
= 4.6656 / 0.02
(2) What will be the new required return for Encore stock assuming that the firm expands into European and Latin American markets as planned?
If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? (Note: Use the new required return on the company’s stock here).