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Contents

1. Assignment Part A

Prepare the case, with recommendations to be presented to the Board of Directors of ProGen.
Assess the viability of the project using the NPV, IRR, and Payback methods.





2. Assignment Part B

The IRR rule is redundant as an investment criterion because the NPV rule always
dominates. Discuss this statement giving examples where possible.



3. Conclusion

The IRR rule is redundant as an investment criterion because the net present value (NPV)
rule always dominates it.



4. Bibliography

References














Assignment Part A



This report evaluates the viability for marketing and distribution of genetically engineered soya
seeds developed by a biotechnology firm. The firm will supply seeds and permit ProGen to
market and distribute them under a licence. The evaluation methods used for this proposal are net
present value (NPV), internal rate of return (IRR), and Payback methods.



Assumptions used for this analysis are summarised below

Marketing cost is assumed to be a sunk cost and therefore not included in the calculation

Cash flow will be considered over 5 years as this is the lifecycle of the product

An annual licence fee included at 1M per annum

Capital investment for vehicles 650k is an upfront payment and therefore not discounted

Year 5 will see a cash inflow of 120K assumed a realistic sum for the sale of the vehicles

Assume no tax implications for this project

Opportunity cost is assumed at 900k for rental as this is market value

Assume that a 47K profitability gain for existing products is a realistic forecast

Assumed a 50K reduction in overheads from 750K to 700K as allocated overhead cost of
50k is not incremental to the group.

Analysis will not include depreciation as this is not a cash flow

Working Capital will increase by 1.5M at the start of the project and will reduce back down
at the end of the project.

Assume no inflation

Assume discount rate of 11%









|Discount rate |11% | | |
|0 |(650) |(650) | |
|1 |(1935) |(2,585) |1 |
|2 |(664) |(3,299) |1 |
|3 |(240) |(3489) |1 |
|4 |1414 |(2075) |1 |
|5 |2,500 |425 |0.8 |










Sensitivity Analysis

A discount rate or over 14.7 % would result in a negative NPV
A reduction in net cash over 115m per annum over 5 years would result in a zero NPV

NPV = - 650 + 1773 + 622 + 217 + 1240 + 2122 = 0

1.11 (1.11)2 (1.11)3 (1.11)4 (1.11)5


IRR = - 650 + 1773 + 622 + 217 + 1240 + 2122 = 0

1+IRR (1+IRR) 2 (1+IRR) 3 (1+IRR) 4 (1+IRR) 5

IRR = 14.7%






Evaluation Results and Interpretation



Pay back using discounted cash flow is the number of years needed to recover the initial
investment outlay; in this case it is 4.8 years. 5-year payback rule would mean that the firm
accepts all projects that recover their initial outlay within 5 years. If internally use a 3 year
payback this project would be rejected. This would a missed opportunity given the positive cash
flow in years 4 and 5. Therefore NPV is 425m, which is a better measure. This result
determines that in 4.8 years time with a discount rate 11%, the firm would have generated
additional 425m of shareholder value.







IRR of 15% discount rate gives a net nil of discounted cash flow

IRR - Is a measure of the profitability of a project but not a true measure of the return of a T
period project. An IRR of 15% does not mean that this will generate an annual return of 15%.
IRR of 15% is the equivalent to the discount rate, which gives an NPV of zero.

If IRR is greater than cost of capital it adds shareholder value.





Project Investment Recommendations



The evaluation methods used (NPV, IRR and Payback) conclude that

This investment project could be viable and should be considered by the firm providing the

Firm can support a 5-year payback rule. This investment would require provisions to support the
negative cash flow present in the first 3 years.



If this is acceptable then this investment delivers a NPV positive value of 425 after 4.8 years at
an annual interest rate of 11%.

Need to consider whether this if this is a mutually exclusive project, or if compared to others. If
this project is compared to others then NPV needs to be compared.

A risk to consider from the sensitivity analysis would be that a reduction in net cash over 115m
per annum over the 5 years would result in a negative NPV making the project a non- viable
option. A detailed review of the assumptions would be recommended to ensure the Board are
happy with this level of risk.

End of part A

Assignment Part B



The IRR rule is redundant as an investment criterion because the net present value (NPV) rule
always dominates it. Discuss this statement giving examples where possible.

Capital budgeting is a vital activity by which organisations make long-term investment
decisions. There are different evaluation methods available to assess whether an investment
project is viable.

The net present value (NPV),

Internal Rate of Return (IRR)

will be discussed.

NPV is the difference between the present value of cash inflows and the present value of cash
outflows. The NPV rule of accepting a project if and only if its NPV is positive is based on the
intuitive premise that money today is worth more than the same amount of money
tomorrow. Arya, Fellingham, Glover (1998). The discount rate in the NPV formula is a way to
account for this. Companies have different ways of identifying the discount rate, although a
common method is using the expected return of other investment choices with similar levels of
risk.







Example

Consider gas station A and B under the NPV method, and a discount rate of 10%



Table 2 Gas station A and B

|Investment |Sale Price |CF1 |CF2 |
|A |50,000 |0 |100,000 |
|B |50,000 |50,000 |50,000 |




NPVA = 100,000 / (1+.10)2 - 50,000 = 32,644



NPVB = 50,000/ (1+.10) + 25,000/ (1+.10)2 - 50,000 = 16,115



Under the NPV criteria, the decision favours gas station A as it has the highest net present value.



Textbooks tend to emphasize the NPV rule, often using the argument that it is superior to the
other methods (Kaplan and Atkinson 1989, Zimmerman 1995). Yet other methods, many of
which do not involve discounting are also used in practice.

The NPV disadvantages that McSweeny (2006) paper discusses, states that when wisely used in
the context of appropriate organizational process and analysis NPV procedure can bring benefits
but also points out that when unavoidable uncertainty is suppressed and excessive powers
attributed to it, the consequences can be at best illusions and at worst highly damaging.



Ross (1995) supports this discussion and notes a word of caution when using the NPV rule and
that the following caveat should hold. Undertake projects with a positive NPV only if taking
the project doesnt prevent another competing project from being undertaken because every
investment competes with itself delayed in time.

IRR Redundant discuss

IRR is a measure of the profitability of the capita that remains internally invested from period to
period, and has not yet been recaptured or recovered by the investor. Crean; (2005). IRR's major
limitation can also be its greatest strength: it uses one single discount rate to evaluate every
investment. All other things being equal, using internal rate of return (IRR) and net present
value(NPV) measurements to evaluate projects often results in the same findings.



The discount rate often used in capital budgeting that makes the NPV value of all cash flows
from a particular project equal to zero. The higher a projects internal rate of return, the more
desirable it is to undertake. As such IRR can be used to rank several projects that a firm is
considering. Assuming all other factors are equal among the projects, the project with the highest
IRR would probably be considered the best.



Early research demonstrates support for IRR as a superior evaluation tool. Hansen (1963) in his
study on the profitability of investment in education noted the NPV of lifetime income is
deficient as the benefit cost calculation. Also that ranking educational investments is sensitive to
the choice of discount rate used for PV. He argues that the internal rate of return (IRR) corrects
the above deficiencies and therefore a superior evaluation tool. Other authors have voiced
similar arguments.



Although using one discount rate simplifies matters, there are a number of situations that cause
problems for IRR. If an analyst is evaluating two projects, both of which share a common
discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably
work. The catch is that discount rates usually change substantially over time. Without
modification, IRR does not account for changing discount rates, so it's just not adequate for
longer-term projects with discount rates that are expected to vary.



An example for which a basic IRR calculation is ineffective is a project with a mixture of
multiple positive and negative cash flows. For example, consider a project for which marketers
must reinvent the style every couple of years to stay current in a fickle, market.





Example

If the project has cash flows of -50,000 in year one (initial capital outlay), returns of 115,000
in year two and costs of 66,000 in year three because the marketing department needed to revise
the look of the project, a single IRR can't be used.

IRR is the discount rate that makes a project break even. If market conditions change over the
years, this project can have two or more IRRs; see below.

[pic]

Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are
multiple rates of return for the project that produce multiple IRRs. The advantage to using the
NPV method here is that NPV can handle multiple discount rates without any problems. Each
cash flow can be discounted separately from the others.



Ben-Horn and Kroll (2012) suggests that the problem of multiple IRRs is highly unlikely to
occur in cash flow structures that have basic economic appeal to practitioners. From a practical
point, an investment project should have a positive NPV at zero cost of capital.



Another situation that causes problems for users of the IRR method is when the discount rate of a
project is not known. In order for the IRR to be considered a valid way to evaluate a project, it
must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible;
if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be
applied to a specific project for whatever reason, the IRR is of limited value. In cases like this,
the NPV method is superior.



Plath and Kennedy (1994) discuss the traditional teaching of discounted cash flow measures of
capital project evaluation. The problem being that business school graduates remain
unconvinced that NPV is a superior measure and surveys show a wide use of IRR and increasing
use as the availability of IRR, MIRR algorithms and computer software products make it easier
for analysts with no advanced training to use.



Chen (2012) discusses the Graham and Harvey (2001) survey where 392 CFOs from US firms
were surveyed regarding the practice and cost of capital, capital budgeting, and capital
structure. This survey showed that IRR was most frequently used in capital budgeting at
75.61% as opposed to NPV at 74.93%. Also the size of the firm was relevant; with larger firms
favouring NPV and IRR and smaller firms relatively preferred payback method.





Ryan and Ryan (2002) survey of 250 CF0 found the most preferred technique to be NPV
followed by IRR. This survey also identified that geography was relevant in the decision with
Europe preferring the payback period to NPV or IRR.











Conclusion

The IRR rule is redundant as an investment criterion because the net present value (NPV) rule
always dominates it.



Research evidence supports the popularity of NPV but also shows that NPV is not the only
preferred way to evaluate investment viability. The IRR method is still commonly used in capital
budgeting and its popularity is probably a direct result of its reporting simplicity.





Advantages

NPV advantage is that it is a direct measure of the pound contribution to the stockholders

IIR advantage is that is shows the return on the original money invested





Disadvantages Hazen (2003)

NPV disadvantage is that the project size is not measured.

IRR disadvantage is that at times it can give conflicting answers when compared to NPV for
mutually exclusive projects. The multiple IRR problem can also be an issue





The evidence concludes that both NPV and IRR are popular investment evaluations methods and
both are used despite the disadvantages researched and published. Both are useful and as such
have been described as companions.








-----------------------
Table 1 Discounted Cash flow



|NPV |425 |
|IRR |15% |
|Payback (on discounted cash flows) |4.8 years |

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