Explore this Free Case Study on capital budgeting and investment appraisal to understand how NPV, IRR, and payback period methods are applied to real-world business decisions. Get expert Assignment Help for Corporate Finance, Capital Budgeting, and Financial Management coursework from experienced academic writers.
Introduction: Capital Budgeting Analysis of Competing Investment Projects
The project evaluation is defined as a systematic and clear evaluation of the different projects so that the most accurate can be selected. In case the most appropriate method is not selected then it will impact the profits of the company to a great extent. The current study is based on Sunshine Coast Pty Ltd which is a manufacturer of construction equipment and after taking feedback they came to know that there are some issues relating to the quality of products, too old system usage and many other issues. The current report will outline the evaluation of the three different projects and ultimately the best will be selected so that performance can be improved.
Main Body
Project Providing The Best Return Based On NPV and IRR
Project A
Net Present Value
| Initial Investment | 1800000 | ||
|---|---|---|---|
| Year | Cash Inflow | Maintenance Cost | Net Cash Inflow |
| 1 | 708000 | 0 | |
| 2 | 1416000 | 380000 | 1036000 |
| 3 | 2124000 | 450000 | 1674000 |
| 4 | 2832000 | 0 | 2832000 |
| 5 | 3540000 | 0 | 3540000 |
| 6 | 4248000 | 0 | 4248000 |
| Year | Cash Inflows | PV Factor @11.20% | Discounted Cash Inflows |
|---|---|---|---|
| 1 | 708000 | 0.899 | 636691 |
| 2 | 1036000 | 0.809 | 837819 |
| 3 | 1674000 | 0.727 | 1217422 |
| 4 | 2832000 | 0.654 | 1852141 |
| 5 | 3540000 | 0.588 | 2081993 |
| 6 | 4248000 | 0.529 | 2246755 |
| Total discounted cash inflow | 6626066 | ||
| Initial investment | 1800000 | ||
| NPV (Total discounted cash inflows - initial investment) | 4826066 |
IRR
| Year | Cash Inflows |
|---|---|
| 0 | -1800000 |
| 1 | 708000 |
| 2 | 1036000 |
| 3 | 1674000 |
| 4 | 2832000 |
| 5 | 3540000 |
| 6 | 4248000 |
| IRR | 72% |
Project A, analyses that the NPV is high and this states that the current project will be beneficial for improving the working of the company. Along with this, the IRR is also 72 % which is very high and this outlines that the rate of return is very effective and the company will be earning a good amount of profit in case they use this project.
Project B
NPV
| Initial Investment | 1098000 | ||
|---|---|---|---|
| Year | Cash Inflow | Maintenance Cost | Net Cash Inflow |
| 1 | 360000 | 120000 | 240000 |
| 2 | 405360 | 108600 | 296760 |
| 3 | 456435 | 98283 | 358152 |
| 4 | 513946 | 88946.1 | 425000 |
| 5 | 578703 | 80496.2 | 498207 |
| Year | Cash Inflows | PV Factor @8.70% | Discounted Cash Inflows |
|---|---|---|---|
| 1 | 240000 | 0.920 | 220791 |
| 2 | 296760 | 0.846 | 251158 |
| 3 | 358152 | 0.779 | 278855 |
| 4 | 425000 | 0.716 | 304418 |
| 5 | 498207 | 0.659 | 328293 |
| Total discounted cash inflow | 1383516 | ||
| Initial investment | 1098000 | ||
| NPV (Total discounted cash inflows - initial investment) | 285516 |
IRR
| Year | Cash Inflows |
| 0 | -1098000 |
| 1 | 240000 |
| 2 | 296760 |
| 3 | 358152.4 |
| 4 | 425000.1 |
| 5 | 498207.2 |
| IRR | 17% |
Further, by analysing calculation relating to project B, it is clear that the expected life of the project is 5 years only and the NPV and IRR are both less in comparison to the other two projects. It is due to the reason that this project is very less risky and because of this the returns are also less.
Project C
NPV
| Initial Investment | 1680000 | |||
|---|---|---|---|---|
| Year | Cash Inflow | Maintenance Cost | Cash Inflow | Net Cash Inflow |
| 1 | 1527763 | 210000 | 1317763 | |
| 2 | 1722552 | 198000 | 1524552 | |
| 3 | 1942178 | 186000 | 1756178 | |
| 4 | 2189805 | 174000 | 2015805 | |
| 5 | 2469005 | 162000 | 820000 | 3127005 |
| Computation of NPV | |||
| Year | Cash Inflows | PV Factor @ 14.40% | Discounted Cash Inflows |
|---|---|---|---|
| 1 | 1317763 | 0.874 | 1151890 |
| 2 | 1524552 | 0.764 | 1164904 |
| 3 | 1756178 | 0.668 | 1172979 |
| 4 | 2015805 | 0.584 | 1176913 |
| 5 | 3127005 | 0.510 | 1595874 |
| Total discounted cash inflow | 6262561 | ||
| Initial investment | 1680000 | ||
| NPV (Total discounted cash inflows - initial investment) | 4582561 |
IRR
| Year | Cash Inflows |
|---|---|
| 0 | -1680000 |
| 1 | 1317763 |
| 2 | 1524552 |
| 3 | 1756178 |
| 4 | 2015805 |
| 5 | 3127005 |
| IRR | 89% |
With further analysis of Project C, it is evident that the project has more IR but less NPV. It might be possible that when the company operates with this project then the profitability is not more as the project is exposed to higher risk. When the risk is high then there are more chances of fluctuation in profitability.
Summary Table
| project A | Project B | Project C | |
|---|---|---|---|
| NPV | 4826066 | 285516 | 4582561 |
| IRR | 72% | 17% | 89% |
With the comparison of both the method and all three projects, it is analysed that based on NPV Project A is better as it provides the highest present value of the case. On the other side, according to IRR, the project recommended is Project C because it has the highest IRR in comparison to other projects which is 89 %. With the evaluation project A must be selected by the company as it has more profit generation and this is assistive in managing the company position well. Project A is preferred over both the other projects because the NPV is higher and also the IRR is good (Sinaga et al, 2023). Moreover, the current project includes moderate risk which is beneficial as there will not be much impact on the profit generation. On the other side, project C has having good NPV and the highest IRR but the exposure of the project to risk is very high. Thus, here the chances of earning profit are impacted and automatically the overall profit might be impacted.
Others Than Financial Aspects That Need To Be Taken Into Consideration
Other than the financial aspect, the most common element which must be considered while selecting the project is risk and return. This is the major element because in case the risk is not evaluated well then corrective actions cannot be taken. This ultimately can impact the overall development of the study (Oke and Conteh, 2020). It is necessary because the company works in environment which is external to their operations and it is necessary for the company to manage the work well. When the exposure to the risk is high then it will impact the work to a great extent.
Other than this the brand reputation is another factor which needs to be evaluated so that the proper decision can be taken. It is necessary for the reason that when the brand value is good then it will be helpful to the company in manage every activity well. When the brand value is good then the consumers will like the product and services of the company (Özekenci and Düzakın, 2023). Thus, it is necessary for the company they effectively try to evaluate the position of the company among the consumers and accordingly, the decision must be taken.
While determining the different estimates Sunshine Coast Ltd must follow the aspects
The calculation of the NPV and IRR depends on the estimates which are made during the study. It is necessary for the reason that when the estimates are not better it will impact the overall working to a great extent. So before estimating the sales and expenses data it is necessary that the Sunshine Coast Pty Ltd must use the estimation correctly. For this, the company must consider the risk associated with every activity and as a result of this, the overall working is improved (Dai et al, 2022). Furthermore, when proper risk is inculcated then it will improve the overall efficiency in a great way. So it is advisable for Sunshine Coast Pty Ltd they consider all the latest marketing trends to be analysed before making the calculations. In case it will not be analysed well then it will impact the calculation of the NPV and IRR. For instance, if the discounting rate used by the company is not by the marketing trends then it will be impacting the overall working capability to a great extent. For example, in the case of project B the discounting rate was 8.70 % and instead of this, the rate estimate was 15 % then the outcome would be different. The net present value will be less in comparison to the earlier value. Thus, it is the responsibility of the company and the investigator they appropriately try to investigate the market changes and try to include these changes in the study so that the work can be managed well and all the latest changes can be included (Adhikari, 2022).
Other project evaluation methods
In case the other methods need to be used then the company can make use of the payback period method. This is a type of method which includes the emphasis on analysing or calculating the total time within which the invested amount will be recovered after deducting all the expenses. This is very necessary for the reason that when the effective type of the method will not be followed then the evaluation of the project will not take place. By using the payback period it is clear that the company can analyse and evaluate the total time after which the company will start earning the profit (Siziba and Hall, 2021). In case the period is more the project will not be viable. Thus, for the payback period, the time needs to be less as then only the project will be more profitable. On the other side, when the project has more payback period then it is not recommended that the company use that project. Also, when successful work needs to be done then it will be assistive to the company in managing the work better.
Payback period
Project A
| Year | Cash Inflows | Cumulative Cash Inflows |
| 1 | 708000 | 708000 |
| 2 | 1036000 | 1744000 |
| 3 | 1674000 | 3418000 |
| 4 | 2832000 | 6250000 |
| 5 | 3540000 | 9790000 |
| 6 | 4248000 | 14038000 |
| Initial investment | 1800000 | |
| Payback Period |
2 |
|
| 0.03 | ||
| Payback Period | 2 years |
Project B
| Year | Cash Inflows | Cumulative Cash Inflows |
| 1 | 240000 | 240000 |
| 2 | 296760 | 536760 |
| 3 | 358152 | 894912 |
| 4 | 425000 | 1319912 |
| 5 | 498207 | 1818120 |
| Initial investment | 1098000 | |
| Payback Period | 3 | |
| 0.5 | ||
| Payback Period | 3 years and 5 months |
Project C
| Year | Cash Inflows | Cumulative Cash Inflows |
| 1 | 1317763 | 1317763 |
| 2 | 1524552 | 2842315 |
| 3 | 1756178 | 4598492 |
| 4 | 2015805 | 6614298 |
| 5 | 3127005 | 9741303 |
| Initial investment | 1680000 | |
| Payback period | 1 | |
| 0.2 | ||
| Payback period | 1 year and 2 months |
With the analysis of all three projects, the best-suited method according to the payback period is Project C. This is because of the reason that in this project all the invested amount will be recovered in 1 year and two months only. However, as it does not include the time value of money and because of this the current basis is not included in the analysis and rather only NPV and IRR are used.
Issues In Considering Other Methods Of Deciding The Project
There are certain issues relating to the use of other methods like the use of the payback period method. The most common issue which is attached to the use of this method is that it ignores the time value of money. It is due to the reason that when the time value will not be used in the study then it will be impacting the overall efficiency to a great extent. Thus, as a result of this, the actual results will not be generated and the project will not be evaluated better. Moreover, when the time value is not included then it implies that the current value is not included (Kalkan, 2023). In simpler terms, time value is defined as the sum of money which is more now as compared to the same amount in the future. It is due to the reason that the value of the money changes with time and it is necessary for the project evaluator they include this aspect in the study. For instance, the project is estimated by considering the current money rate. But it is not necessary that in the future as well the same rate prevails. Thus, it is mandatory for the project manager or the evaluator they try to consider the time value during the estimation only so that the overall working can be improved. Hence, it is the responsibility of Sunshine Coast Pty Ltd
Conclusion
At last, it is concluded that evaluating the project is very necessary as it will include a detailed evaluation of the project and selecting the most effective method. The above study analysed that using NPV was better in comparison to other methods of evaluation. Also, it was recommended to the company that they must effectively undertake compliance with project A as it is more effective in having moderate risk attached to the project and will be profitable to the company well.
References
Books and Journals
- Adhikari, N.R., 2022. Capital Budgeting Technique Used in Nepalese Manufacturing Small and Medium Sized Enterprises. Nepalese Journal of Management Research, 2(1), pp.7-11.
- Dai, H., Li, N., Wang, Y. and Zhao, X., 2022, March. The analysis of three main investment criteria: NPV IRR and payback period. In 2022 7th International Conference on Financial Innovation and Economic Development (ICFIED 2022) (pp. 185-189). Atlantis Press.
- Kalkan, Y., 2023. An Overview of Capital Budgeting Methods. New Frontiers in Social, Human and Administrative Sciences, pp.579-598.
- Oke, O. and Conteh, L.J., 2020. CAPITAL BUDGETING AND FINANCIAL MANAGEMENT IN INVESTMENT DECISIONS: AN ILLUSTRATIVE STUDY. International Journal of Business, Accounting & Finance, 14(2).
- Özekenci, S.Y. and Düzakın, H., 2023. Capital Budgeting Methods Used in Investment Project Evaluation: The Example of Top 500 Industrial Enterprises of Turkey. Fiscaoeconomia, 7(3), pp.2149-2176.
- Sinaga, A.S., Sari, M.M., Hutasuhut, A.A., Zahara, S.T., Amanda, A., Fitri, A. and Caesario, M.A., 2023. Comparison of capital budgeting methods: NPV, IRR, PAYBACK PERIOD. World Journal of Advanced Research and Reviews, 19(2), pp.1078-1081.
- Siziba, S. and Hall, J.H., 2021. The evolution of the application of capital budgeting techniques in enterprises. Global finance journal, 47, p.100504.
