Financial report
Each alternative has been evaluated quantitative, qualitative factors have not been taken into consideration.
1.1 introductions
APL has been facing a problem of lack of capacity of storage of its products as well as industrial disputes. This has reduced profitability as well as destroying the reputation of the company because customers are running away because the products are not supplied on time, being in a business of oil refinery the company requires a large storage capacity as well as a well maintained transport system which will allow customers to come in and come out of the storage facility easily. This requires a huge investment in terms of storage capacity, transport system in a form of a rail, and good administrative building. Without this the company will continue experiencing problems of storage in adequate supply to customers, cancellation of orders, and other internal disputes which may reduce shareholders wealth and incapacitate the companies operation. In order to solve this problem the company needs to evaluate three alternatives proposed by distribution department of the company.
The purpose of this case study is to discover which of the three alternatives could experience little cost in terms of net present value over a period of useful life. The intention of the investor is to put the capital on the alternative with the hope of recovering the invested money after its usefulness, if all things being equal (Mishkin, 2007).
In analyzing this case three approaches will be used. The three alternatives will be taken as mutually exclusive projects which cannot be taken at the same time. Therefore, the net present value, Internal Rate of Return and equivalent annual annuity will be the best approaches to solve the problem.
The net present value is defined as the present value of future cash flows discounted at the projects cost of capital minus the initial net cash outlay for the project. Projects with a positive NPV should be accepted negative NPV projects should be rejected. If two projects are mutually exclusive, the one with the higher NPV projects should be accepted. The cost of capital is the expected rate of return on projects of similar risk.
In mathematical terms, the formula for net present value is
NPV I0 n Xt______
t1 (1 k)t
Where
I0 the initial cash investment
Xt the net cash flow in period t
K the project s cost of capital
N the investment horizon
The net present value works for projects of any length. By subtracting the initial investment form the projects present value, you could calculate NPV directly, as in the following equation, where C0 denotes the initial cash outflow required to build the office block.
NPV C0 C1 C2___ C3____
1 r (1 r)2 (1 r)3
This equivalence should be no surprise, since the present value calculation is designed to calculate the value of future cash flows to investors in the capital markets.
In that case we would discount C1 by r1, the discount rate for 1-year cash flows C2 would be discounted by r2 and so on. Here we assume that the cost of capital is the same regardless of the date of the cash flow. We do this for one reason only-simplicity. But we are in good company with only rare exceptions firms decide on an appropriate discount rate and then use it to discount rate and then use it to discount all cash flows from the project.
The first two steps in calculating NPVs forecasting the cash flows and estimating the opportunity cost of capital- are tricky, and we will have a lot more to say about them in later chapters. But once you have assembled the data, the calculation of present value and net present value should be routing. Here is another example.
Annual equivalent value (AEV) method
In a choice between machines with different lives, we assume that each machine is replaced in the last year of its life. For the purpose of analysis, the replacement chains of the machines can be assumed to extent periods of time equal to the least common multiple of he lives of the machines.
The method for handling the choice of the mutually exclusive projects with different lives can become quite cumbersome if the projects lives are very long. The problem fortunately can be handled by a simpler method. We can calculate the annual equivalent value of cash flows of each project. We shall select the project that has lower annual equivalent cost.
AEV NPV______
Annuity factor
Internal rate of return - The Internal Rate of Return (IRR) is an indicator for the efficiency or quality of an investment, as opposed to the NPV which indicates value or magnitude. The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e., the HYPERLINK httpen.wikipedia.orgwikiYield_28finance29 o Yield (finance) yield on the investment. Put another way, the internal rate of return for an investment is the discount rate that makes the net present value of the investments income stream total to zero.
A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternate investments of equal risk. Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium. In general, if the IRR is greater than the projects HYPERLINK httpen.wikipedia.orgwikiCost_of_capital o Cost of capital cost of capital, or HYPERLINK httpen.wikipedia.orgwikiHurdle_rate o Hurdle rate hurdle rate, the project will add HYPERLINK httpen.wikipedia.orgwikiValue_28economics29 o Value (economics) value for the company.
2.11 Background and comparisons of alternatives
The company, an oil refinery company wants to expand their capacity by looking at three alternatives. Alternative one is to sell the existing equipment purchase a new land and install new storage tanks which will require a wharf a pipeline which will be constructed at the cost of
Storage tanks 1,725,000
A pipeline 40,000
A wharf 2,000,000 and new
Gantries 650,000
The second alternative for the company is to sell the existing equipment to a company and lease it back. In this case they will not construct a wharf but they will need to construct a pipeline from the new facility to the oil refinery. In this case, the company will purchase and install a new storage tanks at a cost of 1,725,000 they will also need a pipeline connecting the two places at a cost of 2,000,000 Gantries will be required and will cost 650,000.
The last alternative for the company will be to the existing facility but will be forced to construct a rail and sliding which will connect the facilities.
2.12 Internal Rate Return
The Internal Rate of Return (IRR) is an indicator for the efficiency or quality of an investment, as opposed to the NPV which indicates value or magnitude.
The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e., the HYPERLINK httpen.wikipedia.orgwikiYield_28finance29 o Yield (finance) yield on the investment. Put another way, the internal rate of return for an investment is the discount rate that makes the net present value of the investments income stream total to zero.
A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternate investments of equal risk. Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium. In general, if the IRR is greater than the projects HYPERLINK httpen.wikipedia.orgwikiCost_of_capital o Cost of capital cost of capital, or HYPERLINK httpen.wikipedia.orgwikiHurdle_rate o Hurdle rate hurdle rate, the project will add HYPERLINK httpen.wikipedia.orgwikiValue_28economics29 o Value (economics) value for the company.
This project will not have internal rate of return
2.13 Results
In this case this projects will be analyzed using the excel spreadsheet to arrive at the net present value which will be used in the analysis. All the three alternatives are estimated to contribute equally to the success of the company. Alternative B has the lowest cost in terms of net present value.
One of the APL was making investment projects by construction of the storage tanks. NPV calculations are only as good as the underlying cash-flow forecasts. The well-known pentagon law of large projects states that anything big takes longer and costs more than youre originally led to believe. As the law predicted, the tunnel proved much more expensive to build than anticipated in 1986, and the opening was delayed by more than a year. Revenues also have been below forecast, and storage has not even generated enough profits to pay the interest on its debt. Thus, with hindsight, the tunnel was a costly negative NPV venture.
as shown below
Alternative Net present valueComment Alternative A -32961572nd Alternative B -3110592 1st Alternative C -4,838717 3rd
Using this criterion alternative B will be acceptable.
To choose alternatives with different lives, one assumes that each alternative is replaced in the last year of its life. For the purpose of analysis, the replacement chains of the alternatives can be assume to the periods of time equal to the least common multiple off the lives of the alternatives.
The method for handling the choice of the mutually exclusive projects with different lives can become quite cumbersome if the projects lives are very long. Annual equivalent value of cash flows off each alternative. One accepts the project that has lower annual equivalent cost. The present value of cash flows alternatives A is -3,296,157. If one is to exchange this lump sum with a 20-year annuity starting after one year. The annual equivalent value of Alternative A cash flows is
AEV NPV_______
Annuity factor
-3,296,157 (526,602)
6.2593
The annual equivalent value of Alternative B cash flows is
AEV NPV_______
Annuity factor
- 3,110,592 (481,210)
6.4641
The annual equivalent value of Alternative C cash flows is
AEV NPV_______
Annuity factor
- (4,838,717) (773,044)
6.2593
The annual equivalent cost of Alternative B is lower than Alternative A and Alternative C therefore, it should be accepted. Normally one assumes that projects can be replicated at constant scale until they at par in terms of years, we imply that an annuity is paid at the end of every n years starting from the first period.
One can summarize the decision criterion for choosing from mutually exclusive projects with unequal lives as follows calculate the real annual equivalent value of each project, and go for the alternatives with the least real annual equivalent value. This criterion is based on the premise that each asset will be replaced with an identical asset. However, if the assets are vulnerable to technological changes, this simple rule will not work, and the decision may not be optimal. In such cases, the analysis should consider the future investment opportunities, and the decision may be made on the basis off the NPV of projects accept the project with lowest net present value of costs, or in case of revenue-generating projects, the project with the highest NPV.
The company may carry out investment analysis to indicate that some of the profitable projects may be more valuable if undertaken in the future. It may also be revealed that some of the unprofitable projects may yield positive NPVs if they are accepted later in their useful live. These categories of investment projects may have different degrees off postponability some of them may be postponed at the most to one or two periods, while a few may be undertaken any time in mutually exclusive alternatives undertake investments.. The firm should determine the optimum timing of investment.
The timing off investment may be a critical factor in case of those investment projects, which occur once in a while and those, which are of importance to the firm. Such projects cannot be deferred for long. Postponability also creates uncertainty. For example, the NPV analysis may show that a firm should introduce a new product next year. The firm may have a corporate strategy of remaining market leader in introducing new products. If it anticipates that its competitors will introduce the product this year if it does not, it may come up with the product this year to remain the market leader. Also for the reason of unanticipated competition from unknown quarters the firm may decide to introduce the product now.
How do we decide the optimum timing of an investment project. The rule is straightforward undertake the project at that point of time, which maximizes the NPV.
An alternative way of approaching the timing problem is to ascertain the next value as of each alternative period when the investment can be undertaken compare the present value of alternative periods. It is noticeable that the firm will make more money as investment is deferred to one or two periods. But the objective of the firm should be to choose that period for undertaking investment which maximizes the NPV.
3.1 Conclusion
From the analysis carried out above that alternative B is the best has it has the lowest NPV of cost and lowest annual equivalent value among the three alternatives, and its value in the next 20 years (Helfert, 2001 Bragg, 2006). On the other hand, investing on alternative A and C would end up in disaster, as the capital invested would lose its value with a higher AEV of cost (Lake, 2000 Fridson, 1996).
They should invest in alternative B as it will increase the shareholders value in both the capital expenditure manual criteria and recalculated NPV. The company stands to gain main from the investment in B rather than other alternatives.
Categories:
0 comments:
Post a Comment