Managerial Finance Task 2: Project Evaluation - RWE Enterprises

Managerial Finance Task 2: Project Evaluation

Table of Contents
Part1: Project evaluation of RWE Enterprises.............................................................................2
A. Cash Flow of concerned project........................................................................................2
B. Explain Net present value.................................................................................................3
C. Calculate the internal rate of return and profitability index..............................................5
D. Calculate the payback period............................................................................................8
Part B: Evaluation of Projects......................................................................................................9
I. Determinate Payback period, net present value and internal rate of return..........................9
II. Evaluation of acceptability of the two projects...............................................................12
III. Rank the two projects and make a recommendation.......................................................14
References:....................................................................................................................................16

Part1: Project evaluation of RWE Enterprises
A. Cash Flow of concerned project
Cash flow: cash flow can be defined as a flow of cash from the activities of an organisation. All
transactions which affect the cash balance of a company included in cash flow statement.
Cash flow diagram of a concerned project denotes all possible outflows and inflows from a
project. The following table denotes the cash inflow and outflow of the project which is
concerning the RWE limited.
Particulars Amounts (AUD)
Initial Investment of project or outflow at o
year -3000000
Return in 1st Year 700000
Return in 2nd Year 700000
Return in 3rd Year 700000
Return in 4th Year 700000
Return in 5thYear 700000
year 5 ( investment at the end of 5th year) -2000000
Return in 6thYear 700000
Return in 7thYear 700000
Return in 8thYear 700000
Return in 9thYear 700000
Return in 10thYear 900000
Note: it is noted that at the end of 5th year, the company has to invest an additional amount of 2
million to continue the inflows from the project. Also at the end of project life, the company will
receive an additional amount from the scrape of machinery and other equipment so inflow of 10th
year will be 700000 + 200000 (Inflow + scrape value) = 900000.

B. Explain Net present value
Definition: In the context of an investment project, net present value can be defined as the
difference between present value of investment amount and the present value of possible
inflows.
A Fact about the money is that one dollar will not be able to purchase that thing after ten years
which it is able to purchase in current time and NPV is used to compute this difference (Weber,
2014). A reduction in the value of money arises due to the inflation rate and such inflation rate
decreases the buying power of money.
NPV has a solution for the same. Selection of a project generates outflow of resources in the
current year but possible benefits from selected project receive in subsequent years. So it is
necessary that organisation should calculate the NPV of the project to find out the profitability of
a project according to the inflation rate.
NPV = Present value of Investment (-) Present value of cash inflows
Advantage of NPV:
 To find the risk of an investment option (Woodruff, 2018)
 To find the profitability of a project according to the Time value of money.
 It clearly shows the value to be gained by the project so management can give an
explanation to the stakeholders on the basis of logical reason.
 Mostly cost of capital rate is used as a discount rate so it provides prevent from less
profitable investment options.
Disadvantages of NPV:
 All possible cash flows are estimated and there is no logical assurance about the receipt
of benefits.
 NPV is not a suitable measurement in that situation when investment value of two
projects different.
 NPV is also not suitable in the case of projects have different inflow life. For example, a
project with useful life five years and another project with useful life twenty years cannot
be appropriately measured on the basis of net present value (Woodruff, 2018).

NPV of the project of RWE:
Particulars Amounts $
NPV
factor NPV
Initial Investment of project -3000000 1 -3000000
Inflow in 1st Year 700000 0.9090909 636363.6364
Inflow in 2nd Year 700000 0.8264463 578512.3967
Inflow in 3rd Year 700000 0.7513148 525920.3606
Inflow in 4th Year 700000 0.6830135 478109.4188
Inflow in 5thYear 700000 0.6209213 434644.9261
year 5 (investment at the end of 5th year) -2000000 0.6209213 -1241842.65
Inflow in 6thYear 700000 0.5644739 395131.751
Inflow in 7thYear 700000 0.5131581 359210.6828
Inflow in 8thYear 700000 0.4665074 326555.1661
Inflow in 9thYear 700000 0.4240976 296868.3329
Inflow in 10thYear 900000 0.3855433 346988.9605
Net present value 136462.9858
NPV is used to find the present value of profitability of a project. NPV may show following
three situations
 Positive NPV: positive NPV means the project is acceptable
 Negative NPV: negative NPV means the project will be rejected (Magni, and Martin,
2017)
 NPV ZERO: it shows the break-even situation.
In above situation, net present value of the project is positive and a project with positive NPV is
acceptable. So RWE can accept the project after considering other aspects of the project.
C. Calculate the internal rate of return and profitability index
Internal rate of return (IRR): internal rate of return is a capital budgeting technique utilised by
the investment and project managers to evaluate the profitability of a project. IRR can be defined

as a break-even rate at which gaining ability of a project becomes zero (Benerjee, 2015). IRR
provides help to investors to measure the profitability of projects on the basis of their yield. It is
a rate which reports the minimum return rate to earn the cost of a project.
Some Advantages of IRR:
 IRR addresses the return on actual investment and ignores repayment assumptions.
 Calculation of Cost of capital does not require.
 Shows Break-even and useful to determinate the profitability.
 Includes risk assessment.
IRR of project of RWE:
Particulars Amounts $
NPV
factor NPV
Initial Investment of project -3000000 1 -3000000
Inflow in 1st Year 700000
0.909090
9
636363.636
4
Inflow in 2nd Year 700000
0.826446
3
578512.396
7
Inflow in 3rd Year 700000
0.751314
8
525920.360
6
Inflow in 4th Year 700000
0.683013
5
478109.418
8
Inflow in 5thYear 700000
0.620921
3
434644.926
1
year 5 (investment at the end of 5th
year) -2000000
0.620921
3 -1241842.65
Inflow in 6thYear 700000
0.564473
9 395131.751
Inflow in 7thYear 700000
0.513158
1
359210.682
8
Inflow in 8thYear 700000 0.466507 326555.166

4 1
Inflow in 9thYear 700000
0.424097
6
296868.332
9
Inflow in 10thYear 900000
0.385543
3
346988.960
5
Net present value
136462.985
8
Internal rate of return 11%
Above IRR represents that a minimum return of 11% is must to achieve the break-even target of
concern project. If above project provides return rate more than 11% it would be acceptable for
the RWE enterprises and if the project provides return less than 11% it would be rejected.
Some disadvantages of IRR:
 Not considers the size of the project.
 More suitable in the case of similar cases.
 It does consider future possible costs which may affect the profitability of the project.
Profitability index: profitability index is also an investment measurement tool utilised by the
investment managers to investigate the relationship between the cost of project and incomes of
the project. It is also known as profitability investment ratio or value investment ratio (Hanks,
2018). This tool measures the suitability of a project on the basis of several factors so that an
organisation can select appropriate investment option.
Profitability Index:
Net present value of project + Amount of initial investment + PV of future cost
amount of Initial investment + PV of future cost
136462+3000000+1241842
3000000+1241842

1.032
Selection of project: profitability index gives ranks to projects according to their profitability
and with the help of this tool investor can choose a highest profitable project. In the case of a
single project, a project with more than one PI will be accepted and a project with less than one
PI will be rejected. In concerned case, PI index of the project is 1.03 which is more than one PI
thus, RWE can accept the project.
Some merits of profitability index:
 Includes time value of money.
 Considers all cash flows.
Limitations of profitability index:
 Not useful in the case of indivisible projects.

D. Calculate the payback period
Definition: payback period is a basic tool of capital budgeting to investigate the gaining ability
of an investment option. Payback period shows the time which is required to an investment
option to gain the initial cost of the project (Erményi, 2015). Recovery of cost of a project is
must to ensure the security of capital from loss and payback period is a best suitable tool to
measure the same.
Need of Payback period: availability of fund is a crucial matter for every business organisation
and if a business organisation manages its funds appropriately it will save the cost and improve
the profit for the organisation. On the basis of payback period, an organisation can easily identify
the future liquidity to ensure the barrier-free operation of the business.
Payback period:
Amount of Inicial investmant + PV of cost incurred at the end of 5 th year
Annual cash flow
3000000+ 1241842
700000
= 6.05 years.
It is finding that the P.B. period of the concerned investment project is 6.05 years so RWE
limited will cover the initial cost of the project in 6.05 years.

Part B: Evaluation of Projects
I. Determinate Payback period, NPV and IRR.
Net present value: NPV is an investment appraisal technique which calculates the net
profitability of investment options after considering time value factor. Net present value is
calculated as follows
NPV = Amount of initial investment (-) Present value of future incomes
Internal rate of return: it is also an investment appraisal technique which is utilised in the
measurement of profitability of investment options. It is a rate which makes the NPV of a project
Zero it means it reports break-even rate.
Payback period: payback period is a period of time in which enterprises will recover its initial
cost of investment.
Project ‘A’ Discounting rate: 12% (NPV and IRR)
Particulars Amount $ PV Factor Present Value
Initial Investment of project -275000 1 -275000
Inflow in 1st Year 50000
0.89285714
3 44642.85714
Inflow in 2nd Year 75000
0.79719387
8 59789.54082
Inflow in 3rd Year 100000
0.71178024
8 71178.02478
Inflow in 4th Year 125000
0.63551807
8 79439.7598
Inflow in 5thYear 175000 0.56742685 99299.69975

6
NPV 79349.88229
Internal Rate of Return 21%
Payback period:
Particulars Amount $ cumulative
Inflow in 1st Year 50000 50000
Inflow in 2nd Year 75000 125000
Inflow in 3rd Year 100000 225000
Inflow in 4th Year 125000 350000
Inflow in 5thYear 175000 525000
Payback period: recovery year' s previous year + Remaining cost
cash inflow ∈next year
: 3+ 50000
125000 = 3.4 years.
Project ‘B’ discounting rate: 12% (NPV and IRR)
Particulars Amount $ PV Factor Present Value
Initial Investment of project -275000 1 -275000
Inflow in 1st Year 100000 0.89285714 89285.71429

3
Inflow in 2nd Year 100000
0.79719387
8 79719.38776
Inflow in 3rd Year 100000
0.71178024
8 71178.02478
Inflow in 4th Year 100000
0.63551807
8 63551.80784
Inflow in 5thYear 100000
0.56742685
6 56742.68557
NPV 85477.62023
Internal Rate of Return 24%
Payback period: Project ‘B’
When a project has same cash inflows throughout the life payback period should be calculated as
below:
Particulars Amount $
Return in 1st Year 100000
Return in 2nd Year 100000
Return in 3rd Year 100000
Return in 4th Year 100000
Return in 5thYear 100000
Payback period (Investment cost / Cash
inflow) 2.75

II. Evaluation of acceptability of the two projects
Several investment options are always available to business enterprises and selection of
appropriate investment option ensures the sustainable success for the organisation and works like
a safeguard for capital (Hanks, 2018). Capital projects require a heavy investment of funds and
time and if an organisation chooses inappropriate investment options it will directly affect the
financial position. To avoid this situation, capital budgeting provides various investment
appraisal techniques which are very useful to investigate the appropriateness and profitability of
concerned projects and assists investment managers in decision-making.
Selection process of the company includes three conditions:
i. Payback of Project should be less than three years.
Payback period is used to calculate the minimum time in which a company can recover its initial
cost amount of investment. Recovery of the cost is the main object in business operations
because it ensures the continuity of operations (Merritt, 2018). Breakeven is a better situation

than loss and payback period helps to find out the period of cost recovery for the same purpose.
Another good thing about payback period is that it includes the assessment of risk also so
investment managers can easily manage the risk associated with projects. In the present case,
project ‘A’ has a PB period of 3.4 years and project ‘B’ has a PB period of 2.75 years. As per the
selection criteria, Company should choose Project ‘B’ because it is providing recovery of cost in
less than three years.
ii. Project with positive NPV:
NPV is used to calculate the aptness of a project on the basis of the present value of possible
incomes. This technique also considers the time value of money during the measurement of
profitability of projects (Magni and Martin, 2017). The buying power of money will be reduced
in the future due to inflation and NPV provides a solution for the same. It uses present value
discounting factors to calculate the suitability of projects. In the present case, both projects have
positive net present value and both are independent but NPV of ‘B’ project is more than ‘A’
project so the company should choose project ‘B’.
iii. IRR more than discounting rate:
IRR is also an investment appraisal technique which marks that rate of return at where the NPV
of the company become Zero. IRR is used to find the breakeven situation and attractiveness of
concerned project (Hanks, 2018). In the current situation, both projects are reporting higher IRR
in the comparison of company’s discount rate but project ‘B’ is reporting 24% IRR which is
more than 21% reported by project ’A’. So the company should choose project ‘B’.
Summary:
Particulars NPV IRR Payback (years)
Project A 79349 21 3.4
Project B 85477 24 2.75
Above table shows that Project ‘A’ does not comply with all three selection criteria so only
project ‘B’ is acceptable

III. Rank the two projects and make a recommendation
In the case of capital decision-making, Projects are ranked according to their profitability and
suitability for the organisation (Li, 2017). Capital budgeting technique provides a logical solution
for this purpose. The company can use profitability index method to rank the projects according
to their profitability.
Profitability index or investment ratio is used to rank the projects according to the gaining ability
of investment options.
Particulars Project A Project B
Income present value of inflow present value of inflow
Year 1 income 44642.85714 89285.71429
Year 2 income 59789.54082 79719.38776
Year 3 income 71178.02478 71178.02478

Year 4 income 79439.7598 63551.80784
Year 5 income 99299.69975 56742.68557
Total NPV 354349.8823 360477.6202
Investment 275000 275000
profitability index
formula
Present value of
incomes/Investment
Present value of
incomes/Investment
PI 1.288545027 1.31082771
Rank 2nd 1st
Both projects are mutually exclusive so if company choose one project other will be
automatically rejected. If the selection of projects is made on the basis of profitability index, a
project with more than one PI will be accepted. In the current case, both investment options have
PI more than one so both projects are acceptable but these projects are mutually exclusive so the
only best project should be chosen and project ‘B’ has higher PI so project ‘B’ would be
accepted.
Profitability index is a good base to measure the aptness of a project but a company cannot make
a selection of investment option only on the basis of the PI index ranking system (Imegi and
Nwokoye, 2015). Many other factors like risk assessment, possible changes in inflow due to
macro factors, human resource factors are also should be considered during the selection process
to secure a well future for the company. In the current case, project ‘B’ is more suitable for the
company on the basis of all investment appraisal techniques so the overall conclusion is that
company should choose project ‘B’.

References:
 Woodruff, J., 2018. Advantages & Disadvantages of Net Present Value in Project
Selection. [online] Smallbusiness.chron.com. Available at:
http://smallbusiness.chron.com/advantages-disadvantages-net-present-value-project-
selection-54753.html [Accessed 7 May 2018].
 Lanctot, P., 2018. The Advantages and Disadvantages of the Internal Rate of Return
Method. [online] Smallbusiness.chron.com. Available at:
http://smallbusiness.chron.com/advantages-disadvantages-internal-rate-return-method-
60935.html [Accessed 7 May 2018].
 Gabriel Filho, L.A., Cremasco, C.P., Putti, F.F., Goes, B.C. and Magalhaes, M.M., 2016.
Geometric Analysis of Net Present Value and Internal Rate of Return. Journal of Applied
Mathematics & Informatics, 34, pp.75-84.

 Weber, T.A., 2014. On the (non-) equivalence of IRR and NPV. Journal of Mathematical
Economics, 52, pp.25-39.
 Benerjee, S., 2015. Contravention between NPV & IRR Due to Timing of Cash Flows: A
Case of Capital Budgeting Decision of an Oil Refinery Company. American Journal of
Theoretical and Applied Business, 1(2), pp.48-52.
 Magni, C.A. and Martin, J.D., 2017. The Reinvestment Rate Assumption Fallacy for IRR
and NPV: A Pedagogical Note.
 Erményi, T., 2015. Evaluating Investment Profitability and Business Controlling
Methods. Management, Enterprise and Benchmarking in the 21st Century, p.183.
 Imegi, J.C. and Nwokoye, G.A., 2015. The Effectiveness of capital budgeting techniques
in evaluating projects’ profitability. African Research Review, 9(2), pp.166-188.
 Hanks, G., 2018. [online] Bizfluent.com. Available at: https://bizfluent.com/how-
8111509-calculate-profitability-index.html [Accessed 8 May 2018].
 Merritt, C., 2018. Net Present Value Method Vs. Payback Period Method. [online]
Smallbusiness.chron.com. Available at: http://smallbusiness.chron.com/net-present-
value-method-vs-payback-period-method-61578.html [Accessed 8 May 2018].
 Li, A., 2017. [online] Bizfluent.com. Available at: https://bizfluent.com/how-8541672-
calculate-index-project-net-investment.html [Accessed 8 May 2018].