Managerial Finance: NPV, IRR, Payback Period, ARR, Profitability Index and Sensitivity Analysis

This article discusses Managerial Finance and its various techniques such as NPV, IRR, Payback Period, ARR, Profitability Index and Sensitivity Analysis. It provides a detailed analysis of a project's financial viability and sensitivity to changes in sales revenue and cost of capital. The article includes relevant data, calculations, and scenario analysis to help readers understand the concepts better.

Running Head: FINANCE
Managerial finance

Finance 1
Question 1
Part1: Net Present Value
Year
Cash flows before
loan payment
Principle
(Refer:
appendix
1) Interest
Net Cash
Flows
PVF@
12.5% Present Value
0
$
-2.40
$ -
2.40 1.000
$ -
2.40
1
$
1.04
$
0.21
$
0.07
$
0.76 0.889
$
0.67
2
$
0.60
$
0.27
$
0.02
$
0.32 0.790
$
0.25
3
$
0.97
$
0.27
$
0.02
$
0.68 0.702
$
0.48
4
$
0.55
$
0.27
$
0.02
$
0.27 0.624
$
0.17
5
$
0.70
$
0.19
$
0.10
$
0.42 0.555
$
0.23
5
$
0.24
$
- $ -
$
0.24 0.555
$
0.13
NP
V
$ -
0.46
Part 2: Internal Rate of Return
Year Cash flows
0
$
-2.40
1
$
0.76
2
$
0.32
3
$
0.68
4
$
0.27
5
$
0.42
5
$
0.24
IRR 3.85%
Part 3: Payback Period
Year Cash flows Cumulative Cash Flows
0 $ - $ -

Finance 2
2.40 2.40
1
$
0.76
$ -
1.64
2
$
0.32
$ -
1.33
3
$
0.68
$ -
0.64
4
$
0.27
$ -
0.38
5
$
0.42
$
0.04
5
$
0.24
$
0.28
Payback
period(years) 3.10
Part 4: Average Rate of return
Average net profit/ Average investment
Year Cash flows Depreciation Interest Net profit
1 $ 1.04
$
0.96
$
0.07 $ 0.01
2
$
0.60
$
0.58
$
0.02 $ 0.01
3
$
0.97
$
0.35
$
0.02 $ 0.60
4
$
0.55
$
0.21
$
0.02 $ 0.33
5
$
0.70
$
0.12
$
0.10 $ 0.48
$ 1.43
Average Profits = 0.012 + 0.008 + 0.603 + 0.327 + 0.483 =$ 0.286
5
Average Investment= salvage value + 0.5 (Initial investment – salvage value)
= .0240 + 0.5 (2.40-.0240)
= $ 1.32
Accounting Rate of Return= 22%
Part5: Profitability Index

Finance 3
NPV + Initial Investment/ Initial Investment
NPV
$
-0.46
Initial Investment
$
2.40
NPV+ Initial investment
$
1.94
P.I 0.81
Part 6: Analysis
According to the calculation done, NPV of the project is negative that is $ -0.46. A negative
NPV means project is not able to generate sufficient cash inflows and is not considered to be
profitable for the purpose of investment. The project has a negative NPV which implies that it
will not generate enough cash inflows to recoup its initial outlay. Hence, it will be
recommended not to invest in such project (Agarwal, 2013).
According to the policy DCL has of repaying its capital investment within 2.50 years, the
payback period calculated for the project is much more. The proposal has a payback period of
3.10 years which states that it will take 3 years and 10 months to repay the initial investment.
Once the period is over, the project will start generating returns. Hence as per the policy, it
should not be accepted (Bierman & Smidt, 2012).
As far as IRR is concerned, it is very much less than the project’s required rate of return of
12%. The IRR is 3.85% and is considered as a discount rate on which project earned no profit
and loss. So it should be rejected. However, it’s ARR of 22% is more than the desired rate,
which gives a valid reason to accept the project from ARR point of view (Agarwal, 2013).
The last calculative part include the determination of profitability index which is 0.81 of the
project. For a proposal to be accepted by the managers, its P.I should be more than one. As it
is clear that the P.I of the project is less than one so it should be rejected. Four out of five
capital budgeting techniques shows the result that the project is not appropriate for
investment. These are mostly used techniques which measures the viability of an investment
proposal. So it will be recommended not to invest in such project (Bierman & Smidt, 2012).
Treatment of loan repayment and salvage value:
The entire instalment amount per year is deducted from the cash flows to reach at net cash
flows to determine the net present values, Profitability index, and internal rate of return and

Finance 4
payback period. But to calculate the accounting rate of return the net profits are to be
calculated. For the purpose of net profit calculation only interest amount is deducted from the
cash flows as it is operating expense but payment of principle amount is not an operating
expense. The tax benefit of interest could be availed but since no tax rate is given in the
questions. Salvage value of fixed asset will be received at the end of project life and it will be
treated as the cash inflow. Hence it will be added to the given cash flows. Also, the capital
gain on sale of asset will not be taxed as there is no tax rate given.
It is assumed that the company is operating in tax heaven treaty and hence no tax obligations
are there in this case of company.
Question 2
Relevant Data
Unit sale 143000
Unit price $ 99.00
Sales $ 14,157,000.00
Cash operating expenses $ 8,918,910.00
Administration Expenses $ 289,000.00
Equipment cost $ 10,700,000.00
Depreciation
Salvage value $ 1,337,500.00
Working capital $ 420,000.00
Tax rate 30%
WACC 10.16%
Price inflation 3.3%
Variable cost and cash fixed cost inflation 2.7%
Calculation of Depreciation
Depreciation Rate 25%
Diminishing method rate 50%
Years Opening WDV
Depreciation
amount Closing WDV
1 10700000 5350000 5350000
2 5350000 2675000 2675000
3 2675000 1337500 1337500
4 1337500 668750 668750
Calculation of cash flows after tax

Finance 5
1 2 3 4 4
A. Sale Units
1,43,000.
00
1,43,000.
00
1,43,000.0
0
1,43,000.
00
B. Sale price 99.00 102.27 105.64 109.13
Total Sales
141,57,0
00.00
146,24,1
81.00
151,06,77
8.97
156,05,3
02.68
F. Cash
operating cost
(89,18,91
0.00)
(92,13,23
4.03)
(95,17,270
.75)
(98,31,34
0.69)
Administration
Expenses
(2,89,000
.00)
(2,96,803
.00)
(3,04,816.
68)
(3,13,046
.73)
H. Depreciation
(53,50,00
0.00)
(26,75,00
0.00)
(13,37,500
.00)
(6,68,750
.00)
I. Operating
Profit
(4,00,910
.00)
24,39,14
3.97
39,47,191.
54
47,92,16
5.26
13,37,5
00.00
J. Tax @ 30%
(1,20,273
.00)
7,31,743.
19
11,84,157.
46
14,37,64
9.58
2,00,62
5.00
K. Operating
Profit after tax
(2,80,637
.00)
17,07,40
0.78
27,63,034.
08
33,54,51
5.68
11,36,8
75.00
Add Back:
Depreciation
(non-cash)
53,50,00
0.00
26,75,00
0.00
13,37,500.
00
6,68,750.
00
Operating cash
flows
50,69,36
3.00
43,82,40
0.78
41,00,534.
08
40,23,26
5.68
Working capital (2,10,000.

Finance 6
00)
Cash flows
after tax
-
95,15,000.00
$
50,69,36
3.00
$
43,82,40
0.78
$
38,90,534.
08
$
40,23,26
5.68
11,36,8
75.00
Part 1: NPV evaluation
Years Net cash flow PVF PV of cash flow
0 $ -9,515,000.00 $ 1.00 $ -9515000
1 $ 5,069,363.00 $ 0.91 $ 4601818.264
2 $ 4,382,400.78 $ 0.82 $ 3611305.569
3 $ 3,890,534.08 $ 0.75 $ 2910297.873
4 $ 4,023,265.68 $ 0.68 $ 2732014.524
5 $ 1,136,875.00 $ 0.68 $ 771999.4793
NPV $ 5112435.709
The net present value of the project is positive which means it will generate enough cash
inflows that will recover its initial outlay. The NPV is $ 5112435.709. Hence, the project
should be accepted.
Part 2: Sensitivity analysis
It is the analysis which measures the sensitivity of the NPV of a project with its various
factors. It determines the changes occurring in the value of NPV corresponding to the
changes in its factors like sales amount, sales units and so on. Here, sensitivity analysis of the
project is done on the sales revenue and cost of capital. Changes in these two factors will
affect the NPV of a proposal.
 Sensitivity to the change in sales units
Table-1:Sales NPV
% Change Unit sales $ 5,112,435.71
5% 150,150.00 5718492.216
10% 157,300.00 6324548.722
15% 164,450.00 6930605.228
20% 171,600.00 7536661.734
25% 178,750.00 8142718.241
Base value 143,000.00 5112435.709
-5% 135,850.00 4506379.203

Finance 7
-10% 128,700.00 3900322.697
-15% 121,550.00 3294266.191
-20% 114,400.00 2688209.684
-25% 107,250.00 2082153.178
 Sensitivity to the change in cost of capital
Table-2: Cost of capital NPV
% Change Rate $ 5,112,435.71
5% 10.67% 5036033.517
10% 11.18% 5030905.366
15% 11.68% 5025745.757
20% 12.19% 5020554.582
25% 12.70% 5015331.732
Base value 10.16% 5041130.318
-5% 9.65% 5046195.876
-10% 9.14% 5051230.3
-15% 8.64% 5056233.698
-20% 8.13% 5061206.178
-25% 7.62% 5066147.848
Part 3: Scenario analysis VS Sensitivity analysis
Scenario analysis takes into account three scenarios of a project which are worst case, base
case and best case. The situation under which project operates is unfavourable is known as
worst case and where the situation is favourable, it is known as best case. When the project is
carried out under normal situations, it is called as base case. The net present value is
determined in all these cases and is analysed on the basis of probability of these three cases.
Therefore it can be said that scenario analysis has a broader scope as compare to sensitivity
analysis. It provides project manager with broader insight regarding the changes in the
situations and their effect on the NPV of a project. On the other hand, sensitivity analysis
considers only one variable to examine the sensitivity of the project. It does not take into
account the overall effect on NPV due to the changes in the scenario. Whereas scenario
analysis considers all the factors and provide additional insights to the management while
evaluating an investment proposal.
Part 4: Risk pricing
Risk is the factor which reflects the uncertainty of the returns which occurs due to the
changes in key factors like inflation rate, demand, economic growth and many more. In this
discussion, sensitivity analysis is used for pricing the risk, where the sensitive of the project

Finance 8
is determined in accordance with the changes in sales units and cost of capital. The net
present value of the project is also calculated to check the risk associated and getting a
positive NPV implies that less amount of risk is there as the project is capable enough to
make sufficient cash flows which covers its cash outflow. This also shows that project will
create good returns and are in accordance with the risk. Hence, project manager must be
confident about the project and it viability (Alessandri, Ford, Lander, Leggio & Taylor,
2004).
References

Finance 9
Alessandri, T.M., Ford, D.N., Lander, D.M., Leggio, K.B. & Taylor, M., (2004). Managing
risk and uncertainty in complex capital projects. The Quarterly Review of
Economics and Finance, 44(5), pp.751-767.
Agarwal, V., (2013). Managerial Economics. Pearson Education India.
Bierman Jr, H. & Smidt, S., (2012). The capital budgeting decision: economic analysis of
investment projects. Routledge.

Finance
10
Appendix 1
Loan amortisation table
Year Opening Instalment Interest Principle Closing
1
$
1.20
$
0.28
$
0.07 $ 0.21 $ 0.99
2
$
0.99
$
0.28
$
0.02 $ 0.27 $ 0.72
3
$
0.72
$
0.28
$
0.02 $ 0.27 $ 0.45
4
$
0.45
$
0.28
$
0.02 $ 0.27 $ 0.19
5
$
0.19
$
0.28
$
0.10 $ 0.19 $ -
Total cost of new equipment $ 2.40
Rate of depreciation 40%
Depreciatio
n
Year Opening Balance Depreciation Closing Balance
1
$
2.40
$
0.96
$
1.44
2
$
1.44
$
0.58
$
0.86
3
$
0.86
$
0.35
$
0.52
4
$
0.52
$
0.21
$
0.31
5
$
0.31
$
0.12
$
0.19
Capital gain
WDV
$
0.187
Less: Salvage Value
$
0.240
Capital gain $

Finance
11
0.053