a)      Evaluate the above project using the following methods:

• Net present value
• Internal rate of return

To calculate the NPV and IRR of this project one must first calculate the relevant cash flows. This will require excluding or adding back depreciation and any apportioned overheads. Also any increases in working capital will be treated as a cash outflow in the year it occur with working capital liquidated in year 5. The cash flow and working capital calculations are as follows.

Once the cash flows are ascertained then one can calculate the net present value and the internal rate of return of the project

Net Present Value

Internal rate of return

The NPV of the project based on the cost of capital of 11% is positive thus to calculate a negative NPV one must use a higher cost of capital.

b)      Compare and contrast the above two approaches to project evaluation

The net present value approach involves discounting all cash outflows and inflows of a capital investment project at a chosen target rate of return or cost of capital. The present value of the cash inflows minus the present value of the cash outflows is the net present value. If the NPV is positive, the project is likely to be profitable, whereas if the NPV is negative, the project is likely to be unprofitable. Its main advantages are

q     It takes into account the time value of money.

q     Profit and the difficulties of profit measurement are excluded.

q     Using cash flows emphasises the importance of liquidity.

q     It is easy to compare the NPV of different projects.

The main disadvantage associated with this method is that it is not as easily understood as the payback and accounting rate of return. Also, the net present value approach requires knowledge of the company’s cost of capital, which is difficult to calculate.

The IRR method calculates the exact rate of return which the project is expected to achieve based on the projected cash flows. The IRR is the discount factor which will have the effect of producing a NPV of 0. It is the return from the project, taking into account the time value of money. Its decision rule is to accept the project if it’s IRR is greater than the cost of capital. It main advantage is that the information it provides is more easily understood by managers, especially non-financial managers. Its main disadvantages are

q     It is possible to calculate more than two different IRR’s for a project. This occurs where the cash flows over the life of the project are a combination of positive and negative values. Under these circumstances it is not easy to identify the real IRR and the method should be avoided.

q     In certain circumstances the IRR and the NPV can give conflicting results. This occurs because the IRR ignores the relative size of investments as it is based on a percentage return rather than the cash value of the return. As a result, when considering 2 projects, one may give an IRR of 10 per cent and the other an IRR of 13 per cent. However the project with the lower IRR may yield a higher NPV in cash terms and thus would be preferable.

 c) Comment on the proposed project

The project gives a positive NPV of €120,000. Also the IRR for the project is 14.05% which is in excess of the cost of capital for the company of 11%. Thus the project is acceptable. However further investigation into the assumptions and projections by applying sensitivity analysis to the key variable should provide further information to support the decision.