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a) Calculate the net present value of the investment
The approach to this question is firstly to calculate the relevant operating cash flows. This means excluding or adding back depreciation as follows
Accounting profits and Cash flows
Cash flows / year |
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
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€ |
€ |
€ |
€ |
€ |
Sales revenue |
|
600,000 |
640,000 |
680,000 |
810,000 |
810,000 |
Variable costs |
|
-360,000 |
-384,000 |
-408,000 |
-486,000 |
-486,000 |
Cash contribution |
|
240,000 |
256,000 |
272,000 |
324,000 |
324,000 |
Fixed costs |
|
-210,000 |
-210,000 |
-210,000 |
-210,000 |
-210,000 |
Operating accounting profit |
30,000 |
46,000 |
62,000 |
114,000 |
114,000 |
Add: Depreciation |
|
120,000 |
120,000 |
120,000 |
120,000 |
120,000 |
Operating cash flows |
150,000 |
166,000 |
182,000 |
234,000 |
234,000 |
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Once the operating and capital and working capital cash flows are known then one can calculate the net cash flows and the NPV of the project
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(a) Net Present Value |
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Year |
Investment. |
(Incr)/decr |
Operating |
Net |
13% |
Present Value |
|
|
working capital |
Cash flow |
Cash Flow |
Disc |
Cash Flow |
|
€ |
€ |
€ |
€ |
|
€ |
0 |
-750,000 |
-50,000 |
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-800,000 |
1.000 |
-800,000 |
1 |
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150,000 |
150,000 |
0.885 |
132,750 |
2 |
|
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166,000 |
166,000 |
0.783 |
129,978 |
3 |
|
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182,000 |
182,000 |
0.693 |
126,126 |
4 |
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234,000 |
234,000 |
0.613 |
143,442 |
5 |
150,000 |
50,000 |
234,000 |
434,000 |
0.543 |
235,662 |
|
-600,000 |
0 |
966,000 |
366,000 |
NPV |
-32,042 |
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b) Calculate the internal rate of return
The NPV at 13% is a negative figure of €32,040. Now we must calculate a positive NPV by choosing a lower discount rate.
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(b) IRR |
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Year |
Net |
10% |
Present Value |
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CF |
Fac |
Cash Flows |
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€ |
|
€ |
|
0 |
-800,000 |
1.000 |
-800,000 |
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1 |
150,000 |
0.909 |
136,350 |
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2 |
166,000 |
0.826 |
137,116 |
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3 |
182,000 |
0.751 |
136,682 |
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4 |
234,000 |
0.683 |
159,822 |
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5 |
434,000 |
0.621 |
269,514 |
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|
366,000 |
NPV |
39,484 |
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IRR |
10% + |
( 39484 x 3)
39484+32040 |
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IRR |
10% |
+ 1.66% |
= 11.66% |
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c) Calculate the payback period
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(c) Payback |
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Year |
Net Cash Flow |
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Cum cash flow |
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€ |
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€ |
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0 |
-800,000 |
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(800,000) |
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1 |
150,000 |
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(650,000) |
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2 |
166,000 |
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(484,000) |
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3 |
182,000 |
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(302,000) |
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4 |
234,000 |
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(68,000) |
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5 |
434,000 |
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366,000 |
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Payback, |
4 years + |
(68,000/234,000 x 12) |
= 4.29 years |
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Note: In calculating the number of months in the final year for the payback the amount outstanding of €68,000 is divided by the projected operating cash flows for the final year as the capital cash flows for that year are very significant (€200,000)and will not be received until the year end.
d) Comment on the proposed investment
The project should be rejected on the basis of the following
- It offers a negative NPV of €32,040 or 4% of the initial outlay.
- It has a IRR of 11.66% compared to the company’s cost of capital of 13%
- The project is not estimated to repay the capital investment until the final year.
However further investigations on the projections and the projected assumptions particularly tourist numbers, the price per tour, the variable cost per tour and also the cost of capital before a final decision is made.
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