Question

The CEO of HuaWa Company is considering a five-year investment project of setting up a production factory in Shezhen of China for manufacturing 5G (5^th Generation) mobile phones. You are a financial manager of the company. Under this current situation of China, explain to the CEO the major considerations and problems associated in the estimation of cashflow of this project. The CEO knows that there are (Internal Rate of Return) IRR and (Net Present Value) NPV methods to evaluate the project. When would it be better to use IRR rather than NPV method to examine the acceptability of the project in this case? The CEO also asks you if it is possible to have a positive initial cash flow at the beginning of the project. Respond also to this question of CEO and illustrate your explanation with example(s). (limit your answer to 450 words

Answer 1

Solution:-

Major considerations and problems associated with estimating the cashflows of the project:

China is a growing economy that has acted as the manufacturing facility for the world, primarily-based on its cheap labour and incredible work efficiencies. While this has surely resulted in incredible economic growth rates for the Chinese economy as a whole, the growth has not trickled down to all sections of the society, with the lower labour section of the society still living in poverty. Many issues have cropped up in the Chinese manufacturing scenario in recent years, including but not limited to the following:

- There have been a lot of concerns over poor working conditions in Chinese factories. It has been observed that the workplace environment in the Chinese factories is pretty hostile for the labour.

- The outside firms who outsource their manufacturing to Chinese factories are now expected to make it a part of their corporate social responsibility that the labour manufacturing their products are treated properly and given appropriate work environments.

- There is uncertainty about long-term labour rates in China as the country aims towards more inclusive growth. In other words, it's very much possible that the era of extremely cheap Chinese labour is over.

Due to above reasons, it is tough to estimate the cash flows from the project as long-term manufacturing costs of products in China is subject to a lot of political and social factors which could kick in any time in future, making forecasting expenditure a tricky thing. This means that the CEO of the company should look for manufacturing partnerships that ensure a long-term certainty of the manufacturing expenditure and thus help with forecasting financial cash flows of the project.

When is IRR better than NPV?

Both IRR and NPV are great methods to evaluate projects and are widely used by financial managers all around the world. However, the following situations or type of projects suit better for IRR than NPV:

- IRR assumes reinvesting of cash flows at the discount rate, therefore it's not the best approach for very long-term projects as the discount rates could change substantially in long-term. However, if the project span is not too long, the discount rates used in IRR can be trusted and thus it can be used. Since in our case the project is just for 5 years, IRR would fit in quite well

- If a projects has inconsistent cash flows, i.e. irregularity of positive and negative cash flows over the project span, NPV is better suited than IRR. However, if the project has more consistent cash flows such as initial outflows followed by inflows, IRR could be better suited than the NPV method

- If the CEO is looking to analyze the project's viability in % terms, IRR method serves the purpose over NPV as it compares the project's actual % returns with the cost of capital and gives concrete answer in % terms

Possibility of positive initial cash inflows with examples:

While generally a project involves cash outflows in the initial phase in the forms of investment, it is possible that the initial cash flows are positive on a net basis. Some of the cases, in terms of examples as required, are as follows:

- If the company enters into long-term supply agreements with its customers in advance which includes receipt of advances upfront against the future supply of goods which are to be manufactured under the project, it is possible that the company gets positive cash flows at the beginning of the project

- If the projects are being setup under certain conditions, such as special economic zones, etc. it may involve receipts of subsidies from governments who are trying to promote jobs and economic growth in those areas. The subsidies may result in positive cash inflows at the beginning of the project

- Entering into strategic partnerships with other companies at the beginning of the project may result in cash inflows in the beginning of the project