Question

You are a corporate Finance manager at penguins plc, a leading operator of domestic waste recycling and incineration services

New legislation on air quality and emissions control means that the company must invest in a new incineration facilities. Two possible investment options have been identified. Each option has an expected life of ten years. Sufficient funding is available to finance only one of the options.

option A Option B

Initial cost year 0 200,250 210,260

Scrap value year 10 310 425

Forecast net cash inflows

year 1 40,000 60,000

year 2 50,000 45,000

year 3 45,000 50,000

year 4 50,000 50,000

year 5 55,000 50,000

year 6 50,000 40,000

year 7 45,000 40,000

year 8 40,000 35,000

year 9 40,000 30,000

year 10 35,000 30,000

assume that all cash flows occur at the end of the respective year.

Penguins plc has a cos of capital of 16 per cent.

The company's approach to investment appraisal was discussed at a recent meeting of Penguins plc's senior executive team. Sarah Crosby, Chief Executive at Penguins plc, is keen to  understand the qualitative factors that might need to be considered in addition to understand the qualitative factors tat might need to be considered in addition to the result of a quantitative investment appraisal. Sarah has commented

Quantitative investment appraisal only tells part of the story we need to consider the qualitative factors that might be relevant to this decision, too

Kris Malkin, Director of Finance at Penguins plc, has highlighted that successful investment appraisal involves a number of practical issues. Kris commented.

Investment appraisal techniques such as payback, accounting rate of return and net present value are useful, but there are several practical points to bear in mind when using these techniques. I would like to know more about these practical points

Required

a) Calculate the net present value of option A and B. Use penguins plc cost of capital as the discount rate.

b) Critically evaluate the net present value technique

c) Advise Penguin plc's senior executive team on the comments made be Crosby and Kris malkin. Your advice should include an explanation of the qualitative factors that will need to be considered before making a decision on in which option the company should invest and any additional information that might aid the investment appraisal process,

Answer 1

a) Calculate the net present value of option A and B. Use penguins plc cost of capital as the discount rate

NPV for option A

intial investment in year 0 is the cash outflow

and scrap value at year 10 is the cash inflow in the 10 th year

future value= present value*(1+r)^n so present value=future value/(1+r)^n

year	Net cash flows (A)	Present value factor @16% (B)	Discounted cash flow (A*B)
0	-200,250	=1/(1.16)^0=1	-200250
1	40000	=1/(1.16)^1=0.862069	34482.76
2	50000	=1/(1.16)^2=0.743163	37158.15
3	45000	=1/(1.16)^3=0.640658	28829.6
4	50000	=1/(1.16)^4=0.552291	27614.55
5	55000	=1/(1.16)^5=0.476113	26186.22
6	50000	=1/(1.16)^6=0.410442	20522.11
7	45000	=1/(1.16)^7=0.35383	15922.33
8	40000	=1/(1.16)^8=0.305025	12201.02
9	40000	=1/(1.16)^9=0.262953	10518.12
10	35310	=1/(1.16)^10=0.226684	8004.198
		Total	21189.05

so NPV for option A =  21189.05$

NPV for option B

year	Net cash flows	Present value factor @16%	Discounted cash flow (A*B)
0	-210,260	1	-210260
1	60000	0.862069	51724.14
2	45000	0.743163	33442.33
3	50000	0.640658	32032.88
4	50000	0.552291	27614.55
5	50000	0.476113	23805.65
6	40000	0.410442	16417.69
7	40000	0.35383	14153.18
8	35000	0.305025	10675.89
9	30000	0.262953	7888.589
10	35425	0.226684	8030.267
		Total	15525.18

so NPV for option B = 15525.18$

so Option A is better as it is having greater NPV

b. Under capital budgeting NPV is one of the method to evaluate the investment . it gives the information whether the cashflows generated by the project over its life time is able to recover the cost or intial investment amount.

It uses discounted cashflows for analysis and therfore considers the time value of money.

it help us to determine whether investing in that project is beneficial or not. if NPV is positive one has to invest in the project and if is negative one should not invest in it.

It also useful for comparing one project with the other. The project with higher NPV is best as it has more worth.

c.The NPV and pay back period and other are used for analysing the investment from finance perspective  but as  commented made by Crosby and Kris malkin the above methods are does not soley provide the basis for analysis at times.Because there are other qualitative factors such as

1. Ability to curb the polution.

2. Sophisticated technology for better monitoring

3. effect on the health of the local residents

4. Company reputation

5. Maintaining company policies, cultures etc

So even if a project is cheaper and better decision from finance perspective but it is not satisfying any of the above mentioned factors they company need to take decision considering these qualitative factors for evaluation.