In: Finance
Question 1: Project Evaluation Part A For
unconventional cash flows, there will often be multiple IRRs. Under
those circumstances, we cannot use IRR for evaluation purposes. i)
Construct a hypothetical unconventional cash flow that yields two
possible IRRs. Present your cash flows in a table and plot its NPV
profile. (1.0 marks)
ii) Construct a hypothetical unconventional cash flow that yields
three possible IRRs. Present your cash flows in a table and plot
its NPV profile. Furthermore, assess which of your two hypothetical
projects (i or ii) you would rather invest in. (1.0 marks) Document
your workings in the Excel Spreadsheet. (1.0 marks)
iii) Briefly explain how you would construct an unconventional cash
flow in order to have k possible IRRs, where k > 1. Next,
comment on the likelihood of such a cash flow occurring in real
life, when k is large.
Unconventional cash flows are a series of cash flows that don’t go in one direction, over the period of project. They are characterized by several changes in the direction of the cash flows. Directional changes are usually represented by a cash inflow or an outflow.
Such cash flow profiles are very common among businesses that require periodic maintenance of equipment, follow-up investment after a certain period of time, mandatory renovation to keep up the capacity etc; One may observe these type of situations in Heavy manufacturing sectors, where the renovation or additional capex to support the existing capex due to change in regulations / technology is envisaged / required. In such cases, one shall observe unconventional cashflows from the projected financials.
The Internal Rate of Return (IRR) is a financial metric used for measuring cash flow, particularly in Project evaluations. IRR is especially used to evaluate acquisitions and other business investments. This can provide a general overview of a company’s financial status and help to predict future cash flows.
A company with a conventional cash flow profile will normally show just a single IRR, however, a company with an unconventional cash flow will demonstrate multiple IRRs.
The situation of multiple IRRs results in a series problem to analysts because the decision is not obvious. IRR decision rule involves comparison of project IRR with the benchmark rate. If there are two values for IRR, we do not know which value to compare with the benchmark rate.
Due to the multiple IRR problem and the unrealistic reinvestment rate assumption inherent in IRR methodology, net present value is the preferred capital budgeting tool.
Based on the given problem, have constructed the below pattern of unconventional cashflows; Have assumed the Initial Investment and further a Renovation and followup investment requirement at selected intervals; While the project keeps on generating the cashflows through out the period, the renovation and additional investment, assuming mandatory, results in the negative outflow for such respective periods;
Have made two scenarios of unconventional cash flows below with same outflows and expected same inflows, however the timing of outflows shall differ; As it can be observed, the IRRs are different at different scenarios:
Scenario 1:
Particulars |
Year |
||||||||||
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
|
Initial Investment |
-50,000 |
||||||||||
Net Post Tax Returns Expected |
15,000 |
18,000 |
21,600 |
19,000 |
24,000 |
27,000 |
30,000 |
33,000 |
35,000 |
37,000 |
|
Renovation |
-55,000 |
||||||||||
Additional Investment |
-70,000 |
||||||||||
Total Cash Flows |
-50,000 |
15,000 |
18,000 |
-33,400 |
19,000 |
24,000 |
27,000 |
30,000 |
33,000 |
-35,000 |
37,000 |
Cumulative Cash Flows |
-50,000 |
-35,000 |
-17,000 |
-50,400 |
-31,400 |
-7,400 |
19,600 |
49,600 |
82,600 |
47,600 |
84,600 |
Discounting Factor @ 10% |
1 |
0.9091 |
0.8264 |
0.7513 |
0.6830 |
0.6209 |
0.5645 |
0.5132 |
0.4665 |
0.4241 |
0.3855 |
Discounted Cash Flow |
-50,000 |
13,636 |
14,876 |
-25,094 |
12,977 |
14,902 |
15,241 |
15,395 |
15,395 |
-14,843 |
14,265 |
Cumulative NPV |
-50,000 |
-36,364 |
-21,488 |
-46,582 |
-33,604 |
-18,702 |
-3,461 |
11,933 |
27,328 |
12,485 |
26,750 |
IRR% |
19% |
Based on the period covering from Year 0 (initial Investment) till Year 10 (covering Renovation at Year 3 and Additional Investment at Year 7); |
|||||||||
IRR% |
20% |
Based on the period covering from Year 0 (initial Investment) and renovation at Year 3 till Year 8; |
Scenario 2:
Particulars |
Year |
||||||||||
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
|
Initial Investment |
-50,000 |
||||||||||
Net Post Tax Returns Expected |
15,000 |
18,000 |
21,600 |
19,000 |
24,000 |
27,000 |
30,000 |
33,000 |
35,000 |
37,000 |
|
Renovation |
-55,000 |
||||||||||
Additional Investment |
-70,000 |
||||||||||
Total Cash Flows |
-50,000 |
15,000 |
18,000 |
21,600 |
-36,000 |
24,000 |
27,000 |
-40,000 |
33,000 |
35,000 |
37,000 |
Cumulative Cash Flows |
-50,000 |
-35,000 |
-17,000 |
4,600 |
-31,400 |
-7,400 |
19,600 |
-20,400 |
12,600 |
47,600 |
84,600 |
Discounting Factor @ 10% |
1 |
0.9091 |
0.8264 |
0.7513 |
0.6830 |
0.6209 |
0.5645 |
0.5132 |
0.4665 |
0.4241 |
0.3855 |
Discounted Cash Flow |
-50,000 |
13,636 |
14,876 |
16,228 |
-24,588 |
14,902 |
15,241 |
-20,526 |
15,395 |
14,843 |
14,265 |
Cumulative NPV |
-50,000 |
-36,364 |
-21,488 |
-5,259 |
-29,848 |
-14,946 |
295 |
-20,231 |
-4,836 |
10,007 |
24,272 |
IRR% |
19% |
Based on the period covering from Year 0 (initial Investment) till Year 10 (covering Renovation at Year 4 and Additional Investment at Year 7); |
|||||||||
IRR% |
4% |
Based on the period covering from Year 0 (initial Investment) till Year 4; |
|||||||||
IRR% |
10% |
Based on the period covering from Year 0 (initial Investment) till Year 6 (covering Renovation at Year 4); |
Based on the above both scenarios, while IRRs are misleading interms of project selection, it shall be appropriate to understand the overall NPV of the project expected, baring other risks of the projects, and accordingly to select the project; Based on the above workings, the NPV of Scenario 1 is good as compared to Scenario 2; Given this, it would be feasible to choose Scenario 1;