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Question 1: Project Evaluation (10 marks) Part A For unconventional cash flows, there will often be...

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.

Solutions

Expert Solution

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;


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