Question

1. City plc is carrying out a project with a life of only 3 years. It expects profits to be £250,000 at the end of each year though feels there is a 50 per cent chance that profit will fall 10 per cent short and a 10 per cent chance profit will be 25 per cent less than expected. The capital needed upfront for the project is £580,000.

a)Calculate the internal rate of return for the project.

City could fund the project from its accumulated retained profits or could borrow at 9 per cent per annum.

b)Discuss what City should consider in deciding how to fund the project. ( 6 Marks)

c)Calculate the payback period for the project assuming for this purpose that profits emerge evenly through each year.                                    

d)Discuss the advantages and disadvantages of using the payback period method rather than the discounted value method for this project.

Answer 1

a)

What is IRR? It's the rate of discounting at which NPV of the all cash flows is zero at year 0 i.e. present. So to calculated IRR we have to consider NPV as 0 (Zero).

In the given case, if you use spreadsheet (Excel), then it's very easy to calculate IRR, which comes to 14.042% (rounded off to 3 decimals)

In case, you wish to calculate it manually, then you have to use below formula:

0 = CF0 + [CF1/(1+IRR)] + [CF2/(1+IRR)^2] + [CF3/(1+IRR)^3]

Where, CF0 = Cash flows at year 0 means present which is outflow of 580000.

CF1, CF2, CF3 = Cash flow at year 1 which is expected profit of 250000 each year

Using above formula as well we will get same answer of 14.042% approx.

Note: If the borrowing @ 9% is considered, then interest cost on this borrowing has to be deducted from expected profits and then net cash flows need to be considered in above same formula or while calculating in excel / spreadsheet.

b)

Since the IRR is lower than rate of interest, in general sense: company should use retained earnings to finance the project. While, there are both pros and cons of using this option. Using retained earnings for the investment leads to reduction in cash for the working capital purpose as well as it passes on the control to outsiders while if we consider pros then it saves the company from entry of creditors in the company and credit risk.

So in the given case, based on the available information, it's difficult to take decision but most beneficially and generally, company should finance from it's retained earnings.

c)

Payback period is the period in which initial investment shall be recovered.(without considering discounting)

If we consider discounting then it's called as Discounted Payback period. But as per question, we have been asked for payback period which we can calculate as follow:

Payback Period = Initial Cash Outflow / Yearly cash inflow

Since, the cash inflow for each year is same, this above formula is suitable here and we get payback period of 2.32 years i.e. 2 years, 3 months and 25 days.

d)

Advantages:

i. Calculation of payback period using discounted payback period method fails to determine whether the investment made will increase the firm’s value or not, while payback period allows it to the firm.

ii. The major problem with using discounted payback period is that it does not give the manager the exact information required to take a decision for investing in a project. The business manager has to assume the interest rate or the cost of capital to determine the payback period.

iii. It does not consider the project that can last longer than the payback period. It ignores all the calculations beyond the discounted payback period.

Disadvantages:

i. Many managers in the organization prefer discounted payback period because it considers the time value of money while calculating the payback period, which is not considered in general calculation of payback period.

ii. It determines the actual risk involved in a project and whether the investments made are recoverable or not. Because it's based upon certain discounting factor which is the basis or considerable factor of inflation in the future.