Mock Question - Calculating the Npv of the Project

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Mock Question 1

1. Calculating the NPV of the Project

Workings are shown below:

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Net Present Value:

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Net Present Value = 323809.3581 (~ 324 000)

1. IRR of the Project

First, we calculate a new Net Present Value for the Project. In this case, the cost of capital shall be at 20%.

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Internal Rate of Return:

HDR = 20 %        NPV @ HDR = 98111.32316

LDR = 12 %        NPV @ LDR = 323809.3581

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Internal Rate of Return = 23.48%

1. Advise on the acceptability of the proposed investment in product P and discuss the limitations of the evaluations you have carried out.

The NPV is positive and so the proposed investment can be recommended on financial grounds. The IRR is greater than the discount rate used by Dodo Co for investment appraisal purposes and so the proposed investment is financially acceptable. The cash flows of the proposed investment are conventional and so there is only one internal rate of return. Furthermore, only one proposed investment is being considered and so there is no conflict between the advice offered by the IRR and NPV investment appraisal methods.

Limitations of the investment evaluations:

Both the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been forecast and so Dodo Co should investigate the key assumptions underlying these forecasted volumes. It is difficult to forecast the length and features of a product’s life cycle so there is likely to be a degree of uncertainty associated with the forecasted sales volumes.

The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future periods. In reality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables. The assumption of constant inflation rates limits the accuracy of the investment evaluations and could be an important consideration if the investment were only marginally acceptable.

Since production of Product P is expected to more than double over three years, future capacity needs should be assessed before a decision is made to proceed, in order to determine whether any future incremental fixed costs may arise.

1. Discuss how the net present value method of investment appraisal contributes towards the objective of maximising the wealth of shareholders.

Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes in share prices can therefore be used to assess whether a financial management decision is of benefit to shareholders. In fact, the objective of maximising the wealth of shareholders is usually substituted by the objective of maximising the share price of a company.