Capital Budgeting Internal Rate Of Return Essay

Question:

Discuss about the Capital Budgeting Internal Rate of Return.

Answer:

Introduction

For a business to undertake a new project, it is important to analyse the risks and returns associated with that investment project. Capital budgeting is a tool that provides for such analysis and helps in ascertaining the economic and financial profitability of any such investments. There are a number of techniques which might be used in the capital budgeting process to provide an analysis of the projects profitability. Some of these techniques include Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index, Payback Period (Fabozzi & Drake 2008). However, the most effective of the above is NPV as it gives absolute measure of the profits from the investment.

In the current scenario, Riverlea Limited, a public listed company is in the process of negotiation with Wowcoles, a supermarket chain to supply confectionary in a private label for Wowcoles. The project is for a period of 10 years and in order to undertake the project, the company will have to undertake a long term investment of purchasing a new machinery to increase its production levels.

An analysis of the project was performed taking into account all the incremental revenues and costs with the help of capital budgeting techniques. Also a sensitivity analysis was conducted to see the effect of lower revenues on the NPV. The findings have been discussed below.

The NPV of the project was derived taking into account the incremental revenues, variables costs, the decrease in current revenues, decrease in current operating costs, depreciation on the new machinery, the initial investment required and the terminal value of cash flows. Also the payback period, IRR and Profitability index were calculated to confirm the results.

The various assumptions taken for the analysis are:

  • The decrease in current revenues is considered as an opportunity cost and is considered a cash outflow
  • The decrease in current variable costs is considered as a cash inflow
  • The new machinery has been depreciated on a diminishing value method. The value of machinery to be depreciated is the cost of machine plus its installation and shipping charges.
  • Tax rate has been assumed to be 30%
  • There is an increase of working capital and subsequent increase in working capital from 1 to 9 years. All the working capital is assumed to be recovered at the end of the project i.e. the 10th year of the project.
  • For discount rate, the cost of equity has been considered.
  • Cost of equity has been calculated using the CAPM approach, where the risk free rate is the average return on the 10 year Australian Government Bond, market return is the average return of ASX200 from 1997 to 2016. Beta has been calculated using the variance and covariance approach.

Now, conducting a sensitivity analysis to compensate for the uncertainty of the expected cash flows, the results are as flows:

Techniques

Base case

Allow for a 40% probability that incremental revenues associated with the supply will be 40% lower than expected starting from year six.

Allow for a 10% probability that incremental revenues associated with the supply will be 20% higher than expected starting from year six.

NPV

$14,74,896

$11,85,514

$15,11,068

Payback period

4.6

4.6

4.6

IRR

21%

19%

21%

PI

1.8

1.7

1.9

The acceptance rule for NPV is that accept the project if the NPV is positive or else reject the project. This is because NPV is the difference of the total present value of cash inflows and the cash outflows. Here the NPV of the investment by Riverlea Limited is positive, hence according to the NPV rule, the project should be accepted. This means the cash inflows discounted at the company’s cost of equity is more than the cash outflows and hence the investment in the new machinery to supply confectionary to Wowcoles proves beneficial for the company as the cash inflows in the form of revenues is more than the cash outflows in the form of initial investment and other operating costs. Also the payback period is within the investment period, the IRR is more than the cost of capital and the PI is more than 1. All the capital budgeting techniques give a positive result for the project.

Since the company is relying on a future outcome, hence the forecasted cash flows cannot be assumed to be totally accurate, so to have an idea as to how the company’s cash flows will look like under different scenarios, a sensitivity analysis was conducted taking into consideration two scenarios of higher and lower expected revenues. Scenario 1 where there is a 40% probability that the incremental revenues will be lower by 40% from year six onwards, the NPV has fallen by almost 20%. And for scenario 2 where there is a 10% probability that the incremental revenues will be higher by 20% from year six onwards, the NPV has increased by almost 2.5%. Under both conditions, we have taken a pessimistic approach in a way that the incremental revenues are falling by a higher percentage and the probability of the fall is also much higher than the probability of an increase in the revenue. Still, we see that the NPV is positive for scenario 1 and 2 both. We can also conclude that NPV is sensitive to the revenues and with an increase in revenues by 20%, the NPV increases by 2.5% showing a lower change in NPV as compared to a change in revenues. Even in the two scenarios, the payback period, IRR and PI is favourable.

Since the NPV of the project is positive and the other capital budgeting techniques are favourable under all the scenarios, it is recommended that Riverlea Limited should go ahead with supplying confectionary to Wowcoles under a private label and to purchase new machinery required to fulfil the increased production levels.

Efficient market hypothesis (EMH) states that a stock is always correctly priced in the sense that all publicly available information about the stock is factored into the price of the stock and hence no investor can have abnormal gains from any analysis like fundamental or technical analysis (Clarke, Jandik & Mandelkar n.d.)There are three forms of market hypothesis that are said to exist like Strong form EMH, semi strong form and weak form EMH. According to weak form EMH, the prices of stock have all past information incorporated into it. Semi weak form suggests that all new information is immediately incorporated into the stock price and under strong form, both public and private information is incorporated into the stock prices and no investor can gain advantage (Sandhar, Nathani & Holani 2009)

From the above we see that the stock price is in the range of $1.2 till four days prior to the announcement, it has increased by 80% one day prior to the announcement and on the day of the announcement the stock price has increased by about 100%. Thereafter the price has fallen by 1.8% the next day of the announcement and has increased by 1.7% on the second day of the announcement. In general, for the next five days, the stock price has fallen by approx. 1.5% but has remained in the range of $4.2 to $4.3. A similar pattern was being followed prior to the announcement.

Conclusion

As a result of the new project, the increase in per share price should be $6.86 (NPV value / number of shares) and therefore the increase in stock price on the day of the announcement should be by $6.86 according to the semi strong form EMH as the hypothesis assumes that all publicly available information is incorporated into the share price. However, here this is not the case as the share price has increased by 80% one day prior to the announcement which shows some insider information caused the prices to increase and on the day to the announcement the prices further increased by 100% or by $2.19. The total increase in share price due to announcement is $3.15 and the increase has happened in two days’ time. The increase in share price less than expected by $3.71. This means the share price of Riverlea Limited does not reflect its intrinsic value and hence we can say the shares are undervalued. Moreover, the share prices have fallen by 1.8% on next day of announcement and have increased by 1.2% on the second day, this shows adjustment of the price as investors buy and sell the shares.

As we see that the share prices do not reflect the actual intrinsic value, we can expect the share prices to rise in the future, hence it is recommended to buy the shares of Riverlea as the prices are expected to rise. Moreover, since semi strong form EMH is said to exist, we will see that when more and more investors will buy the shares of the company, the price of the stock will increase till the level it truly reflects its intrinsic value. Thereafter, the EMH will exist.

Bibliography

Clarke, J, Jandik, T & Mandelkar, G, Efficient Market Hypothesis, viewed 5 October 2017, <

Sandhar, S, Nathani, N & Holani, U 2009, 'TESTING SEMI-STRONG FORM OF MARKET EFFICIENCY: A Study of NSE', Appejay Journal of Management and Technology , vol 4, no. 1.

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