Author: Arend Pryor | Created: 06/29/2021
Details: Sharing content created as part of pursuing my MBA degree
Scenario Details:
Dwight Donovan, the president of Donovan Enterprises, is considering 2 investment opportunities. Because of limited resources, he will be able to invest in only 1 of them.
Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of 4 years and no salvage value.
Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $400,000 and for Project B are $160,000. The annual expected cash inflows are $126,000 for Project A and $52,800 for Project B.
Both investments are expected to provide cash flow benefits for the next 4 years. Donovan Enterprises’ desired rate of return is 8%. Your task as Senior Accountant is to use your knowledge of net present value and internal rate of return to identify the preferred method and best investment opportunity for the company and present your results to Dwight Donovan.
Use Excel — showing all work and formulas — to compute the following:
The net present value of each project. Round your computations to 2 decimal points.
The approximate internal rate of return for each project. Round your rates to 6 decimal points.
Assignment Details:
Create an 8- to 10-slide presentation showing the comparison of the net present value approach with the internal rate of return approach that you calculated.
Complete the following in your presentation:
Analyze the results of the net present value calculations and the significance of these results, supported with examples.
Determine which project should be adopted based on the net present value approach and provide rationale for your decision.
Analyze the results of the internal rate of return calculation and the significance of these results, supported with examples.
Determine which project should be adopted based on the internal rate of return approach and provide rationale for your decision.
Determine the preferred method in the given circumstances and provide reasoning and details to support the method selected.
Synthesize results of analyses and computations to determine the best investment opportunity to recommend to the president of Donovan Enterprises and provide rationale for your recommendation.
Include detailed speaker notes.
Hi everyone and thank you for joining us today.
My name is Arend Pryor and I will be leading you through today’s presentation
Let’s go ahead and get started
In this presentation, we are going to be covering details for the two capital investment opportunities being considered here at Donovan Enterprises. Our goal is to identify the option that provides the most optimal return on our investment.
In order to accomplish this, my plan is to take you through a review of the following areas:
Investment Opportunity Details
Net Present Value Calculations
Significance of NPV Results
NPV Based Recommendation
Internal Rate of Return Calculations
Significance of the IRR Results
IRR Based Recommendation
Preferred Analysis Technique
Recommended Investment Option
At the conclusion, we will take some time to answer any additional questions you might have
Lastly, we will take a brief look at the references page to view the origin of this information
As previously mentioned, Donovan Enterprises has identified two capital investment opportunities, each of which has the ability to generate additional revenue for the company. However, at this time, the company has the resources to invest in only one of these options. Before jumping into the calculations that were performed, let’s walk through the details for each.
Project A: Project A focuses on introducing automation into our production process and would require the purchase of a new machine.
Details: The up-front cost of this machine would be $400,000, which will provide our company with four years of useful life. At the end of its useful life, there would unfortunately not be a salvage value
Cash Inflows: In terms of revenue, we are expecting $136,000 annually during the life of the machine, meaning four years.
Project B: The second opportunity being considered is Project B. This would involve implementing a training program aimed at improving the skills of those who operate the machinery in our production workforce.
Details: The cost to fund this training program would be $160,000 and is expected to provide an annual return for four years.
Cash Inflows: Moving to revenues, the annual expected cash inflows for this opportunity are $52,800, to be received annually.
Required Rate of Return: I would also like to point out that the company’s required rate of return for both projects is 8%
In order to calculate the Net Present Value for these projects, we had to first identify the cash inflows and outflows. Starting with Project A, we can see from the screenshot here, we have four years of annual expected cash inflows of $126,000 under step 1.
Looking at the cash outflows section in step 2, we added the initial cost of the automation machinery, which is shown a negative value of $400,000. This is the amount the company will be required to spend at the onset of the project.
Looking back at step 1, you will also notice the conversion factors that were identified in order to calculate the present value for each of the cash inflows, from year 1 through year 4, which are based on the 8% required rate of return. The totals of these calculations were then summed up, providing total expected cash inflows of $417,328.00
Next, let’s take a look at the Net Present Value calculation shown here in step 3.
As you can see, this section includes the two summarized values from above, which now represent the total present cash inflows and outflow. Dividing these values we come up with a Net Present Value of $17,328.00
This tells us that Project A would offer the company a positive net present value, meaning, we would see a rate of return that exceeds our required rate of 8%. Had the value been negative, this would indicate a negative net present value, meaning the rate of return was less than the 8% we desire. Keep this number in mind, as we will come back to it in few minutes.
Jumping over to Project B, we can see that the same calculations were performed based on the cash inflows and outflows identified.
The differences here are in the annual expected cash inflows and the initial cost to the company to invest in the project, which work out to annual inflows of $52,800 and an outflow of $160,000.
In light of having the same required rate of return as well as the same four year period of expected revenues, we applied the same conversion factors that we used for Project A and performed our calculations. This resulted in a total expected cash inflow of $174,880.31
In this next slide, we now see the Net Present Value calculation performed using the total present cash inflows and outflow for project B, which resulted in a Net Present Value of $14,880.31
Just like with project A, Project B is also offering a positive rate of return. One that exceeds our required rate of 8%.
Based solely on the Net present value calculations shown for each capital investment opportunity, my suggestion would be to go with Project A.
While both projects offer a positive net present value, Project A offers the greater positive value of the two options.
However, I should also point out a disadvantage of using this technique is in comparing the Net Present Value for projects of different sizes. Based on the differences in the initial cash outflow and cash inflows, project A would be considered larger in size, thus, the comparison of Net Present Value, does not paint a complete picture. That being said, my recommendation would remain unchanged.
As we saw with the Net Present Value calculations, both projects offered a rate of return that exceeds our required rate of 8%, which is great. However, let’s dig a bit deeper and take a look at what specific rate of return we would be getting using the Internal Rate of Return analysis technique.
The benefit of performing a secondary analysis using a separate technique is that we are not limiting ourselves to one set of calculations or data.
The process of calculating the Internal Rate of Return requires us to first divide the initial cash expenditure by the annual expected cash inflow amount. For each project, this provided us with a Present Value Table Factor, which was then used as a reference to identify the corresponding Present Value Annuity Factor from our handy dandy table, which ultimately provided us with the internal rate of return for each project.
For project A, we would be getting a 10% return on our investment, while project B would give us an even higher return at 12%.
If we take a step back for a minute and compare what we know about these two analysis techniques, such as their advantages and disadvantages, we can then choose our preferred method.
The Net Present Value technique is very easy to use and interpret, while also considering the time value of money. The downsides of this method however are in its inability to compare projects of differing sizes and in taking into account hidden costs (Thakur, 2021).
Using internal rate of return offers some of the same advantages as NPV such as ease of use and using the time value of money, however, it also eliminates the need for selecting a hurdle rate or required rate of return. Thus, companies avoid the risk of choosing the wrong rate. Similar to NPV, disadvantages of this method are the inability to compare projects of different sizes and in ignoring future costs (Wilson, 2016).
Considering these two analysis techniques share some of the same benefits and disadvantages, the area where it presents a big advantage in my eyes is in the benefit of not requiring a hurdle rate. This takes some of the guess work out of the calculation, which would be required when using NPV. While this makes IRR my suggested and preferred method, I would still include NPV calculations as part of my due diligence in order to have as much data as possible.
In reviewing the calculated outcomes, we saw how NPV favors Project A, while the IRR calculations showed Project B as the clear favorite in terms of the increased rate of return. However, one area that deserves attention in making this decision is the higher amount of revenue that the company would receive as part of selecting Project A. As previously mentioned, despite Project B offering a higher rate of return, this is due to the difference in project sizes and the associated cash inflows and outflows for each project.
Nevertheless, my suggestion for selecting a capital expenditure opportunity lies with Project A. This is due to the positive NPV and increased revenue received.
Ares to be explored further should include an analysis of future costs associated with Project A such as training that will be required to operate the new automated machinery and any scheduled maintenance that might be required. Revenues received can possibly be used to invest in these areas as needed. The company will more than likely have cost savings as a result of the increased automation, which could also be attributed to cash inflows.
That’s all the information being covered today. Before concluding the presentation, I wanted to thank everyone for your time and attention in covering the elements associated with evaluating these projects.
I welcome any questions you may have before we conclude
Last but not least, included here are two of the references mentioned during today's presentation, for those who are interested.
Thanks again for everyone's time
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