BlueSky Ltd.
NPV (Present Net Value)
This I where the difference in cash inflow and cash outflow of the present time is determined over a specified period.
Advantage of NPV
NPV does not make any assumption about the cash flow being reinvention at IRR, and it is almost impossible. How is the cash flow reinvested at the project’s rate of return? When the cash flow is being reinvented at IRR, then that means the cash flow from your project, I being invested back into the market at a proportional rate as that of your project rate of return. This will force you to look for alternative investment yield, which I same us your project for reinvestment, and this is very difficult.
It’s good when you want to measure profitability, especially when you want to choose a single project among the many NPV. You might select a small project which has high IRR and a short term nature at the cost top NPV project and long term if we use IRR for mutually restrictive projects.
The danger of engaging the project will be factored into this method since NPV will be calculated using discount rates.
It utilizes both the unconventional cash flow and convectional, whereby the cash flow with both the positive and negative is convectional, and the positive cash flow is unconventional. There will be a calculation of the project yield even if the project is positive or negative. Don't use plagiarised sources.Get your custom essay just from $11/page
NPV will help us to know if what you’re investing will create value, where the advantages will be described by acknowledging the real expectations that increase in the time, even if discounting today’s cash flow is done. Nevertheless, there is no guarantee that NPV will be followed by 100%.other tools can be used with this information to give us a clear picture of an expected outcome.
Disadvantages
The sensitivity of the discount rate is high in the NPV, especially when coming up with this ratio, the reason being that it is the summation of many discounted cash flows. The figure is converted to the present value by taking the negative and positive information. Current value denominators calculation uses the discount rate, which is a crucial component of NPV figure determination. If the figure has small decreases or increases, it might have a considerable impact on the final results.
Because of future uncertainties, short term projects will be focused on NPV instead of long term results. Decision-makers might underrate the profitability of the long term project if the evaluation of the plan by the company is done by looking at the potential a near term profit creates.
We have cost estimations impossibilities sometimes when NPV is calculated, and we cannot use the cash inflows and outflows only as estimates when calculating NPV despite them being the primary component of the equation, the opportunity cost must also be estimated. The figure is defined as an expense that happens and an alternative that might produce a promising inflow not accepted. Payments might not even be calculated by some companies; if the estimation of other options is challenging, then the desired accuracy of the results might not be there from the NPV.
Discount rate choosing might be impossible with NPV; the ability come with exact percentage estimation of a project that represents is dangers premium is not an exact science, if the investment comes with both low risk of loss and safety, then the reasonable discount rate could be 5%.what if there 10% justification from the investment by holding enough chances? Since NPV dictates discount rate selection, then it might not be reliable if the range of standard is incorrect.
As time goes by, the risk level might change. NPV might become so challenging to calculate because it is because we have a notion that the risk might continue at the same level over the lifetime of the effort. What will be the outcome if there are essential dangers to control during the initial year of a project, and the figure reduces so much in the three of a four-year attempt? There will be an application of different discount rates by investors for each expected change; when this calculation is used in the first place, it will remove the efficiencies found.
When there is a change in risk level over the project’s lifetime, then the NPV ratio becomes a nonreliable tool.
IRR (Internal Rate of Return) advantages
When evaluating projects, the internal rate of return will consider the time value of the money. And this is great destruction to the accounting rate return, and both the payback rate and average rate of return. IRR is measured through interest rate calculation at which the PV of future cash flow is the same as the capital required for investment.
The interpretation of the IRR is straightforward if the IRR exceeds the cost capital, the project is accepted, not the other way round. It makes it easy for the managers to visualize, and that’s why most of them prefer using it unless there are exceptional situations.
Deciding about the hurdle rate is subjective and ambiguous, finding of hurdle rate or rate of return is not required in the IRR since it does not depend on the hurdle rate, hence reducing the dangers of determination of hurdle rate. The calculation of profitability index and net present value will require a hurdle rate.
There is always an approximation estimation of the rate of return by managers; IRR is based on return rate requirement. When we stumble upon the IRR, we do both IRR and hurdle rate comparison. If the estimation of the IRR is far from the return rate, there will be safe decision making on both sides by the managers. Room for estimation errors can be maintained too.
IRR (Internal rate return) disadvantages
IRR does not put their concentration on the value of the actual dollar benefits. 10% rate of return and $1,000,000 should always be considered over 50% return of price and $10,000 project value, depth analysis is required; $180,000 is the benefit of past projects, and $5,000 is the dollar benefit of the project. The worthiness cannot be determined, and the IRR will rank the latter with lower dollar profit, the reason being that the IRR of 50% is greater than 18%.
When we use the IRR method to analyze a project, implicitly estimates the positive future cash flow reinvestment for those periods remaining for the project. In another way, if the IRR in other projects is high, the reinvestment rate will be assumed at a very high standard of return. The validity of the situation is not practical; when cash flows are received, there will be a rare possibility to have the same level of investment opportunity.
The two have different project duration, where one of them ends at the period of two years and another one at the period of 5 years, reinvesting the money of the first project has an additional point, unlocking is done at the end of the second year for another three years until the completion of another project, IRR does not consider this point.
Payback period advantages
The calculation and understanding of the concept are simple, and you do not require a calculator or electronic spreadsheet to calculate the payback period when it hooked in a project of a rough analysis.
How fast money can be returned from a project is the only thing focused on this analysis. The risk measurement is of great value. And I am therefore making the payback to be used when comparing the varying payback periods and relative risk of projects.
Disadvantages
It does not consider the standard business features due to its simplicity. Since capital investment cannot be used as an onetime investment, further investigation is needed is such projects in the coming years. Nevertheless, irregular cash inflows are frequent in projects.
There’s a consideration of only the cash flows until the return of the initial investment. The subsequent year’s cash flows do not consider here. And such things might lead you to overlook the project that might be of high profit in the coming years.
NPV calculations
First project
PN=FV/ (1+r) n
WHERE
pn =present value
fv=future value
r=interest rate
n=periods
| COST | Year | 0 | 1 | 2 | 3 | |
| £m | 40 demolition Costs | 30 Construction costs | 30 Construction costs | 30 Construction costs | TOTAL | |
| 10% PV | 1 | 0.91 | 0.83 | 0.75 | ||
| PV | 40 | 27.27 | 24.79 | 22.54 | 114.25 |
10/100=0.1
Fv=40/(1+0.1)0=40
REVENUE
| YEAR | £m | PV |
| 0 | 20 | 20 |
| 1 | 30 | 27.27 |
| 2 | 30 | 24.80 |
| 3 | 30 | 22.54 |
| 4 | 40 | 24.84 |
| PV TOTAL | 119.45 |
NPV of project one=total revenue PV-total cost PV
£119.45-£114.25=£5.2 Million
Second project
COST
| YEAR | £m | PV |
| 1 | 50 | 45.46 |
| 2 | 50 | 41.32 |
| 3 | 50 | 37.57 |
| 4 | 1 | 0.68 |
| 5 | 1 | 0.62 |
| 6 | 1 | 0.56 |
| 7 | 1 | 0.51 |
| 8 | 1 | 0.47 |
| 9 | 1 | 0.42 |
| 10 | 1 | 0.39 |
TOTAL PV=£128
REVENUE
| YEAR | £m | PV |
| 4 | 10 | 6.83 |
| 5 | 12.5 | 7.76 |
| 6 | 15 | 8.46 |
| 7 | 18 | 9.23 |
| 8 | 20 | 9.33 |
| 9 | 20 | 8.48 |
| 10 | 20 | 7.71 |
| 11 | 30 | 10.51 |
TOTAL PV=£m 68.31
NPV of project one=total revenue PV-total cost PV
68.31-128= (59.69)
IRR calculations
Formulae
IRR=R1+ ((NPV1)/ (NPV1-NPV2)) (R2-R1)
Where
R1 stands for the lowest rate.
R2 highest discount value
NPVI=Net present value at the lowest discount rate
NPV2=net current value at the highest value
IRR PROJECT ONE
We can see that R1 is 10% and NPV1 is 5.2, what if the R2 is 30%
COST
| YEAR | £m | PV |
| 0 | 40 | 40 |
| 1 | 30 | 23.08 |
| 2 | 30 | 17.75 |
| 3 | 30 | 13.65 |
| 4 | 30 | 10.50 |
TOTAL PV=104.98
REVENUE
| YEAR | £m | PV | |
| 0 | 20 | 20 | |
| 1 | 30 | 23.08 | |
| 2 | 30 | 17.75 | |
| 3 | 30 | 13.65 | |
| 4 | 40 | 14.01 |
TOTAL PV=88.49
Therefore NPV=88.49-104.98= (16.49)
We can now calculate IRR which is 0.1+5.2/(5.2-(-16.49)(0.3-0.1)=0.11 making IRR =11.21%
PROJECT TWO IRR
The R1=10 and NPV1 is 59.61
What if R1 was 2%?
COST
| YEAR | £m | PV |
| 1 | 50 | 49.02 |
| 2 | 50 | 48.06 |
| 3 | 50 | 47.16 |
| 4 | 1 | 0.93 |
| 5 | 1 | 0.90 |
| 6 | 1 | 0.89 |
| 7 | 1 | 0.88 |
| 8 | 1 | 0.87 |
| 9 | 1 | 0.86 |
| 10 | 1 | 0.85 |
TOTAL PV=£150.42
REVENUE
| YEAR | £m | PV |
| 4 | 10 | 9.26 |
| 5 | 12.5 | 11.36 |
| 6 | 15 | 13.27 |
| 7 | 18 | 15.65 |
| 8 | 20 | 17.95 |
| 9 | 20 | 1.67 |
| 10 | 20 | 0.91 |
| 11 | 30 | 24.19 |
TOTAL PV=£94.26
NPV=94.26-150.42= (55.74)
The IRR is 0.01+-55.74/(-59.61-(-55.74)(0.2-0.1)=0.28
Therefore IRR is -2.8%
Payback
Project one
Cost = 40+30+30+30=£130m
Revenue=20+12.5+15+18+20+20+20+20+30=£150m
Payback period=3 years and we add half a year due to 20/40=0.5 the whole year will be 3.5; hence there is profit.
Project two
Cost= 50+50+50+7=£157m
Revenue= 10+12.5+15+18+20+20+20+20+20+30=£145.5m
We reject the project since it brings loss, and it will take more than ten years for it brings the profit.
According to the NRR, NPV, and payback,it is that project one is the best to use, simply because it the shortest payback period of 3.5 years, the cost of IRR is exceeded by the internal rate return, the NPV is positive while others are negative.
Factors to consider before taking an investment decision
The right time of investment should be put into consideration for the best use of your money. For example, the money you always spend on a credit card can be more than what you can earn when you invest, and that means you should put a restriction on this because it might wipe out your investment.
The reason why you’re investing is fundamental; you might be investing because you’re almost retiring. For that, you should invest in projects that are not risky, but you have enough money you can spend elsewhere.it all depends on your intentions.
Age is also one factor to consider before investing; you being younger is an added advantage because you will take your time to wait for your business to grow, unlike older adults. There are always little responsibilities when you’re young, and therefore give you time to concentrate on the work you’re doing.
Besides, you should have a risk tolerance before starting a project, because the more money you put in your investments, the higher the risk, and also the higher the profit. You should go growth stock if you have a strong personality of losing money for the reason of getting a lot of them.
Net Asset Method
This is the method used to evaluate the value of assets, where adjustments are made to balance the company’s historical balance sheets. That helps in the presentation of each liability and asset, and this is examples taken to normalize the adjustment, fixed asset adjustment for them to fit their specific market values. It helps to reflect any liabilities that have never been recorded, for example, judgments.
ASSETS
| Non-Current assets Land and buildings £25m Fixture and furniture £3m Total £28m Current Assets. Receivables £2m Cash at Bank £3m Total £5m Current liabilities £4m 28+5=33 33-4=29
Assets value £29m.
|
This means Blue sky limited should only accept a value above £29m.
P/E ratio Method.
Price to earnings ratio, is where the company measures the current share price, to it’s per sharing, it’s also known us earning multiple. It’s used to determine the company’s relative share value in apples to apple comparison; it can be used to compare the historical record against the company, and also the market aggregate and overtime.
| Turnover £89m Cost £72.4 Total £16.6 |
| Tax £ (4.98) Profit after tax £11.62 |
| Dividends Earnings £1.62 |
The value of Blue sky is £11.25m
Dividend growth method model
It used by investors and financial experts to steer many available investment financial experts, also to help in the selection of the individual worthiness that fits their portfolio strategy. The primary purpose of this model is to measure the fair value of equity.
p=D1/(k-g) where p is fair value per share of the capital, D. dividends that are expected g=expected profit and k rate of return required, and therefore the blue sky company is PO=10(1+0.02)/0.13-0.02=£29.32
Advantages of Net Asset Method
It is since it has information from the past
It has value despite a lack of historical data
It gives the importance of things that will arise in the future.
Disadvantages
It doesn’t give a picture of future benefits
Traffic amount should be known for it to be analyzed
Advantages of the P/E ratio method
It explains the potentiality of a specific company
It uses both present and past earning to tell the future of the company.
It easy to determine the value of a target since it requires only the earnings, PS, and MPS.
Disadvantages
Earning can be manipulated easily and therefore giving wrong figures
It doesn’t use liabilities when the calculation is done, which is very important in business valuation.
Advantages of the dividend growth model
Growth assumption is not required to create value like other models
For any stock that gives dividends, the model can be used.
The growth of your portfolio is given by the model; you can easily find a place to invest in this model.
Disadvantages
Only the stock with pay dividends works with this model since the small business cannot pay its dividends; it will be difficult to determine its value.
Non-dividend factors are not included, which used to influence the valuation of a stock.
Stock buyback is ignored, and the buyback always has effect on stock value.
Cash offer benefits
Faster closing because waiting for an appraisal is not required
Little risk of foreclosure, once you have bought something, you don’t have to worry at all.
It’s safe in such a way you cannot be conned easily.
Reduces the paperwork and long procedures and hence saves time
Share for share benefits
It is easy for a vendor to exit the business
The shareholder receives purchase funds directly because there’s a direct transaction between the company and the shareholder.
The purchaser is assuming all the liabilities of the company.
The purchaser
acquires the ownership of the company’s liabilities and assets.
Blue sky Ltd should accept share to share exchange since it easy for a vendor to exit the business, and this will be a guarantee for more income.
References
Elmaghraby, S.E., and Herroelen, W.S., 1990. The scheduling of activities to maximize the net present value of projects. European Journal of Operational Research, 49(1), pp.35-49.
Yang, K.K., Talbot, F.B. and Patterson, J.H., 1993. Scheduling a project to maximize its net present value: An integer programming approach. European Journal of Operational Research, 64(2), pp.188-198.
De Reyck, B., Degraeve, Z. and Vandenborre, R., 2008. Project options valuation with net present value and decision tree analysis. European Journal of Operational Research, 184(1), pp.341-355.
Smith‐Daniels, D.E. and Aquilano, N.J., 1987. Using a late‐start resource‐constrained project schedule to improve project net present value. Decision Sciences, 18(4), pp.617-630.
Sunde, L. and Lichtenberg, S., 1995. Net-present-value cost/time tradeoff. International Journal of Project Management, 13(1), pp.45-49.
Kim, Y.H., Philippatos, G.C. and Chung, K.H., 1986. Evaluating investment in inventory policy: A net present value framework. The Engineering Economist, 31(2), pp.119-136.