Capital Budgeting: Cash Flow Estimation and Risk Analysis

NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. Following is the mathematical computation of the NPV, IRR and MIRR of the proposed investment Particulars Year Now 1 2 3 4 Sales - 250,000 257,500 265,225 273,182 Cost of sales - (125,000) (128,750) (132,613) (136,591) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - 45,801 20,752 96,616 119,795 Taxation - (18,320) (8,301) (38,646) (47,918) Profit after tax - 27,481 12,451 57,969 71,877 Depreciation Charges (added back) - 79,200 108,000 36,000 16,800 Rent forgone - (20,000) (20,000) (20,000) (20,000) Working Capital (30,000) (900) (927) (955) 32,782 Sale proceed from disposal of asset - - - - 25,000 Capital expenditure Invoice amount (200,000) - - - - Shipping charges (10,000) - - - - Installation charges (30,000) - - - - Net Cash flow (270,000) 85,781 99,524 73,014 126,459 Present value factor 1 0.9091 0.8264 0.7513 0.6830 Present Value (270,000) 77,982 82,251 54,857 86,373 Net present value 31,464 IRR 15% MIRR 13% As apparent from the above initial investment appraisal analysis, the project appears to be lucrative and feasible as the Net present value is positive and the Internal rate of return and the marginal rate of return is both higher than the cost of capital of the company. It is also of prime importance to perform a sensitivity analysis on any investment appraisal in order to analyze how sensitive is the profitability of the project is to the variables of the project. Sensitivity Analysis Unit Sales Variation Plus 10% Minus 10% NPV 106,379 7,266 Salvage Value Variation Plus 20% Minus 20% NPV 60,238 20,000 Cost of capital Variation Plus 30% Minus 30% NPV (91,978) 593,097 Following is the graphical representation of the sensitivity analysis Change in unit sales Change in sale proceeds on disposal Change in discount rate As apparent from the above analysis, the project is not so much sensitive to the change in the unit sales. However, the most sensitive variable in the investment appraisal of this project is the discount rate a variation in which is likely to result in drastic change in the net present value of the project. The following tabular information also presents the percentage change by which if all of the three variables under consideration increases or decreases, the NPV would be negative and the project would not br worthwhile taking. Unit Sales 13.76% Sales Proceeds 3.33 times Discount rate 19.00% In order to account for various probabilities, it is also advisable to undertake a probability analysis considering various scenarios. Worst Case Particulars Year Now 1 2 3 4 Sales - 144,000 148,320 152,770 157,353 Cost of sales - (90,000) (92,700) (95,481) (98,345) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - (25,199) (52,378) 21,292 42,211 Taxation - 10,080 20,951 (8,517) (16,885) Profit after tax
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