The company does not seem to be cash-rich as it currently has an overdraft facility. Although the company has been operating successfully, taking on the project will put the company in an unfavourable cash flow position.
The Internal Rate of Return in which the Net Present Value is zero is undefined as there is no discount rate that is small enough to make the Net Present Value zero. The company has already incurred a considerable sum of GBP 750,000 on research and development of this new range. Perhaps, the company can consider alternative ways of manufacturing this product, such as outsourcing or negotiating for better material costs without compromising on its quality.
The initial research cost of the project has already been incurred by the company and is considered as sunk cost. This is because whether Paddle Your Own Canoe Plc takes up the project, or not, the initial research cost will still be considered as being spent. In analysing the cash flow that will be generated from the project, sunk costs must be ignored. As such, the treatment of the initial research cost is to exclude from the cash flow calculation.
Likewise, depreciation of the plant and machinery is not included in the calculation of the cash flow because this is a non cash flow item, while the investment appraisal focuses on cash flows. Depreciation is an accounting method of recognising the reduction of the company's fixed assets in its income statement over time and does not affect cash at all. Thus, this item has also been excluded.
The additional working capital that the company needs to invest in is meant for other purposes at the end of the project. In fact, this will only be released for use at the end of the project. Although the company has to commit to this much earlier, the item has also been excluded in the calculations. This is because the working capital is not related to the project and will not affect the investment at all. However, in the event that the working capital is sought for the purpose of the project, then this will have to be considered in determining the feasibility of the project.
The payback period calculation looks at the shortest number of years to recover the cost of the project. Although the calculation is easy to understand and simple, it still has its limitations. It ignores the benefits that occur after the payback period and more importantly, the method ignores the time value of money.
The Net Present Value is an indicator of how much value an investment or project adds to the company. The Net Present Value is a more reliable method of calculating the returns expected from investments as the method considers the time value of money. The Net Present Value compares the value of a dollar today to the value of that same dollar in the future, taking both inflation and returns into account. A positive Net Present Value generated from a prospective project is a good sign and should be accepted On the contrary, a negative Net Present Value resulting from projects should be rejected because the cash flows will also be negative.
The Internal Rate of Return is the discount rate that delivers a Net