Coursework

Notes and assumptions

• License fees have been taken on the basis of the amount incurred.
• The overhead cost of 150000 is only allocated not incurred thus it is not associated with the project.
• Working capital will be received back at the end of project
• Tax paid is considered as cash outflow and computed on the basis of given projected profit and loss accounts (income statements)
• Depreciation is ignored.
• The cost of cutting tool will be considered as an expense as the cost is increasing due to this project.
• Resale value of the project will be considered as income.
• Survey cost is the expense of the first year irrespective of the year in which it is write off.

Other things are remaining constant, the investment that pays itself back in the shortest time frame is regarded as the optimal choice. Businesses prefer a shorter time frame as investment costs get sooner recovered and the funds are again available for use in further activities. In addition to this, a short payback period is considered to be less risky. Analysts usually presume that the longer it takes to get back the funds, the higher is the uncertainty of the positive returns (Das, 2011). Due to this, the payback period is at times seen as a measure of risk.

Discounted payback period is the length of time that the discounted net cash revenue of a project takes to pay back the original investment. When calculating the discounted payback period, time value of money is considered and is, therefore, more reliable than the regular payback period. In simple terms, this period presents the number of years it consumes to break even from original investment, by discounting future cash flows and acknowledging the time value of money. However, it does not consider the cash inflows from project subsequent the payback period (Drury, 2008).

The Accounting Rate of Return refers to the amount of return or profit, a business can expect on the investment made by it. Under this method, the average profit is divided by the initial investment to obtain the return or ratio that the company can expect. ARR does not take into account the time value of money, which implies that returns taken in later years might worth less than those taken at present. It also ignores cash flows which can be an instrumental element of managing a business (Harris and Mongiello, 2012). This metric is employed primarily to compare between several projects as it takes a fundamental stance at how a project is performing.

IRR refers to the rate of interest at which the NPV of all cash flows from an investment, or a project will be zero. This metric is employed to assess the attractiveness of an investment or a project. In contemplating projects, the company will set a required rate of return for determining the percentage of minimum acceptable return which the investment should earn to be worthwhile. If the IRR of the new investment is higher than the firm’s needed rate of return, then it is a desirable investment and vice versa (Bandy, 2014).

Interpretation: As the IRR is greater than the cost of capital (15%) the investment in the exploration project is worthwhile and the profitable one.

Advantages of project

High initial investment

Post payback period is shorter

Recommendation

The company is recommended to select the project because it has positive net present value and the payback period is lower than project duration. By accepting this project, company will be able to make an increase in their overall profitability.

Part II

NPV when market condition is good

Based on the above calculations, the earlier recommendations are slated to change. Previously, the sales numbers produced by the accountant reflected only a specific market condition. On getting the estimated sales from the statistician and learning that the sales could fluctuate widely, a new insight has been obtained. It is recommended that the company should not select a project as NPV is negative as well as it contains higher risk. Even when the times are good, the NPV is £9278 which is less than the alternative project’s NPV of £30,000. By considering alternative option of investment, the company is recommended to select the project with expected NPV of £30,000 and standard deviation of NPV is £1,000,000. It is because; the project has positive NPV, so it will be beneficial for the company to invest.

The expected return on a single investment is basically the summation of the probabilities of the likely expected returns for that investment. Portfolio standard deviation refers to the standard deviation of an investment portfolio. It is a measure of the deviation of the expected cash inflows from a specific portfolio. Variance identifies the volatility or the variation from the average. As volatility is the measure of risk, this metric helps in determining the risk the business may take when investing in a particular project. One of the finance’s most fundamental principles is that diversifying the portfolio results in mitigation of risks unless in the case of perfect correlation between the cash inflows on the portfolio investments. Due to the advantages of diversification, a portfolio’s standard deviation must be less than the weighted average of the individual investments’ standard deviations (Halpin and Senior, 2011).

References

Bandy, G., 2014. Financial Management and Accounting in the Public Sector. Routledge.

Das, C. S., 2011. Business accounting and financial management. PHI Learning.

Drury, C., 2008. Management and Cost Accounting. Cengage Learning EMEA.

Halpin, W. D. and Senior, A. B., 2011. Financial Management and Accounting Fundamentals for Construction. John Wiley & Sons.

Harris, P. and Mongiello, M., 2012. Accounting and Financial Management. Routledge.

Tantisuvanichkul, V., 2014. Optimising Net Present Value Using Priority Rule-based Scheduling. The university of Manchester.

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