International Food Genetics (IFG) is going to distribute a range of genetically engineered vegetable seeds to the market. The purpose of the first part of this report is to evaluate the viability of this investment by analyzing the predicted cash flows of IFG and evaluating them using the NPV, IRR and payback methods. The second part of this report is to compare the pros and cons of using NPV and IRR methods.
When beginning capital-budgeting analysis, it is important to determine the cash flow of a project. Cash flow is the difference between cash received and cash paid out. And cash flows can be segmented into three types: 1)Initial outlay 2)operating cash flow 3)total cash flow In International Food Genetics (IFG), its initial outlay is $100,000. The operating cash flow of IFG is sales –costs of goods sold-wages-license-rent (minus opportunity cost)-overheads=operating cash flows. The rent of is considered as the opportunity cost given IFG gave up rental value of $1000, 000 by undertaking the project. The overhead of $100,000 is directly related to the project, which gives us a further set of cash outflows. And the rest of the overheads costs ($500,000-$100,000) is considered sunk costs. The cost of vehicle was $500,000 and it was sold at the end of 2012 at $200,000. The salvage value is considered cash inflow.
The following table shows the summary of the cash flows:
| T0 | 2008 | 2009 | 2010 | 2011 | 2012 |
| sales | | 5000 | 6000 | 6000 | 6000 | 6000 |
| costs of goods sold | | 2000 | 2400 | 2400 | 2400 | 2400 |
| wages | | 500 | 500 | 500 | 500 | 500 |
| licence | | 1000 | 1000 | 1000 | 1000 | 1000 |
| rent | | 200 | 200 | 200 | 200 | 200 |
| minus rent-opportunity cost | | 1000 | 1000 | 1000 | 1000 | 1000 |
| vehicle-variable transport costs | | 500 | 500 | 500 | 500 | 500 |
| Add: vehicle-salvage value | | | | | | 200 |
| depreciation | | | | | | |
| overheads | | 100 | 100 | 100 | 100 | 100 |
| operating cash flow | | -200 | 400 | 400 | 400 | 600 |
| total cash flow | -100 | -1300 | 400 | 400 | 400 | 1600 |
Depreciation is a noncash expense. It is considered important only if it reduces taxable income (textbook). As a growth company, IFG did not subject to any taxation. Its depreciation costs should be deducted from the calculation of the net present value.
Net working capital which is the difference between current assets and current liabilities should also be recognized. The working capital of $1000, 000 was considered cash outflows, whereas when the project comes to an end in 2012, the working capital is recovered.
| | period |
| | T0 | 2008 | 2009 | 2010 | 2011 | 2012 |
| capital investment | | -100 | | | | |
| change in working capital | | -1000 | 0 | 0 | 0 | 1000 |
Therefore, the total cash flows (after tax) is initial outlay plus change in working capital plus the operating cash flows. The discount rate of return is 7%. The present value (PV) can be calculated for each year:
To: -100/(1.07)= XXXXXXXXXX
2008:-1300/(1.07)= XXXXXXXXXX
2009:400/1.034= XXXXXXXXXX
2010:400/1.225= XXXXXXXXXX
2011:400/1.311= XXXXXXXXXX
2012:1600/1.403= XXXXXXXXXX
| T0 | 2008 | 2009 | 2010 | 2011 | 2012 |
| total cash flow | -100 | -1300 | 400 | 400 | 400 | 1600 |
| | | 1.07 | 1.034 | 1.225 | 1.311 | 1.403 |
| PV | XXXXXXXXXX | XXXXXXXXXX | XXXXXXXXXX | XXXXXXXXXX | XXXXXXXXXX | XXXXXXXXXX |
| Net present value | | 806.73 | | | | |
The sum of the present values is $806.73, which is the net present value (NPV). NPV is usually calculated by adding the present value of future cash flows, residual values, and interest, minus investment costs, opportunity costs, and future expenses. NPV=C0+C1/(1+r)+C2/(1+r)²+C3/(1+r)³+C4/(1+r)4+C5/(1+r)5
When NPV is greater than 0, it is suggested that IFG should invest in the investment.
The IRR is the interest rate that makes the NPV zero.
IRR= NPV=C0+C1/1+IRR+C²/(1+IRR)² +C³/(1+IRR)³ +C4/(1+IRR)4 +C5/(1+IRR)5 +Cn/(1+IRR)n=0
=25%
The IRR is 25%, which is the rate that makes the present value of the investment’s cash flows equal to zero. From a purely financial standpoint, IFG should invest in this project because it generates 25%-much higher than the 7% return available from other investments.
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from cash inflows generated by the investment (textbook).
Because the cash flows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:
Payback period=A+B/C
A: the last period with a negative cumulative cash flow
B: the absolute value of cumulative cash flow at the end of period A
C: the total cash flow during the period after A
(Cash flow in million)
| Year | Cash flow | Cumulative cash flow |
| 0 | -100 | -100 |
| 1 | -1300 | -1400 |
| 2 | 400 | -1000 |
| 3 | 400 | -600 |
| 4 | 400 | -200 |
| 5 | 1600 | 1400 |
=3+(-600/400)
=3+(600/400)
=4.5 years
It takes about 4.5 years to repay the investment. The longer the time required for covering funds, the more uncertain are the positive returns.
Decision criterion:
If NPV is greater than 0, we should accept the project.
If IRR is greater than cost of capital (7%), we should accept the project.
Both NPV, IRR and payback methods show that the project is worthwhile to undertake.
NPV measures how much wealth a project creates or destroys for shareholders. Given our objective is to maximize shareholder wealth, the NPV approach has the clearest link to this objective, and therefore is the standard in this case for evaluating investment opportunities. Also, since inflation and taxation is not included in the project of IFG, we can use NPV methods to determine the appraisal value after adjustment of inflation and taxation. IRR is used to measure profitability of an investment through the decision of higher IRR to cost of capital. NPV measures only give us absolute increase or decrease in wealth; on the other hand, IRR gives us percentage figure for projects comparisons. However, using IRR alone is not as effective as using NPV to discount cash flows because IRR use one single discount rate to evaluate every investment. The payback method is the reciprocal of IRR and is the most effective method to decide which type of investment that will generate quick cash flow. However, since payback methods only consider cash flows up to the time when the expected future cash inflows recoup the net initial investment in a project, it ignores profitability. Furthermore, when the cash flows are non-uniform, like our case, the payback method may not give fair approximation of the IRR. Since IFG is in growth industry, and is a new entry to the market, there is uncertainty in future cash flow. The length of the time to generate cash flow is very important in investment decisions. Payback methods therefore are also suitable to use to help IFG to select projects to minimize risks. It is important to note that payback methods are inadequate appraisal techniques and should not be used alone. NPV and IRR are appropriate ways of valuing future cash-flows. However, if there is the use of conservative cash flow forecasts, combined with the incorrect treatment of inflation, and excessive discount rates, it may lead to rejecting profitable investments. They must be used for evaluation with
Overall, NPV with the complementary methods of IRR and payback methods, we are then able to make a sound investment decision out of the available options.
There are also other factors IFG may consider before coming to final conclusion regarding the project investment. Apart from financial factors, it is also important to consider factors, such as government regulations, market opportunities, quality of management, training personnel procedures and environmental impact..Etc. Those are also important factors to consider before making a final investment decision.
2)
Both NPV and IRR use discounted cash flow approach in which all expected future cash inflows and outflows of a project is measured. All other things being equal, using NPV and IRR to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flow. :1) IRR ignores the size of investment projects 2) if the cash flows are positive and negative then we obtain two IRRs or no IRR 3) Both of the methods reach the same decisions with investments that are independent. However, with mutually exclusive investments, NPV methods are easier to use and more reliable.4) IRR rule is difficult to apply when discounting factors used over the years are difficult. 5) In some cases, several zero NPV discount rates may e xist so there is no unique IRR. 6) NPV calculation uses different discount rates, and then it produces different results for the same projects. But IRR always gives the same result. The following examples illustrate the drawbacks of using IRR in some situation:
- Timing of cash flows:
We assume that we have two type of investment (Foreign Food and Local Food). The cash flow for Foreign Food is as below:
Foreign Food
| C0 | C1 | C2 | C3 | C4 | C5 |
| -1000 | 0 | 0 | 460 | 550 | 900 |
At the cost of capital of 16%
NPV=-1000+0/1.07+0/1.07²+460/1/07³+550/1/ XXXXXXXXXX/1.075
=$23.25
At the cost of capital of 17%
NPV=-1000+0/1.09+0/1.09²+460/1.09³+550/1/ XXXXXXXXXX/1.095
=$-7.51
Therefore, somewhere between the cost of capital of 16%-17%, we change from accepting to rejecting it. And we can also calculate the IRR, which makes NPV=0
=0
IRR=-1000+0/1+r+0/1+r²+460/1+r³+550/1+r4+900/1+r5…..+CF/(1+r)?
=17%
In such case, we can tell that rejecting the project of Foreign Food if the cost of capital is greater than the IRR (17%). However, sometimes NPV and IRR provide conflicting result when the investment have different timing of cash flows.
Foreign Food
| C0 | C1 | C2 | C3 | C4 | C5 |
| -1000 | 0 | 0 | 460 | 550 | 900 |
Local Food
| C0 | C1 | C2 | C3 | C4 | C5 |
| -1000 | 320 | 320 | 320 | 320 | 320 |
The cash flow for Foreign Food is delayed, whereas the cash flows for Local Food equally distributed over the years. The IRR for Local food is 18%. Therefore, the IRR ranks Local Food higher. However, it might not be necessarily the case for NPV rule.
| Cost of capital | Foreign Food NPV | Local Food NPV |
| 30% | ¥-273.58 | ¥-169.71 |
| 25% | ¥-195.43 | ¥-111.54 |
| 20% | ¥-89.06 | ¥-35.84 |
| 15% | ¥55.98 | ¥63.21 |
| 9% | ¥302.55 | ¥224.48 |
| 7% | ¥408.20 | ¥291.65 |
Note that the project of Local Food is better when the cost of capital is greater than 15%, whereas the project of Foreign Food is better if the cost of capital is less than 9%. Under NPV rule, Foreign Food will be chosen when cost of capital is less than 9%. However, IRR rule chose Local Food. When the cost of capital is relatively high, the delayed cash flows are penalized, and vice versa. And the relative low cost of capital makes the delayed cash flows more favorable. When IRR is high relative to the cost of capital it is not unrealistic to assume reinvestment at a high rate. What makes NPV more preferred is when comparing investment with different timing of cash flows.
- Cost of Capital:
IRR is the discount rate that gives a zero discount cash flow value. IRR is a measure of profitability but not a true measure of the return of a T-period (textbook).
That means IRR can favor investments with high rates of return even if the dollar amount of the return is small. For example, Foreign Food invested $100,000, the IRR was 25%. On the other hand, a $1 investment returning $1.6 will have a higher IRR(71%) than a $100,000 investment returning $1600,000.
3)Lending or borrowing
| Project | C | C | IRR | NPV at 10% |
| Foreign Food | -1000 | 1600 | 60% | 413.22 |
| Local Food | 1000 | -1600 | 60% | -413.22 |
Both projects have IRRs of 60%. However, it is clearly that Foreign Food, we are lending money, which indicates a high rate of return. However, for Local Food, we are borrowing money, which indicates a low rate of return. NPV in such case is a more reliable measure.
- More than one opportunity cost of capital:
When we have several opportunity cost of capital, we have to compute a complex weighted average of the rates in order to obtain a number comparable to IRR. Therefore, some firms just assume there is no difference between short-term and long-term discount rates in calculating IRRs.
- Mutually exclusive Investment:
If undertaking any one type f investments will change the profitability of other investments, such investments are said to be mutually exclusive. IRR Methods are less reliable for mutually exclusive investments than NPV methods. For example, Local Food has a higher NPV; however, the IRR rule indicates that we should choose Foreign Food. The IRR on incremental basis is 70%, which is in excess of opportunity cost of capital. Therefore, we prefer Local Food to Foreign Food. Unless we look at incremental expenditure, IRR is unreliable in ranking projects in different scale.
| Investment | Cash flow | IRR | NPV at 10% |
| Foreign Food | -100 | 190 | 90% | $66.12 |
| Local Food | -200 | 360 | 80% | $115.7 |
Incremental
(Local-Foreign) | -100 | 170 | 70% | $49.59 |
Both Foreign Food and Local Food require an outlay of $300 but the pattern of cash flows is different. Foreign Food’s cash flows are increasing over time, whereas Local Food’s cash flows are decreasing over time. IRR method leads to the selection of Local Food. However, when NPV at 10%, it implies that Foreign Food should be selected. Therefore, IRR in such case is misleading.
| Investment | Cash Flows | IRR | NPV |
| C0 | C1 |
| Foreign Food | -300 | 180 | 250 | 380 | 440 | 76% | $596.61 |
| Local Food | -300 | 638 | 138 | 100 | --- | 138% | $426.53 |
| Investment | Cash Flows | IRR | NPV |
| C0 | C1 | C2 | C3 | C4 |
| Foreign Food | -300 | 180 | 250 | 380 | 440 | 76% | $596.61 |
| Local Food | -300 | 638 | -138 | 100 | --- | 98% | $219.17 |
Again, if the cash outlay occurs after regular intervals during its expected life, decision of IRR leads to the selection of Local Food. However, at NPV 10%, Foreign Food should be picked. Therefore, the timing and pattern of cash flows can produce conflicting results in NPV and IRR methods.
6)Multiple rate of return:
When cash flows of a project change sign more than once, then there will be multiple IRRs. From the example below, we can calculate both NPV and IRRs with change in the sign in cash flows:
| C0 | C1 | C2 | C3 | C4 | IRR |
| -580 | 530 | 530 | 530 | -1080 | 10% |
| discount rate% | NPV |
| 0 | -70 |
| 1 | -58.55 |
| 5 | -24 |
| 8 | -7.38 |
| 10 | 0.34 |
| 12 | 5.9 |
| 16 | 11.94 |
| 26 | 8.68 |
| 32 | 0.3 |
| 40 | -13.57 |
| 50 | -31.6 |
| 60 | -48.2 |
| 70 | -62.52 |
The above NPV curve shows that the cure crosses the X-axis twice, which means there are two IRRs. We can also tell from the graph that these two IRRs are between 10% and 32%. With the help of excel, we got two IRRs: 9.8966% and XXXXXXXXXX%. NPV is positive if the discount rate is between two IRRs. And it is also possible that there is no IRR exist. For example, the below project has a positive value at all discount rates:
| C0 | C1 | C2 | C3 | C4 |
| 500 | -360 | 520 | 400 | 550 |
IRR: None
NPV at 3%:$1451.81
Therefore, in evaluating projects with change in the sign of cash flows streams, it is better to use NPV methods.
Although there are quite a lot of pitfalls for IRR methods, ease of comparison makes IRR attractive. IRR if used appropriately gives the same answer as NPV. IRR allows management to rank projects by their overall rates of return rather than the net present vales. IRRs work for investments have an initial cash outflow followed by one or more cash inflows.
NPV considers different things such as investment opportunity costs, interest rates and cost of capital, which is very important for evaluating long-term ventures. Hence, NPV enables a company to consider the risk of prospective cash flow and tells whether the investment is going to enhance the value of the firm. Another key benefit of NPV is that it also takes uncertain cash flow and inflation into account. These make NPV very helpful for projects appraisals. On the other hand, NPV is only accurate if there is required information. It requires that the investor know the exact discount rate, the size of cash flow, when the cash flow occurs. And it is very difficult to determine in real life situations. For example, the cost of developing technology know-how and how much revenue it will earn is hard to determine. Moreover, NPV is only useful for comparing investment at the same time, without considering the opportunity costs. If investors consider the opportunity cost of investment in the future, NPV does not build in the opportunity cost of not having the capital to spend on future investment options. Also, NPV does not provide a gain or loss picture of the investment. IRR, on the other hand, provide answers to percentage gain or loss of executing a certain project. IRR also provides information on the margin of safety which NPV does not provide. In summary, for any project which is long-term, has multiple cash flows at different discount rates or has uniform cash flows, NPV is more suitable for project evaluation. On the other hand, when evaluating two projects, both of which share one discount rate, predictable cash flows, equal risk and a short time period, IRR would work better because of its simplicity. IRR is best-suited for analyzing venture capital and private equity investments, which typically entail multiple cash investments over the life of the business, and a single cash outflow at the end via IPO.