Net present value for rapid - Costs Essay Example

Executive Summary

The main advantages of the net present value method over other capital investment appraisal techniques will be the opening section of this assignment - Net present value for rapid introduction.  We will mainly outline the advantage of the time value of money and other benefits over the internal rate of rate.  Two main disadvantages, which limit the utility of such approach, will also be put forward.  The Rapid-Jet proposal will be analyzed with the net present value method nothing its unfeasibility.  Sensitivity analysis will then proceed on the number of flights and number of passengers required to reach a positive net present value.  A 19% increase and a 15% rise will be determined from the relevant calculations.  In the latter section, we shall also examine the importance of qualitative characteristics of the project on employees, shareholders and the brand image of the Frontier Air Freight Limited.

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1.1 Benefits of the Net Present Value Method

The net present value technique of capital budgeting is frequently known as a technique based on concept that a project is regarded viable if the net present value of all anticipated cash inflows is greater than or equal to the capital expenditure incurred in the project.  Indeed the cash inflows and outflows during the course of the project are discounted with an agreed discount rate (Weetman P. 2003, p 739).  One of the main benefits of the net present value method arises from such principle of discounting, commonly known as the time value of money concept.  This concept is based on the premise that £1 today is more valuable that £1 next year.  This arises from a number of logical factors present in the business environment.  In economics lost alternatives are assessed and an opportunity cost is attached to such lost options in business evaluation.  For instance, if a person endows £10,000 pounds today in assets to commence trading as an electronics retailer, he is losing the opportunity from having this money available for other business opportunities, like for example investment in a 5% savings account.  This opportunity cost1 thus justifies the proposition that £1 today is more valuable that £1 next year.  Therefore the net present value method is acclaimed for considering proper economic factors in the capital project analysis.  Indeed the utilisation of this technique allows comparison of the return on investment in capital projects with a similar investment risk (Drury C. 1996, p 388 and 389).

It is also frequently contended that the net present value method is technically superior to the Internal Rate of Return method.  The internal rate of return system applies discount factor to calculate the exact rate of return at which the project’s net present value equates zero (ACCA Study Text 1999, p 110).  The net present value is considered as an absolute measure on the project’s return, while the internal rate of return comprises a relative measure on the timing and amount of cash flows in relation to the initial capital expenditure.  Therefore the net present value is capable to reflect the scale of the project, whereas the other method is not (Lucey T. 2003, p 418).

In case of mutually exclusive projects the ranking derived by the net present value method tend to differ from that of the internal rate of return.  In these instances the ranking derived from the net present value scheme is more desirable because it directs towards the project with the greatest increase in wealth for the organisation (Lucey T. 2003, p 419-420).

Likewise, the net present value method exceeds the internal rate of return system when non-conventional cash flow patterns arise, due to the inherent assumptions in the model.  The net present value approach assumes that cash flows generated from the project are reinvested at the company’s cost of capital rate, whereas the internal rate of return scheme presumes that funds are invested back at the internal rate of return.  This is inherently fallacious because the internal rate of return is higher than the cost of capital in case of viable projects.  The modified internal rate of return developed is also of a lesser effectiveness when compared to the net present value approach because it introduces additional strata of assumptions in the capital project calculations (Lucey T. 2003, p 421-422).

1.2 Limitations of the Net Present Value Method

A negative argument on the net present value method is that the computation approach of the net present value is much more complex than other capital expenditure appraisal systems like the accounting rate of return and payback method (Randall H. 1999, p 442-443).  Indeed in practice, such other methods are preferred because interested users in capital evaluations find difficult to comprehend such method due to lack of accounting and finance knowledge.

Another argument why management seek other ways of appraising projects, such as the accounting rate of return system is because this approach does not consider profitability (Randall H. 1999, p 442).  Management frequently dislike this since they contend that the return on the project will be determined in terms of profitability in the financial statements and their performance will be examined by external users on the profit derived and not the cash flow obtained.  They thus state that hidden expenses like depreciation will further deduct the project return that is actually portrayed in the net present value method approach, since profitability is determined in line with the accruals concept (Lewis R. et al 1996, p 29).

1.3 Net Present Value for Rapid-Jet Proposal

The cash inflows and outflows for Rapid-Jet project leading to the discounted net present value are depicted below:

Details 2007 2008 2009
Cash Inflow:      
Sales Revenue 400,000 1,200,000 3,150,000
Disposal proceeds from Planes 0 0 210,000
Total Cash Inflow 400,000 1,200,000 3,360,000
Cash Outflow:      
Planes capital expenditure 1,050,000 0 0
Fuel costs 80,000 200,000 450,000
Landing fees 150,000 360,000 1,050,000
Skoprad labour costs 235,000 320,000 405,000
Bookings costs 20,000 48,000 105,000
Advertising and Marketing costs 120,000 120,000 90,000
Other salaries 60,000 60,000 60,000
Total Cash Outflow 1,715,000 1,108,00 2,160,000
Net Cash Inflow/(Outflow) (1,315,000) 92,000 1,200,000
10% Discount Factor 0.9091 0.8264 0.7513
Present Value (1,195,467) 76,029 901,560

Net Present Value = ₤(217,878)

Source: Horngren T. C. 1997, p 834 – 837.

Notes:

  • The consultancy fees payable to Carneige Ltd. were not considered in the analysis because they are already incurred and will be paid irrelevant of the decision taken (Drury C. 1996, p 44).

With the information provided, the Rapid-Jet proposal is not financial feasible because the firm will end up with a negative net present value of ₤217,878.  In this respect, basing solely on the financial information data, the project should be rejected.

1.4 Sensitivity Analysis on the number of flights in 2009

By examining the net present value table determined in the section above, one could see that the financial year 2009 is critical for the viability of the project.  In this respect the sensitivity analysis carried out will focus on this year.  The net present value arising from variations in the number of flights is shown below:

Details Higher Percentage
  19% 18%
Number of RJ Flights 1,785 1,770
2009 Cash Inflow/(Outflow)
Cash Inflow:    
Sales Revenue 3,748,500 3,717,000
Disposal proceeds from Planes 210,000 210,000
Total Cash Inflow 3,958,500 3,927,000
Cash Outflow:    
Fuel costs 535,500 531,000
Landing fees 1,249,500 1,239,000
Skoprad labour costs 405,000 405,000
Bookings costs 124,950 123,900
Advertising and Marketing costs 90,000 90,000
Other salaries 60,000 60,000
Total Cash Outflow 2,464,950 2,448,900
Net Cash Inflow/(Outflow) 1,493,550 1,478,100
10% Discount Factor 0.7513 0.7513
Present Value 2009 1,122,104 1,110,497
Present Value: 2007

2008

(1,195,467)

76,029

(1,195,467)

76,029

Net Present Value 2,666 (8,941)

In order to become financially viable the project, the number of flights in 2009 have to increase by 19% as shown by the above calculations.  If this is the case, a net present value of £2,666 will be achieved.  If the percentage falls below this category losses will be incurred.

1.5 Sensitivity Analysis of the number of passengers in 2009

Again variations in the number of passengers will be carried out in order to identify the minimum number of passengers required to achieve a positive net present value from the Rapid-Jet Project.  The calculations are depicted below:

 

Details Higher Percentage
  15% 14%
Number of passengers 40.25 39.9
2009 Cash Inflow/(Outflow)
Cash Inflow:    
Sales Revenue 3,622,500 3,591,000
Disposal proceeds from Planes 210,000 210,000
Total Cash Inflow 3,832,500 3,801,000
Cash Outflow:    
Fuel costs 450,000 450,000
Landing fees 1,207,500 1,197,000
Skoprad labour costs 405,000 405,000
Bookings costs 120,750 119,700
Advertising and Marketing costs 90,000 90,000
Other salaries 60,000 60,000
Total Cash Outflow 2,333,250 2,321,700
Net Cash Inflow/(Outflow) 1,499,250 1,479,300
10% Discount Factor 0.7513 0.7513
Present Value 2009 1,126,387 1,111,398
Present Value: 2007

2008

(1,195,467)

76,092

(1,195,467)

76,092

Net Present Value 7,012 (7,977)

In this instance the increase in number of passenger to reach a minimal net present value is lower than the other instance and amounts to a 15% increase.  In such a situation a net present value of £7,012 will be achieved.  Lower percentages will lead to a negative present value as indicated above.

1.6 Additional Considerations to be evaluated

In the project of Rapid-Jet we have only considered the financial aspects of the project.  However a meticulous company should also take into account qualitative characteristics related to the project.  For instance, the effect of the brand image of the service provided should be considered.  If management believe that they cannot provide the attributes, which they are already adopting, they should not embark into such project (Kotler P. et al 1999, p 571).

The effect that the project will entail on shareholders perception is another important qualitative issue.  We have to keep in mind that an organisation is set to maximize shareholders wealth.  However, the firm’s investors are frequently risk-averse and are not will that the company undertakes risky investments that require a substantial amount of capital invested.  In this respect if the directors intend to enter in such project, they should set meetings with the shareholders in order to illustrate them the capital project at hand and thus try to minimize the negative effect it may have on the company’s value in the capital market.

The effect on employees and other entities affected by such decision ought to be put in contemplation before deciding on the acceptability of the project.  Management should also keep abreast the fact that a part of the organization’s achievement is due to the employees of the firm.  Thus it is vital that such significant projects are communicated properly to all staff in order that everybody in the firm is ready for such a new venture.  It should also be stressed out the fact that neglecting staff can lead to demotivation and lower productivity in the long-term.  Therefore executive management should stress out with operational managers the importance of communicating and if possible involving employees in such new venture.

References:

ACCA Study Text (1999). Information for Control and Decision Making. Seventh Edition. London: BPP Publishing Limited.

Drury C. (1996). Management and Cost Accounting. Fourth Edition. London: International Thomson Business Press.

Horngren T. C.; Foster G.; Datar M. S. (1997). Cost Accounting – A Managerial Emphasis. Ninth Edition. London: Prentice-Hall International (UK) Limited.

Kotler P.; Armstrong G.; Saunders J.; Wong V. (1999). Principles of Marketing. Second European Edition. London: Prentice Hall Europe.

Lewis R.; Pendrill D. (1996). Advanced Financial Accounting. Fifth Edition. London: Pitman Publishing.

Lucey T. (2003). Management Accounting. Fifth Edition. Great Britain: Biddles Limited.

Weetman P. (2003). Financial and Management Accounting. Third Edition. Gosport: Ashford Colour Press Limited.

Randall H. (1999). A Level Accounting. Third Edition. Gosport: Ashford Colour Press Limited.

1 Is an economic measure of the income contribution foregone by not using limited resources in the next-best alternative.

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