Project+Management+UG

1rt npv npv i r c ta r s rr tt 0 accept indifferent

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Unformatted text preview: se are variable and changes with the size of project What determines the discount rate r r = rf + ri + rr Where: r rf ri rr r is the discount rate the risk free interest rate. Normally government bond Rate of inflation. It is measured by either by consumer price index or GDP deflator. Risk factor consisting of market risk, industry risk, firm specific risk and project risk Market Risk Industry Risk r = Firm specific Risk Project Risk Example: If risk free interest is 5%, inflation 3% then nominal rate of interest is 8%. In addition if we add 5% risk premium then our discount rate is 11% Later we argue that weighted average cost of capital would make a good indicator for discount rate Example: Meehan to accept road construction project Meehan corp. is a civil engineering company with annual revenue of $8 billion per year. The company is a multinational with operation in Latin America and South East Asia. Meehan was established in 1962, and since then it has experienced a high rate of growth. The company is involved in infrastructure development, commercial property development and oil exploration and development. Company is currently considering whether or not to accept a road construction project. Meehan has collected the following information about the project; which will take four years to complete and Meehan must initially invest about $64 million on equipment and $26 million on buying the necessary property, for a total of $90 million. The annual operation cost is $20 million a year, which include labor cost, and other operational cost. The company uses straight line 8 years depreciation. The salvage value of equipment is calculated at the cost. The tax rate of the Meehan is 34%. Example: Meehan to accept road construction project The contract calls for payment of $32 million at the end of first three years and $100 million upon completion at the end of the four year period. The project will commence in January 2007. Therefore all initial expenses such as purchase of land and equipment must take place prior to the start of the project. However, operational revenue and costs are calculated for the end of each subsequent year. -Should Meehan accept this project, if the discount rate is 10%? -What if Meehan used 8% discount rate? -What if Meehan needed a $5 million working capital that it would recapture at the end of the project? Meehan Construction 2007 2008 2009 2010 2011 Revenue 32 32 32 100 Operation Cost Depreciation Cost 20 8 20 8 20 8 20 8 Total Cost 28 28 28 28 4 4 4 72 Tax (0.34) 1.36 1.36 1.36 24.48 Profit after Tax 2.64 2.64 2.64 47.52 10.64 10.64 10.64 55.52 Earning Before tax Add back depreciation Salvage Value 32 Initial Investment I -90 Working Capital Cash Flow -90 10.64 10.64 10.64 87.52 Discount Factor 0.909 0.826 0.751 0.683 Present Value of Cash Flow 9.673 8.793 7.994 59.777 -80.327 -71.534 -63.540 -3.763 NPV NPV (10%) IRR = NPV (8%) ($3.4205) 9% $1.62 Meehan Construction 2007 2008 2009 2010 2011 Revenue 32 32 32 100 operation Cost Depreciation Cost 20 8 20 8 20 8 20 8 Total Cost 28 28 28 28 4 4 4 72 Tax (0.34) 1.36 1.36 1.36 24.48 Profit after Tax 2.64 2.64 2.64 47.52 10.64 10.64 10.64 55.52 Earning Before tax Add back depreciation Salvage Value 32 Initial Investment I -90 Working Capital -5 Cash Flow -95 5 10.64 10.64 10.64 92.52 Discount Factor 0.909 0.826 0.751 0.683 Present Value of Cash Flow 9.673 8.793 7.994 63.192 -80.327 -71.534 -63.540 -0.347 NPV NPV (10%) IRR = NPV (8%) ($4.8614) 8% $0.39 Points about NPV • • • • • Timing: Analysis should be on accrued bases Working Capital must be taken into account Separation of current from capital expense Overhead cost should be allocated to the project Salvage value of plant and equipment must be considered NPV • NPV and Internal rate of return are superior method of calculation of investment relative to payback period, since they recognize the time value of money • NPV and IRR depend solely on forecasted cash flow and opportunity cost of capital and does rely on management taste and accounting practices • NPV of independent projects are additive obtain total NPV. That is the NPV of two different independent projects can be summed up to. For two projects A and B NPV (A+B) =NPV(A)+NPV(B) • The additive condition is an important aspect. For two project, A and B, one with positive NPV, A, and the other with negative NVP, B, we do not have to take both because they are packaged together. NPV • There are however circumstances that A and B are two different stages of project. In this case, if the second stage depends on the first stage then the additive condition is violated. • An example is when a construction company may bid for a project with negative NPV in order to be able to get second project which is substantially larger and would have potentially a very high NPV. [for this types of investment there is other analytical instrument called Real Option. Real Option will be discussed subsequently]. • Or that a project opens other opprtunities that have positive NPV Breakeven Analysis – Breakeven structure and lumpiness of capacity • What is breakeven for a firm? It determine at what level of activities a project can cover all its cost. • Breakeven Point: Fixed cost + Variable cost = Re...
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