Should They Invest or Not?
Table of contents:
I. Executive summary
II. Statement of Problem
III. Analysis & Methodology
IV. Discussion of Results
I. Executive Summary
The objective of financial management is to always make decisions in order to maximize shareholder wealth. They do this by different methods; one of them is by investing in projects that will maximize the value of the firm. However, many analyses should be made before making the decision to invest in determinant projects. The process by which the firm decides which investment is most profitable is called capital budgeting. There are different methods by which a firm can find the economic valuation for a project: net present value (NPV), internal rate of return (IRR) and profitability index (PI).
Even though the firm has different evaluation methods to help it decide which project to choose, the decision is not always very clear. For instance, the future cash flows provided by the project to the firm are not always apparent. It is very obvious that different projects will have different revenues and different risks associated with them. For instance, financial managers need to understand what can go wrong with different investment projects before they make the decision of investing. This is when they implement sensitivity analysis. Sensitivity analysis is a calculation, which takes into account present value for one value or several values that will affect the investment. For instance, net present value in an investment can be easily affected by salvage value and sales. When financial managers are faced to choose different projects to invest in, they are allowed to implant independent projects or mutually exclusive projects. Independent projects are the ones, which, as their name implies, are independent from one another. For this reason, financial managers can choose any of the two or both of them. In this type of project, any of the three methods of economic evaluation can be implemented, such as net present value; internal rate of return and profitability index can be used. II. Statement of problem
Rediform Concrete wants to invest 5 million dollars in a factory that manufactures concrete products. This investment will provide annual sales between 2 and 5 million dollars. It will have after-tax fixed costs of $500,000 annually and after-tax variable costs of 50 percent of sales. Therefore, the after-tax annual cash flow calculation consists of 0.5 of sales. The factory can be built on Palmetto Rd, in which case it will have a salvage value of 3 million dollars. Alternatively, if it is going to be built on one of the two competing roads, it will only have a salvage value of 1 million dollars. The expected life of the project is 5 years. The firm has estimated the level of systematic risk to be , the expected return on the market is , and the risk-free rate of return is .
The example above is an illustration of a project where the firm has to implement a mutually exclusive project. This is because the factory can be located at only one of the two places, but not in both of them.
In the above example, managers need to determine where the factory should be located. Since it is a mutually exclusive project, they will use net present value (NPV) for their evaluation to consider the risks involved in each scenario.
III. Analysis & Methodology
To calculate NPV it is necessary to know required rate of return. Required rate of return for the given project can be determined by using Capital Asset Pricing Model (CAPM), which takes into consideration market risk (βP), expected return on the market, and risk free rate of return. E(R) =RF+β(RM-RF) where E(R)-expected rate of return
RF – risk-free rate of return