Question Tag: Internal Rate of Return (IRR)

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  • 20 Marks

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

The Board of Peartek Ltd is considering the company’s capital investment options for the coming year, and is evaluating the following potential investments:

Investment A:

  • Investment of GH¢60,000, including GH¢40,000 for capital equipment and GH¢20,000 for increases in working capital.
  • Expected sales of 10,000 units next year with a sales price of GH¢10 and variable costs of GH¢6 per unit.
  • Sales price is expected to decline by 20% per annum due to competition, sales volume to fall by 10%, and variable costs to decline by 20%.
  • Overheads of GH¢15,000 annually, including a GH¢4,000 depreciation charge.
  • The project will be wound up in year three, with working capital recovered and capital equipment sold off for 25% of its cost.

Investment B:

  • Immediate outlay of GH¢90,000, financed by borrowing at 6%.
  • Expected net profits of GH¢12,000 next year, rising by 3% per annum indefinitely.

Investment C:

  • Outlay of GH¢25,000 financed by retained profits.
  • Expected annual net cash profits:
    • Years 1 to 4: GH¢3,000
    • Years 5 to 7: GH¢5,000
    • From year 8 onwards: GH¢7,000 in perpetuity.

The company discounts projects lasting 10 years or less at 10%, and others at 13%. Ignore taxation.

Required:

a) As a financial management analyst, you have been asked to advise the board of Peartek Ltd (in the form of a briefing report) which investment should be undertaken. Use the NPV method in your analysis. (15 marks)

b) Minority of board members feel that the Internal Rate of Return (IRR) should also be used as either an alternative or a complementary method of investment appraisal. Calculate the IRR of investments A and B and comment accordingly. (5 marks)

a) Net Present Value (NPV) Analysis (15 marks):

Investment A:

Recommendation:

All projects have positive NPVs and should be undertaken, but Investment B is the most attractive with the highest NPV (GH¢30,000), followed by Investment A and Investment C.

b) Internal Rate of Return (IRR) Analysis (5 marks):

Investment A:

Conclusion:

Both Investment A and Investment B have IRRs above their required rates of return (10% for A and 13% for B). Investment A has a higher IRR (19.4%) than B (18.5%), but Investment B remains more favorable due to its higher NPV.

  • 20 Marks

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

a) Sakyiama Poultry Farms is considering purchasing a new incubator that will improve its incubation efficiency to 90% as against the current 50%. The incubator, which is to be purchased immediately, will cost GH¢120,000. The incubator has a useful life of 4 years, after which it would be sold for scrap at GH¢10,000. The current contribution of GH¢3 per day-old chick will not change. The number of day-old chicks sold at 12,000 units per annum will increase by 80%. Fixed cost will be GH¢20,000 per annum. Sakyiama Farms has an after-tax cost of capital of 12.5% and pays tax in the year in which profit is made at a rate of 15% per annum. The farm is also entitled to capital allowance at 25% on a reducing balance.

i) Calculate the Net Present Value (NPV) and the viability of the investment. (7 marks)
ii) Calculate the Internal Rate of Return (IRR). (8 marks)

b) Two blue-chip companies – Abu Ltd and Ada Ltd are seeking to raise funds from venture capital to boost their production in order to satisfy demand for their solar-powered refrigeration and air-conditioning systems, which they developed through a joint venture. They have consulted you for advice.

Required:
Explain FIVE conditions that a venture capitalist will consider in accessing an application for funding. (5 marks)

a) Sakyiama Farms
i) Investment appraisal

Years 0 1 2 3 4
Cost 120,000.00 90,000.00 67,500.00 50,625.00 37,968.75
Capital Allowance 30,000.00 22,500.00 16,875.00 12,656.25
Tax Gain 4,500.00 3,375.00 2,531.25 1,898.44
Additional Gain (37,968.75-10,000) x 15% 398.44
Contribution (64,800 units/year) 64,800.00 64,800.00 64,800.00 64,800.00
Fixed Cost (20,000.00) (20,000.00) (20,000.00) (20,000.00)
Cash Flow Before Tax 44,800.00 44,800.00 44,800.00 44,800.00
Tax (15%) (6,720.00) (6,720.00) (6,720.00) (6,720.00)
Tax Gain 4,500.00 3,375.00 2,531.25 1,898.44
Additional Gain 398.44
Cost of Incubator (120,000.00)
Scrap Value 10,000.00
Net Cash Flow (120,000.00) 42,580.00 41,455.00 40,611.25 50,376.88
Discount Factor (12.5%) 1.000 0.889 0.790 0.702 0.624
Present Value (120,000.00) 37,848.89 32,754.57 28,522.58 31,450.04
Net Present Value 10,576.07

Total for this part: 7 marks

ii) IRR Calculation

Years 0 1 2 3 4
Net Cash Flow (120,000.00) 42,580.00 41,455.00 40,611.25 50,376.88
Discount Factor (17%) 1.000 0.855 0.731 0.624 0.534
Present Value (120,000.00) 36,393.16 30,283.44 25,356.47 26,883.62
Net Present Value (1,083.31)

The IRR calculated using interpolation is approximately 15.67%.

Total for this part: 8 marks

b) Venture Capitalist Considerations
Venture capitalists will evaluate a funding application based on:

  • Nature of the Company’s Products: The products should generate adequate and sustainable sales and profits.
  • Expertise in Production: Technical efficiency and value-driven competencies must be demonstrated.
  • Expertise in Management: Management should show commitment, skills, and experience in promoting the company’s objectives.
  • Market and Competition: The company should have a competitive strategy to maintain and expand its market share.
  • Future Profits: The company’s ability to generate realistic and sustainable future profits should be evident in its business plan.
  • Board Membership: The company should have a board of directors that effectively represents stakeholders’ interests.
  • Risk Borne by Existing Shareholders: The company’s owners should bear a significant portion of the risk.

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