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INSTITUTE OF TECHNOLOGY CARLOW

2014/15

ASSIGNMENT 2

Programme: Masters in Business

Module: Financial Analysis & Investment Appraisal

Prepare a report for the board of directors of Great Flights plc concerning the proposed

expansion plans.

In the report, you should include the following:

1.

Calculate the net present value and payback period of the proposed plans. (30

marks)

Net present Value

Net present value is the value of present net cash inflows. The value is a reliable measure

to use in capital budgeting. It is very important for the investment, as it accounts the time

value through cash flows use. While calculating the net present value, the target rate is set

for the analysis of the cash inflows projects (Explained, 2014).

Advantages of the net present value

It is a beneficial measure in accounts for the valuation of the money. It is the most reliable

technique, which do not discount the future cash flows for the pay back periods and the

accounting rate for return.

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Disadvantages of the net present value

The estimation of the net present values are based on the future cash flows of the business

projects. Its estimations can be far from the actual and exact results.

Formula of Net present Value

The formula of Net Present Value (NPV) is used to describing the present value of an

investment project by the discounted sum of all cash flows, received through the project

(Formulas, 2014). The formula of net present value is as below;

NPV = R

1 (1 + I)-n

Initial Investment

I

When any investor or the company takes part in any project or investment, then it is the

important stage to knowing the estimation processes for the profits calculations. In the

form, -Co is the sign of initial investment that shows the negative parts of the cash flow of

opposite money directions. If the money is going towards the subtracted from the

discounted sum of cash flows, then the value of net present value will be positive by

showing the impressive and valuable trends of the investment.

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Payback period of the plan

The payback period is a simple way to analysing the different ideas of any business plan.

The main objective of the payback period plan is to getting back the invested money,

which was spent on the project before it. The formula of the pay back is (solutions, 2014);

Payback Period =Initial Investment / Cash Inflow per Period

In case of uneven cash flows, the formula will be such as

Payback Period = A +B / C

A stands for the last period of cash flow with negative cumulative

B stands for the absolute vale of the cumulative cash flow, which was ended at the end of

period A

Cstands for the total cash flow, during the specific period after time A

Advantages of payback period

It the very simple and easy way to calculate the given data for output. It is a useful

measure to inherent the project in case of any risk. The occurrence of the uncertainty of

the cash flows is unpredictable, but the payback period plans describes the certain

conditions of the cash inflows very earlier. Some companies face the liquidity problems;

in this case, the payback period provides best plans to improve the ranking for the return

of the money.

Disadvantages of payback period

There are a few disadvantages concerned to the playback period. There is no proper

solution for the taking account the time value of the money, which can be a cause of

drastic drawbacks to leading the immoral judgments. To decrease the effects of

drawbacks, the method of discount payback period is adopted to attempt the variations.

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There is no credibility account to know the occurrence of the payback period cash

inflows.

Calculations of the net present value and payback period of the proposed plans

I ncome statements for the year to 30 September

Year of new strategy Year 2 Year 3 Year

4

Ancillary revenues 35 42 52

380 457 574

Employee costs (52) (67) (81)

Fuel and oil (54) (68) (95)

Maintenance (15) (22) (25)

Depreciation (48) (51) (52)

Marketing (25) (23) (20)

Route charges (28) (35) (48)

Airport charges (45) (59) (79)

Miscellaneous expenses (18) (13) (30)

Operating profit 95 119 144Net interest charges (20) (14) (18)

Profit before taxation 75 105 126

Tax (25) (31) 30

Profit for the year 50 74 96

Discount Rate = 30.625

Discount Rate = 30.625

Initial invest amount = 9

Number of years = 3

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Year Cash flow Present value

1 40 38.28

2 76 44.54

3 96 43.07

Present net value of the proposed project = 116.89

Calculation for Payback period of the plans

Initial investment amount = 9

Number of years = 3

Year Cash flow

1 40

2 76

3 96

Payback period = 0.127 years

Average annual cash flow = 70.667

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2. Using the population data and the Netta Group estimates re-calculate the net

present value and payback period using an alternative approach to predicting the

incremental cash flows to act as a check on the reliability of the

calculations provided in your answer to (i) above;(16 marks)

Recalculating net present value and payback period of the population data and the Netta

Group estimates

Approaches to predicting the incremental cash flows

Incremental cash flow is a term, which is used in operating the calculation process of any

firm or organisation. The positive results of the increment cash flow results in the increase

in the companys financial revenues for accepting the new projects. Different components

of the incremental cash flows describe the true identifications of any project; such as, cash

flows from the receiving of any project, terminal costs, initial outlays, and the timing scale

of any project. Based on the incremental cash flows predictions, the financial companies

expand or reduce their financial activities to find great revenues (Yoder, 2006). There are

some approaches to predicting the incremental cash flows;

1.

Sunk costs

To analyse the project at the initial stages, sunk cost analysis is necessary for the best

predictions. The analysis of the sunk costs describes that these costs will not influence the

future cash flows of the projects during the budgeting making decision.

2.

Opportunity costs

Opportunity costs do not go forward with the cash outflows, which will not be earned

easily by using maximum output for the project. For the predictions of the incremental

cash flows approaches, the opportunity costs work as externalities by benefiting the

project very easily.

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While considering the incremental cash flows of any new project, many new effects

happen during the companys operations for possible considerations. These possible

considerations are called externalities.

Predicting the incremental cash flows formula

Incremental Cash Flows = Cash Inflows Cash Outflows Taxes

Taxes = (Inflows Outflows Depreciation Expense) Tax Rate

Incremental Cash flows = Cash Inflows Cash Outflows (Inflows Outflows

Depreciation) Tax Rate

4.

Cannibalizations

It is the type of externality, which describes the state of the projects for the sales by taking

away the present product.

Recalculating net present value of the population data and the Netta Group estimates

Year of new Year 5 Year 6 Year 7 Year Year 9 Year 10 Year 11 Year

Eastern Europe

Discount Rate = 30.625

Initial invest amount = 9

Number of years = 8

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Year Annual cash flow in Present value

1 165.3 126.55

2 164.5 96.41

3 163.1 73.18

4 162.2 55.71

5 161.8 42.54

6 160.5 32.31

7 158.4 24.41

8 158.1 18.65

Net present value = 460.76

Recalculating the payback period of the population data and the Netta Group estimates

Year of new strategy Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year

Eastern Europe

Initial investment amount = 9

Number of years =

Year Annual cash flow in

1 165.3

2 164.5

3 163.1

4 162.2

5 161.8

6 160.5

7 158.4

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8 158.1

Payback period = 0.056

Average annual cash flow = 161.7374

Checking reliability of the answers

3. Calculate the sensitivity of the net present value calculations in (I) and (I) above

to the possible options relating to the weighted average cost of capital. (12 marks)

Weighted average cost of capital

The companies and organisations have numerous sources to run the business activities.

These business or financial activities are known as the common stock, preferred stocks,

retained earnings and the debts. Weighted average cost of capital is a type of average cost,

which is gotten after the tax collections of all resources. The calculation method of the

weighted average cost of capital is achieved by the multiplying costs of each source of the

finance related by the weights and the products summing (Explained, 2014).

WACC is mostly used in discounting cash flows for the calculations of net present value

and for the other investment projects analysis. The term WACC describes the

organisations average risks. For the adjustments of the risks, the WACC provides

reasonable solutions to decrease the rate of risks.

Formula of Weighted average cost of capital (WACC)

If a company has two specific sources for financial activities, which are debt and equity,

then WACC will be such as;

WACC = weight of equity x cost of equity + weight of debt x cost of debt

The calculation of cost of equity are based on different models of calculations, such as

divided growth model and the capital asset price model.

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The calculation of cost of debt is based on the yielding maturity for the relevant

instruments. If there are no yielding maturity for calculations, then cost of debt is

calculated based on current yielding instruments.

For the detailed analysis of any business plan, the formula will be such as

WACC = E / V * Re + D / V* Rd * (1Tc)

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firms equity

D = market value of the firms debt

V = E + D

E / V = percentage of financing that is equity

D/ V = percentage of financing that is debt

Tc = corporate tax rate

Calculation of the Weighted average cost of capital

Cost of equity = 60%

Total Equity () = 1178

Cost of debt = 6%

Total of debt = 385

Corporate tax rate = 20%

WACC= 46.40 %

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4. State what additional information would be required before a final decision is made as to

whether the plans should go ahead (12 marks)

Net present value of the business plan is positive, which is a good indicator. The given business

plan needs suggestions and decisions to take further steps. To run a business efficiently, the

management of the business should adopt new stratiegies to expand the business.

For the successful measure of a business plan, the role of net present value is very strong. The

positive numerical calculations help for the profitable revenues in the future. For the long term

projects, the plan should go ahead. It will give effective revenues for the owners and employees

of the business.

5. Separately comment on the results of your calculations in (i-iii) above. (12 marks)

The results of the (1-3) portions are very efficient. No negative signs for the business have seen

based on the calculated results. Positive net value is a good sign for the revenues. Average

annual cash flow is also high. Net present value is also a good indication for the best outcomes.

Debt ratio is high. For this concern, the business management should take effective steps to

decrease the debs and increase the revenues. The business plan is also worked weakly in a few

year, so the activities should run efficiently.

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Bibliography

Explained, A. (2014).Net Present Value (NPV).Retrieved from http://accountingexplained.com/

Formulas. (2014). http://www.financeformulas.net/.Retrieved from

http://www.financeformulas.net/

solutions, b. (2014).Payback Period Analysis.Retrieved from http://www.wbsonline.com/

Yoder, T. R. (2006). THE INCREMENTAL CASH FLOW PREDICTIVE ABILITY OF

ACCRUAL MODELS.