PROJECT EVALUATION PLAN ESSAY.

PROJECT EVALUATION PLAN ESSAY

PROJECT EVALUATION PLAN

Instructions:-

PROJECT EVALUATION

You are required to submit a project report that describes and evaluates three project alternatives, using the project evaluation techniques discussed in this course. The project alternatives may be hypothetical. Assume you are writing a proposal to your Board of Directors.

Your analysis should include brief estimates of projected revenues and costs of productions and use Discounted Cash Flow analysis, using a justified discount rate to give Net Present Values of three (3) alternatives of a capital investment project as well as determine the Internal Rate of Return.

Description of the project alternatives should be less than one (1) page.

The layout and content should be:

Prepare a clear definition of the objectives of the project and, where practicable, this should be related to the current strategies of the organisation.
The formulation of options to achieve the objectives (e.g. set up a manufacturing plant at locations in countries A, B, or C). Three investment alternatives should be compared.
A formulation of the detailed costs and benefits of the options.
Calculate the cost of capital (debt / equity).
Evaluate each option using D.C.F. techniques (use a minimum period of 5 years and justify the discount rate used).
Evaluation of the risks of the project.
Recommendation of the most economic option and discussion of any non-financial factors relevant to your decision.
The assignment report should be brief and to the point.

NOTE: The project to be analysed must be approved by the lecturer before commencing the assignment. You should have sent your teaching staff an email with your proposed topic by Day 7 of Week 8.

Suggested format for your report. To ensure adequate coverage of the topic the following format is suggested for your report:

Executive summary
Table of contents
Introduction (not more than one page for introducing the project)
Discussion of options
Cost of capital assumptions and calculations (debt/equity costs)
Description of the costs and benefits of the project
Evaluation of the project – e.g. DCF calculations to give NPV and IRR
Evaluation of the risk of the project
Recommendations
Bibliography

More info:
You can create any three scenarios for the week 10 assignment. As such, all three can be workplace based projects , or entirely hypothetical projects or ventures – which means you can generate the numbers yourself

I usually suggest to students that if they don’t have anything to hand at work, to select 3 different geographical locations to set up the same type businesses. Many students go for setting up in 3 different countries as the variation gives them more to work with in the risk analysis section

Solution

PROJECT EVALUATION PLAN ESSAY.

PROJECT EVALUATION PLAN

Introduction and project objectives

XYZ limited, a company domiciled in California, United States deals with the manufacture and sale of specialized health monitoring gadgets that can track your body vital signs during exercise. It’s worn as a wrist band and is able to capture health information such as heart rate, blood pressure, blood sugar level which helps manage lifestyle diseases such as hypertension and diabetes. In a recent board meeting, it was noted that despite the high uptake of the gadget in California, there is still an unmet need in the wider global market. The board, therefore, tasked me, as the finance manager in charge, to come up with a proposal on the best investment decisions that would increase the company earnings. In this project report, I propose and evaluate three projects using various capital investment appraisal methods learned in this course such as the Net Present Value (NPV) and Internal Rate of Return (IRR). In making a recommendation on what project best suits the company goals and objectives, the risks associated with each project will also be evaluated.

Projects description

Financial and market analysis has revealed that XYZ limited may achieve its intended goals by setting up a manufacturing plant in either South America, Europe, or distributing the gadgets directly to clients from the California manufacturing plant. For the purpose of this assignment, setting up a manufacturing plant in South America will be our project 1, Europe project 2 and direct distribution is project 3. The appraisal covers a projected period of five (5) years. The initial capital outlay, revenue, and expenditure resulting in net cash flows are shown for each project.

Calculation of cost of capital

For the purpose of this assignment, the source of funding for these projects will be entirely on external borrowing. The cost of debt, therefore, shall be the interest rate of the borrowings but since interest expense is a tax deductible expense the cost of debt, therefore, will be calculated as X (1-t), where t is the marginal tax rate. Interest rate assumed is 14.28% which is the average interest rate in the financial market while tax rate is assumed at 30%

Utilizing the above formula;

Cost of debt = X (1-t)

Cost of debt=14.28% (1-30%)

Cost of debt= (14.28%) 70%

Cost of debt = 10%

Project 1 (manufacturing plant in South America)

Project 1
For this project, the initial investment is expected to be $3,950,000 which will go towards
setting up of the manufacturing plant, hiring the necessary workforce and setting up
Operations. This is taken up in year 0. In year 1, revenues start streaming in as shown below
We assume that the investment will not have any salvage value at the end of the five years
Project 1	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000
Cash inflow	0
Sales	0	2250	4125	4850	4084	3990
Total cash inflows	0	2250	4125	4850	4084	3990
Cash outflows
Initial investment	3950
Direct/manufacturing costs	800	1450	1832	1650	1433
Sales and marketing		530	875	995	832	627
Other costs		170	550	773	602	1180
Total cash outflows	3950	1500	2875	3600	3084	3240
Net cash flows	3950	750	1250	1250	1000	750
Assuming the cost of capital is pegged at 10%, the discounting factors are shown
on the table below
	YEAR	Discount factor
	Year 1	0.909
	Year 2	0.826
	Year 3	0.751
	Year 4	0.683
	Year 5	0.621
To arrive at the net present value of future cash inflows, the cash inflows are discounted
to the present value by multiplying with the discounting factor as shown below
	Year	Net cash flow	Discount factor	NPV ($)
	Year 1	750	0.909	681.82
	Year 2	1250	0.826	1033.06
	Year 3	1250	0.751	939.14
	Year 4	1000	0.683	683.01
	Year 5	750	0.621	465.69
		Total Present value of all cash flows	3802.72
			Less initial cost	-3950.00
			Net present value	-147.28
This project, although having positive cash flows, yields negative net cash flows
at the end of the five year period. It should not, therefore, be selected.
Internal rate of return
The internal rate of return is that rate of return at which the net present value
equals nil. It’s the minimum rate of return required for the project to break-even
To calculate the internal rate of return, we assume a cost of capital at 8% on the lower side
and 15% on the upper side.
	NPV AT 8%
	Year	Cash flows	Discount factor	Present value
	Year 1	750	0.926	694.5
	Year 2	1250	0.857	1071.25
	Year 3	1250	0.794	992.5
	Year 4	1000	0.735	735
	Year 5	750	0.681	510.75
			Total PV	4004
			Less initial cost	-3950
			Net present value	54
	NPV AT 15%	Cash flows	Discount factor	Present value
	Year 1	750	0.8696	652.2
	Year 2	1250	0.7561	945.125
	Year 3	1250	0.6575	821.875
	Year 4	1000	0.5718	571.8
	Year 5	750	0.4972	372.9
			Total PV	3363.9
			Less initial cost	-3950
			Net present value	-586.1
IRR	=	8% +	54/ (54+586.1) * (15%-8%)
	=	8% +	(54/640.1)*7%
	=	8% +	0.59
	=	8% + 0.59%
	=	8.59%
The internal rate of return for project 1 is 8.59%
Risk
Evaluating the risk of these projects is a key consideration, as net present value alone, cannot
be an adequate measure of whether to invest in a capital project or not. There are several statistical
methods of risk evaluation, however, for the purpose of this assignment, standard deviation from the
Expected returns will be used to determine the risk associated with the project using year 1 cash flows.
In determining the project risk, we assume that there can either be a boom, normal or recession
Economic conditions. The probability of the occurrence of the various economic conditions and
the expected cash flows are assigned as shown below.
The formula			is used to calculate the variance of the cash flows,
			the square root of which is the standard deviation
			which measures the risk of the project
	Project 1
Economic condition	Cash flow	Probability	Expected return	Deviation	Squared deviation	Weighted squared deviation
Boom	1250	20%	250	640	409,600	81,920
Normal	750	50%	375	140	19,600	9,800
Recession	-50	30%	-15	-660	435,600	130,680
			E(x) 610		σ²	222,400
					σ	$471.59
The standard deviation of this project is $471.59 which is very high relative to the year 1 cash flows

Project 2.

Project 2
For this project, the initial investment is expected to be $6,250,000 which will go towards
setting up of the manufacturing plant, hiring the necessary workforce and setting up
operations. This is taken up in year 0. In year 1, revenues start streaming in as shown below
We assume that the investment will not have any salvage value at the end of the five years
Project 2	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000
Cash inflow	0
Sales	–	3,250	3,870	4,125	4,430	3,986
Total cash inflows	–	2,390	3,610	4,816	4,990	3,110
Cash outflows
Initial investment	6,250
Direct/manufacturing costs	685	990	1,160	1,200	806
Sales and marketing		392	450	500	506	405
Other costs		313	170	156	284	399
Total cash outflows	6,250
Net cash flows	(6,250)	1,000	2,000	3,000	3,000	1,500
		Net cash flow	Discount factor	NPV
	Year 1	1000	0.909	909.09
	Year 2	2000	0.826	1,652.90
	Year 3	3000	0.751	2,253.93
	Year 4	3000	0.683	2,049.03
	Year 5	1500	0.621	931.38
			Total PV	7,796.33
			Less initial cost	(6,250.00)
			Net present value	1,546.33
IRR	NPV AT 8%
	Year	Cash flows	Discount factor @8%	NPV
	Year 1	1000	0.926	926.00
	Year 2	2000	0.857	1,714.00
	Year 3	3000	0.794	2,382.00
	Year 4	3000	0.735	2,205.00
	Year 5	1500	0.681	1,021.50
			Total NPV	8,248.50
			Less initial cost	(6,250.00)
			Net present value	1,998.50
	NPV AT 15%
	Year	Cash flows	Discount factor @15%	NPV
	Year 1	1000	0.8696	869.60
	Year 2	2000	0.7561	1,512.20
	Year 3	3000	0.6575	1,972.50
	Year 4	3000	0.5718	1,715.40
	Year 5	1500	0.4972	745.80
			Total NPV	6,815.50
			Less initial cost	(6,250.00)
			Net present value	565.50
	IRR	=	8% +	1998.5/ (1998.5+565.5) * (15%-8%)
		=	8% +	(1998.5/2564)*7%
		=	8% +	5.4561232
		=	8% + 5.5%
		=	13.50%
Risk ( Utilizing the formula in project 1)
Economic condition	Cash flow	Probability	Expected return	Deviation	Squared deviation	Weighted squared deviation
Boom	2,000	20%	400	1,130	1,276,900	255,380
Normal	1,000	50%	500	130	16,900	8,450
Recession	(100)	30%	(30)	(970)	940,900	282,270
			E(x) 870		σ²	546,100
					σ	$738.99
The standard deviation of the project is $738.99, indicating a high risk associated with the project

Project 3

Project 3
The initial investment for this project is $5000,000 which will go towards setting up a
distribution system, hiring, and managing of satellite warehouses, shops, workforce
etc. The revenues and expenditures from the project are detailed below
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000	$ ‘000
Cash inflow	0
Sales	–	3,220	3,780	6,325	8,000	5,880
Total cash inflows	–
Cash outflows
Initial investment	5,000
Direct/manufacturing costs	1,449	1,980	2,430	3,360	2,160
Sales and marketing		483	567	1,165	1,250	1,065
Other costs		788	483	230	390	655
Total cash outflows	5,000
Net cash flows	(5,000)	500	750	2,500	3,000	2,000
		Net cash flow	Discount factor	NPV
	Year 1	500	0.909	454.55
	Year 2	750	0.826	619.84
	Year 3	2,500	0.751	1,878.28
	Year 4	3,000	0.683	2,049.03
	Year 5	2,000	0.621	1,241.84
			Total NPV	6,243.53
			Less initial cost	(5,000.00)
			Net present value	1,243.53
IRR	NPV AT 8%
	Year 1	500	0.926	463.00
	Year 2	750	0.857	642.75
	Year 3	2,500	0.794	1,985.00
	Year 4	3,000	0.735	2,205.00
	Year 5	2,000	0.681	1,362.00
			Total NPV	6,194.75
			Less initial cost	(5,000.00)
			Net present value	1,194.75
	NPV AT 15%
	Year 1	500	0.870	434.80
	Year 2	750	0.756	567.08
	Year 3	2,500	0.658	1,643.75
	Year 4	3,000	0.572	1,715.40
	Year 5	2,000	0.497	994.40
			Total NPV	4,920.63
			Less initial cost	(5,000.00)
			Net present value	(79.38)
IRR	=	8% +	1194.75/ (1194.75+79.38) * (15%-8%)
	=	8% +	(1194.75/1274.13)*7%
	=	8% +	6.56
	=	8% + 6.56%
	=	14.56%
Risk ( Utilizing the formula in project 1)
Economic condition	Cash flow	Probability	Expected return	Deviation	Squared deviation	Weighted squared deviation
Boom	1000	20%	200	580	336400	67,280
Normal	500	50%	250	80	6400	3,200
Recession	-100	30%	-30	-520	270400	81,120
			E(x) 420		σ²	151,600
					σ	$389.36
The standard deviation of the project is $389.36, indicating a much lower risk as compared to the other
two projects.

Recommendations and conclusion ($figures in millions)

As shown in the above computations, project 1 yields a net present value of $ (147.28), an internal rate of return of 8.59% with a standard deviation (risk) of $471.59; project 2 yields a net present value of $1,546.33, an internal rate of return of 13.50% with a standard deviation (risk) of $738.99 while project 3 yields a net present value of $1,243.53, an internal rate of return of 14.56% and a standard deviation of $389.36.  Project 1 is out of the question, as it yields negative net present value and cannot, therefore, be undertaken as it would lead to loss of shareholders wealth, project three is less risky, although it yields a lesser net present value as compared to project two, which, although bears the highest level of risk, also  yields the highest returns. The recommendation for selecting project two is also supported by the slightly lower internal rate of return as compared to project three. Setting up a project in Europe will not only lead to positive returns but will also create employment for the local population and enhance the company brand in the global market.