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Corporate Finance - Investing in Large Projects

Essay by   •  January 22, 2019  •  Essay  •  486 Words (2 Pages)  •  618 Views

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Investing in large projects requires careful evaluation of the company’s cashflows because these large projects require big amounts of money and proper evaluation methods will ensure that the company will remain profitable in future. We identified different requirements for some appraisal methods and came up with recommendations that would help Vacances SA to effectively evaluate their future investment proposals.[pic 1][pic 2]

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Payback method

This is an appraisal method that evaluates the number of years the company takes to recover its initial investment from the cashflows that occur from a capital investment project. Even though this is an easy method to calculate, there are some drawbacks that could lead to difficulties in evaluating the profitability of the project. First of all, this method ignores the time value of money. In other words, it gives equal weight to all the cash flows that occur within the payback period. For example, this may ignore profitable projects such as startups, innovative projects etc. because these projects take time to become lucrative and generate positive cash flows. Therefore, if there were no cashflows within the payback period but if a particular project generates cashflows outside this benchmark, payback period would say the managers to ignore that particular project. Therefore, this method does not consider cashflows outside the payback period and fails to consider the project as a whole. Due to these drawbacks, our team have provided recommendations for improvements as follows:

  • The company could use “Discounted Pay Back method” instead of the regular payback method. Also, this method is better than the normal payback as it considers the time value of money. This implies that the discounted payback period would generate a longer period as opposed to the normal payback period, but it gives an accurate estimate of the profitability/return of the investment project that the company is planning to invest in.
  • Justification to use the discounted payback period is as follows:

Year

Cash flow

Discount factor @ 9% (Optimistic scenario)

Present value of cash flows

Present value of the cumulative cashflows

2018-2019

(1,000,000)

1

(1,000,000)

(1,000,000)

2020

253,600

0.917

232,551

(767,449)

2021

372,320

0.842

313,493

(453,956)

2022

(12,020)

0.772

(9,279)

(463,235)

2023

254,871

0.708

180,449

(282,786)

2024

336,323

0.65

218,610

(64,176)

2025

105,975

0.596

63,161

(1,015)

2026

74,183

0.547

40,578

39,563

2027

74,183

0.502

37,240

76803

2028

74,183

0.46

34,124

110,927

2029

74,183

0.422

31,305

142,232

2030

(31,793)

0.388

(12,336)

129,896

The above table relates to the optimistic scenario of the case and it implies that the discounted payback period is 6 years and 3 months as opposed to the normal payback period which is 4 years and 5 months. Since this method considers the time value of money, Vacances SA will be able to evaluate the riskiness of the cash flows generated in the project through the cost of capital.

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