Corporate Finance - Investing in Large Projects
Essay by Mateen Javed • January 22, 2019 • Essay • 486 Words (2 Pages) • 507 Views
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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