Sample of assignment: Ranking of projects – Report to the board of directors

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Ranking of projects

Report to the board of directors

 

1.        Introduction of the investment options and background

 

As a new branch of the long lasting Kingdom Gearge in the property management industry in New Wales, in this year we are going to invest in a large major real estate project based on the major environmental factors: (1) according to our market analysis, the real estate market show trend of recovery from the global financial crisis and the price of the property is actually raising slowly and this trend is expected to continue for the coming five years; (2) with the anticipated accumulative and incremental inflation, the current cash that we hold in the bank will face depreciation and investment in the real estate will be a sound choice to develop our business. Beside the macro economic considerations, another major consideration in our business decision is that we are going to deepen our influence in the New Wales property market, it will be important to ensure the success of this investment which will show smart investment decision makings to our potential customers and shareholders in the future. The six investment projects are listed as following along with the calculation of three major project measurement index: Internal Rate of Return (IRR), Net Present Value (NPV) and Profitability index (PI).

 

 

JobInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)Cost of capital
KCC Pearl

0.43

$5,832,191

2.94

16%

Sea View

0.38

22,046,133

2.47

16%

Mountain View

0.41

15,533,863

2.73

16%

Hill Top

0.43

18,160,696.50

3.07

8%

Bridgetown

0.27

3,805,830.00

1.73

8%

Northern Giant

0.39

22,647,109.50

2.68

8%

 

2.        Key issues

 

Which criteria we should follow?

 

What are the advantages of disadvantages by following each particular evaluating criterion?

 

Which investment we should select?

 

 

 

3.        Ranking criteria

 

3.1    Net Present Value (NPV)

 

The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm (zenwealth.com 2011). The calculation

 

In this formula, CFt refers to the cash flow at the time of t and r refers to the cost of capital.

 

3.1.1            Advantages

 

The Net Present Value (NPV) approach offers a quantitative measurement as to whether or not one project is worth investment. In general a positive Net Present Value (NPV) means that the project is generating positive values to the company while a negative Net Present Value (NPV) suggest a red traffic light for the investors (Maguire, Smith & Kouyoumijan 2008, p. 187). Also comparisons could be made based on the NPV of different NPV of different projects in order to select the optimal choice.

 

Another advantage of Net Present Value (NPV) approach is that it takes into consideration of the time value of the money. One hidden assumption of Net Present Value (NPV) approach is that it assumes that all cash flows can be reinvested at the discount rate (El-Sharkawy 2005, p. 20). This point of view provides a developing perspective about the usage of money because money should be invested and kept flowing to generate profit for the company.

 

3.1.2            Disadvantages

 

The consequences of the Net Present Value (NPV) approach are quite sensitive to the discount rate which has been set in the beginning; therefore, a failure to select the proper discount rate will result in very different ranking of the projects (Tiwari & Mishrap 2011, 503). In another word, the heavy reliance on the discount rate will tend to impact the results that we can foresee regarding the profitability and value of the investments. In this point, the combined usage of different criteria could of significant important to reduce the system errors caused by selecting an inappropriate discount rate for a particular project.

 

Another major disadvantage of the Net Present Value (NPV) approach is that this method does not take into calculation of the cost of each investment project. In another word, it only calculates the ultimate value created through the investment but does not measure the cost involved. For example, Mountain View and Hill Top have different NPV, with a NPV of $15,533,863 compared to Hill Top’s only $12,438,807, Mountain View is believed to be better than the Hill Top because of the higher NPV, but the fact is that this approach neglect the fact that Mountain View requires a beginning investment of $9,000,000 and in contrast Hill Top requires only an initial investment of $6,000,000. Hence, it is a major setback of the NPV method to only consider the NPVs and based on which results and ranking are defined.

JobInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)Cost of capital
Mountain View

0.41

15,533,863

2.73

16%

Hill Top

0.43

12,438,807

3.07

8%

 

3.2    Profitability Index (PI)

 

Profitability Index (PI) PI analysis is equal with NPV analysis. The differences are that the appraisal unit of NPV is money and PI is index. The formula is that (Zaharuddin 2008, p. 268):

Profitability Index (PI) = Present Value of the benefits earned / Present Value of the Cost of Capital

 

Profitability Index (PI) is another major evaluator of the investments that is widely used in the investment analysis practices; below we will talk about its major advantages and defects which help us to better understand our current investment options.

 

3.2.1            Advantages

 

There are advantages of using Profitability Index (PI) in the investment appraisals. Firstly, the Profitability Index (PI) could be understood as the present value of the return in term of the return for each dollar of the initial investment (Moyer, McGuigan & Kretlow 2009, p. 330). And according to this index, any investment which is worth to be focused on should exhibit a PI which is more than 1 or else it is not necessary to invest in term of financial considerations only. The Profitability Index (PI) is a very good index and measurement indicating the efficiency of the dollar spend in the investment and also it takes into consideration of the of the size of the investment because it calculates the return based on each dollar spent and in addition it also consider the time value concept and discount the future income by an anticipated discount rate.

 

3.2.2            Disadvantage

 

The first major disadvantage of using the Profitability Index (PI) is that it does not take into consideration of the resource constrains. Following the rule of PI, a company may prefer to choose the top several investments which have the highest PI, but because of the resource constrain, it may only choose several small projects within its resource limit but neglect the large project which has a lower PI but could generate a better net present value compared to the sum of the several smaller projects. This means that when there is a limit of

 

In addition, if the projects are not mutually exclusive, the use of KP will tend to recommend several top KP high ranking small projects which could have a less total NPV than a large investment project. Also an additional disadvantage of the method is regarding the choice of discount rate which also impacts greatly the result of the evaluation results.

 

4.        Investment analysis

 

Below we will analyze these six options and see which one or mixture of them is optimal to maximize the shareholder value and value to the company. And because these are property investments, we expect that they are not mutually exclusive which make it possible that we can choose several of them at the same time without resulting in additional cost. Let’s again review some facts about the investments.

 

 

JobInvestmentCost of capitalInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)
KCC Pearl

$3,000,000

16 %

0.43

$5,832,191

2.94

Sea View

15,000,000

16 %

0.38

22,046,133

2.47

Mountain View

9,000,000

16 %

0.41

15,533,863

2.73

Hill Top

6,000,000

8 %

0.43

18,160,696.50

3.07

Bridgetown

3,000,000

8 %

0.27

3,805,830.00

1.73

Northern Giant

9,000,000

8 %

0.39

22,647,109.50

2.68

 

Now let’s make a sensitivity analysis on these investments based on our possible resources constrains:

 

4.1    If capital budget is $18,000,000

 

If we follow the PI ranking, then because of the capital budget which is $18,000,000, Hill Top ($6,000,000 initial investment), KCC Pearl ($3,000,000 initial investment) and Mountain View ($9,000,000 initial investment) together will make up the best portfolio investment because these three have the highest Profitability index (PI) scores. And there total Net Present Value (NPV) will be:

 

$5,832,191 + 12,438,807 + 15,533,863 = $33,804,861

 

After calculation of other options, it seems that this portfolio investment generates the largest total net present value suggesting that this mixture is the best provided that the discount rate is closed to the actual digits in the future and also the budget reaches $18,000,000 and no other operational cost is needed to manage the property.

 

But if we follow the NPV to choose the top NPV options, we will include the following two investments options because Sea view is the best NPV performance, and after using up 15,000,000, for the remaining 3,000,000, again we choose the KCC Pearl which generates the better NPV result:

 

JobInvestmentCost of capitalInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)
KCC Pearl

$3,000,000

16 %

0.43

$5,832,191

2.94

Sea View

15,000,000

16 %

0.38

22,046,133

2.47

 

Then the total NPV will be:

 

22,046,133 + 5,832,191 = $ 27,878,324

It is obvious that the PI ranking generates the better measurement because of the better present value of the mixed investment.

 

4.2    If capital budget is $12,000,000

 

Suppose we have only a budget of $12,000,000, let’s do the measure and analysis again:

 

If we follow the PI ranking, then because of the capital budget which is $12,000,000,

 

JobInvestmentCost of capitalInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)
KCC Pearl

$3,000,000

16 %

0.43

$5,832,191

2.94

Hill Top

6,000,000

8 %

0.43

18,160,696.50

3.07

Bridgetown

3,000,000

8 %

0.27

3,805,830.00

1.73

 

Then first we choose the best PI performer which is Hill Top and then we choose KCC Pearl which enjoys the second best PI, and for the remaining 3,000,000 we can only choose Bridgetown because of the capital limit. Then the total NPV under this portfolio will be:

 

5,832,191 + 12,438,807 + 2,194,030 = $20,465,028

 

If we follow the NPV ranking, then the results will be quite different,

JobInvestmentCost of capitalInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)
KCC Pearl

$3,000,000

16 %

0.43

$5,832,191

2.94

Mountain View

9,000,000

16 %

0.41

15,533,863

2.73

 

Because is the NPV best performer, therefore we first choose it as the first investment to be focused on, and then for the remaining $3,000,000, again we invest it in the KCC Pearl which provides better Net Present Value (NPV).

 

Then the total NPV will be:

 

$5,832,191 + 15,533,863 = 21,366,054

And obviously this time the NPV measurement provides a better solution.

 

5.        Conclusions

To conclude the above investment analysis, our conclusion is that there is no one best measurement of the investment portfolio, and we can use different methods to calculate different options and locate the best solution.

List of references

Baggini, A. 2008, Handbook of Power Quality New York: John Wiley & Sons Inc. p. 484

Choudhry, M. 2010, Fixed Income Securities and Derivatives Handbook: Analysis and Valuation. New Jersey: John Wiley & Sons, Inc. p. 4

Edenhofer, O. 2012, Renewable Energy Sources and Climate Change Mitigation: Special Report of the intergovernmental panel on climate change. Mexico City: Cambridge University Press. p. 842

El-Sharkawy, A. 2005, Economic Feasibility Studies. Cairo: CAPSCU Press. p. 20

 

Maguire, D. J., Smith, R. & Kouyoumijan, V. 2008, The Business Benefits of GIS: An ROI Approach. New Jersey: ESRI Inc. p. 187

 

Moyer, R. C., McGuigan, J. R. & Kretlow, W. J. 2009, Contemporary Financial Management. Mason: South Western Cengage Learning. p. 330
Quiry, P., Fur, Y. L., Salvi, A., Vernimmen, P. & Dallochio, M. 2011, Corporate Finance: Theory and Practice. New York: John Wiley & Sons Inc. p. 301

 

Tiwari, G. N. & Mishrap, R. K. 2011, Advanced Renewable Energy Sources. New York: RSC Publishing. 503

 

zenwealth.com 2011. Net Present Value. Viewed on 10 Apr 2012 [online] http://www.zenwealth.com/BusinessFinanceOnline/CB/NetPresentValue.html

 

Zaharuddin, H. 2008, A to Z Entrepreneur in Practice. US: Diskon 40% – 50%. p. 268