The calculation of the net present value is carried out by deducting the sales of the years by the variables costs and the fixed costs of GBP 5000 per year. This gives the contribution of the project. The contribution is then deducted by tax with the rate of 40% given in the case scenario. This gives the contribution after tax. The contribution after tax is then deducted by working capital requirements of the project and then added with the release of the working capital at the fifth and last year of the project and also with the tax benefits on the depreciation charges.
After adjusting the inflows and outflows of the project, finally the net cash flows are derived. These cash flows are then discounted with the discounting factor of 14%. The discounting of the cash flows to the present value gives the net present value of GBP 6,728 for the project on the basis of the estimated sales and all costs figures. The project also gives the IRR of 15%, which is 1% greater than the expected return on the investment in other projects by the management.
Â Explanation to the boss:
This is the previous cost before the commencement of the project. This may include the study or finding related to the feasibility of the project. It is an irrelevant cost with respect to the project as the cost has essentially incurred regardless of the commencement of the project. Therefore, it is not included in the calculation of the net present value of the project.(Brag, 2013)
Opportunity costs are also relevant cash flows. Opportunity costs are the revenues that are lost or additional costs that arise from transferring the resources from one project to another. If the funds invested in a particular project make a lossthen that loss will also be a relevant cost in the net present value calculations and must be deducted as cash outflow.(ACCA, 2015).
The incremental costs are the costs directly associated with the project of the company and are relevant in the calculation of the net present value. These include the property, plant and equipment purchase for the project, inflows of the revenues of the project, working capital increase due to the project etc. (Goodrich, 2013)
Discounting the cash flows:
As the inflows and outflows of the project are related to future periods, five to ten years, therefore these cashflows are discounted to the present value in order determine the profitability of the project at the present time. The discounting of cash flows is due to the discount factor; this is the percentage by which the future cash flows are discounted to the present value.
The company can use different discounting factors for discounting. It includes weighted average cost of capital of the company (WACC), and expected return rate on the investment if invested elsewhere other than the given project etc.(Haaland, 2013)
Â Risk analysis:
The study carried out to estimate the future revenues and costs of the Jiffy clean project is completely on the basis of subjective assumptions and is not necessary that these estimates are similar to the actual results. Therefore,risk analysis is necessary in the project appraisal to identify the sensitivity of the variables involved in the calculations of the net present value.
For example, if we adjust only the corporate sales estimates in the project by reducing the sales by 10%,then this would reduce the revenue of the project with the reduction of variable costs also therefore, the contribution of the project would also be reduced. On the other hand, positive Net Present Value would decrease from GBP 6728 to negative of GBP (7,753). This shows if only one variable in the project reduces by the 10 % project, then it would make a loss. Over here it is assumed that other variables are constant through five years of period, which is again extremely difficult to happen……………………………..
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