Introduction
This project proposal focuses on the British Petroleum (BP) Company. The company seeks to obtain funding and manage a project budget for purchasing equipment and increasing workers’ safety (“BP Sells Non-Strategic Assets”, 2012). In this regard, various investment appraising methodologies have been employed in evaluating the economic viability of the proposed project.
Net Present Value (NPV)
NPV would be the true measure of investment profitability. It can be clear that the “acceptance rule using the NPV method is to accept the investment project if the net present value is positive and to reject it if the net present value is negative” (“Net Present Value Method”, 2010). The market value of the firm’s shares can increase if the projects with the positive Net Present Values are accepted. This would imply that the positive net present value could be displayed by those projects, which generated cash flows at a rate higher than the minimum amount required by investors (Titman, Keown & Martin, 2011)
In selecting between mutually exclusive projects; the one with a higher net present value should be selected. To this end, “using the net present value method projects would be ranked in the order of net present value” (“Net Present Value Method”, 2010). That is, “the first rank would be given to the projects with the highest positive net present value” (“Net Present Value Method”, 2010).
Strengths
NPV recognizes the time value of money, because it employs all cash flows occurring over the entire life of the project. Discounting methodology fosters measuring of cash flows in terms of their present value (Callahan, Stetz & Brooks, 2007).
Weaknesses
The net present value method also suffers from the fact the NPV values and/or rule are dependent on the discount rate.
Internal Rate of Return (IRR)
The accept- or-reject rule using the IRR method is to accept the project if its internal rate of return is higher than the firm’s cost of capital (Callahan, Stetz & Brooks, 2007). The project shall be rejected if the internal rate of return is lower than the opportunity cost of capital in the firm.
Strength
The IRR method of project evaluation has certain strengths, because it recognizes the time value of money just like the NPV method.
Weakness
The method may give inconsistent and misleading results.
Profitability Index
This is a method for appraising investments, which is found by dividing cash flow’s present value by the initial investment cost (Titman, Keown & Martin, 2011). The profitability index is used in making investment decisions. For instance, accept a project when the profitability index is more than one. On the other hand, an investor should be indifferent when the profitability is zero. However, the investor should not accept a project when the profitability index is below one. Even though, the profitability index is necessary for making investment decisions, especially when ranking projects, it is less analytical, because it is a relative measure. The reason for this is that the profitability index provides a ratio figure.
Payback period methodology
Payback period would be the most popular and widely acknowledged traditional method of evaluating investment proposals. PBP would refer to the number of years required for the firm to recover the original outlay amount that was invested in a project. Many firms use the payback period as an accept-or-reject criterion as well as a method of ranking projects (Callahan, Stetz & Brooks, 2007). If the amount calculated was greater than the maximum period set by the management, it would be accepted, however, if not it could be rejected.
As a ranking method, it gives the highest ranking to the project that promises shortest payback period and the lowest ranking to the project that promises the longest payback period (Callahan, Stetz & Brooks, 2007). Therefore, if the BP Company has to choose among mutually exclusive projects, the one with the shortest payback period can be chosen.
Strength
PBP would be significantly simple to understand and easy to calculate.
Weaknesses
In spite of the fact that PBP is simple, it suffers from several drawbacks. However, “PBP does not take into account the cash inflows earned after the payback period” (“Shareholders’ Opportunities and Values”, 2010). It would also ignore the pattern of cash inflows. Moreover, PBP would not be an appropriate method of measuring the profitability of an investment project (Titman, Keown & Martin, 2011). Finally, “despite the fact that PBP will create administrative difficulties in accepting the maximum payback period, it cannot be consistent with the objective of maximizing the market value of the firm’s shares” (“Shareholders’ Opportunities and Values”, 2010).
Net Present Value (NPV) Calculation
NPV= ${[5/(1+0.1)^2] + [10/(1+0.10)^3] + [15/(1+0.10)^4] + [12/(1+0.10)^5]} – 25
NPV =$ (4.132 + 7.513 + 10.245 + 7.451) -25
NPV = $29.341 -25
NPV = $4.341 million
Internal Rate of Return (IRR) Calculation
NPV = 0
-25 + {[5/(1+IRR)^2] + [10/(1+IRR)^3] + [15/(1+IRR)^4] + [12/(1+IRR)^5]}= 0
Therefore, IRR = 14.87%
Calculation of profitability index
This is calculated as follows.
Profitability index = Present Value of Net Cash Flows/Initial Investment Required
Profitability index =42/25
Therefore, profitability index = 1.68
Payback period
This is calculated by the following formula.
Year Cash flow Net Cash flow
0 -25 -25
1 0 -25
2 5 -20
3 10 -10
4 15 5
5 12 17
Payback period = 3 + 10/15
Payback period = 3.67 years
Conclusion
Given the analysis above, it is evident that NPV can give an accurate and appropriate measure of the project’s capabilities. Since there could not be a satisfactory way of attributing the true rate of return over a long-term asset given in the method of internal rate of return, the method would sometimes give misleading measures of the investment worth. The method may give inconsistent and misleading results. In addition, given that the PBP would not be an appropriate method of measuring the profitability of an investment project. Therefore, given the analysis above, it would be evident that NPV would give an accurate and appropriate measure of the project’s capabilities. Consequently, the BP Company should use the NPV method to evaluate its project and in this case would choose to finance Project one since it could provide the highest positive NPV. This could perform better since the net present values would be more realistic as they put into consideration the time value of money as well as all the cash inflows that the project would bring to the firm. Further, as opposed to the payback period method, the NPV values could be used directly to evaluate the projects.
References
BP Sells Non-Strategic Assets (2012). Web.
Callahan, K., Stetz, G., & Brooks, L. (2007). Project management accounting: Budgeting, tracking, and reporting costs and profitability. Hoboken, NJ: John Wiley & Sons.
Net Present Value Method (2010). Web.
Shareholders’ Opportunities and Values (2010). Web.
Titman, S., Keown, A., & Martin, J. (2011). Financial management: Principles and applications. Boston, MA: Pearson/Prentice Hall.