Good Example Of Net Present Value Methodology When Creating A Cost-Benefit Analysis To Evaluate The Following Project Research Paper
Type of paper: Research Paper
Topic: Finance, Investment, Project, Value, Cost, Money, Present, Shopping
An investment project is the amount of material, human and technological resources required for production and distribution of a product in order to satisfy a particular human need. We must take into account different aspects to develop an investment project as market penetration, incorporation of new products or services in a market and export opportunities (Zarinpoush, 2006). The investment project brings new opportunities and changes in production for better quality and lower cost, improvements in infrastructure to boost competitiveness. The investment projects, considering the actual trend, it must bring social benefits. There are several tools in order to evaluate the success of a project, as the present value, the benefits and costs and macroeconomic tools as the offer and demand surplus. The study case considered in this Paper is the comparison between a rehabilitation project of a National Guard armory and the actual process of maintenance with a fixed annual cost.
The National Guard of Massachusetts spends every year USD 275,000 in the maintenance in its entire armory. The Office of the Governor is considering replacing the armory of all the National Guard. The Department of Military Affairs made a Rehabilitation Budget of all the armory of USD 4,000,000.00. The provider or contractor says that the rehabilitation of the entire armory will extend the armory's service life by fifteen years.
It is necessary to determine if the rehabilitation is convenient to the State of Massachusetts in the financial aspect.
The primary objectives of the project are:
Objective 1: The discount factor is representation of any of the cash flow for the future using the appropriate coefficient for calculations. The discount factor also does depend on the rate of interest and the value of the money based on the time that has passed. The financial market uses this concept to come up with a proper way to weigh in on their financial progress.
DF = (1 + r)^(- t)
In this case "r" represents the interest rate that is expressed in an annual active term. In a scenario by what the interest rate is a decisive factor, then the property DFt<FDv if t <v is satisfied. DF0 = 1.
The "r" is the interest rate. R is always a percentage.
The formula sanctions one to calculate the Net Present Value is:
t = year, B = benefits, C = cost, i=discount rate.
NPV=∑ (t=1, n) (VT/ (1 + r) ^t-I0)
VT – this is a representation of the cash flows in each period t.
I0 - stands for the value of the initial investment expenditure.
t - is the number of periods that are being considered.
r - is the interest rate in percentages.
The condition that is associated with the project is that is there is no financial risk. Then they shall refer to a type of bond. A perfect way is such that the Net Present Value estimate regardless of if the investment is more superior to use for investment in something that is safe and no particular risk involved. In other different scenarios, where there is a risk involved, then the opportunity cost of all that is applicable.
The cost-benefit ratio (B/C), also the net profitability index refers to the quotient that is obtained by distributing the present value of the entire net income or net profits of the Present Value of Costs outlay or total costs (VAC) of the project.
The National Armory CBR where the State of Massachusetts maintenance of the Armory will be based on the initial figure of $4,000,000 and will look as table 1. The unique reimbursement of USD 4,000,000.00 with a depreciation time of fifteen years.
The annual present value for fifteen years is NPV = 7057556.544
Third objective: Discounted benefit of rehabilitating the armory.
Initial investment I0 = 4,000,000.00
Time in years t = 15 in an incremental order
Interest rate r = 4%
Using the equation of NPV:
4,000,000.00 = VT * 11.12
VT = 4,000,000.00 / 11.12
VT = 359,764.40
For the second scenario:
First objective: Discount factor for each year of the rehabilitation guarantee
Interest rate r = 4%
Time in years t = each year in increment
DF for year 1 = (1 + 0.04)^(-1), DF for year 2 = (1 + 0.04)^(-2), DF for year 3 = (1 + 0.04)^(-3), DF for year 4 = (1 + 0.04)^(-4), .all the way to year 15 DF for year 15 = (1 + 0.04)^(-15).
The discount factor for each year is indicated in the above table. Each year has a different factor. The first year has a factor of 1.04 and year 15 has that one of 1.8. The rate increases with time.The discount factors are very much applicable in calculating the value of a swap. In the financial market, the zero coupon in the interest rate curve is what is used to calculate the value of discount factors(NYU, 1997).
Objective 2: The Net Present Value, (NPV)it is an innovate way to calculate the current value of any number of flows of future cash that arise from an investment portfolio. The methodology does consist of the discounting to all the current cash flows. The NPV comprises of a way of determining the equality at time 0 of all the future cash flows that result from a project, and that gets compared to the initial expenditure (Jonathan& David 2015).
The discount rate (r) or DF (explained above), is the outcome of the product of the weighted average cost capital (WACC) and the inflation rate for the same period. The next step sees this equality as being greater than the initial cash flow from the investment. Then it is suggested that the project should are supposed to be accepted.
In the international transactions, it becomes necessary for the parties to apply an inflation rate that is ideal for both for receipts and, for those of payments. It is right to say that the margin of the payments is pegged to the expert economy, and they possess the Consumer Price Index that is much lower than the cost of importing. The reverse of the statement is also true (Jonathan& David 2015).
Annual present value cost of maintenance of the Armory
Cash flow VT = 275,000.00
Interest rate r = 4%
Time in years t = 15 years
The annual present value for fifteen years is NPV =
Objective 3: Discounted benefit of rehabilitating the armory.
Initial investment is = 4,000,000.00
The time in years is t = 15
The interest rate r = 4%
Using the equation of NPV:
In the calculation of NPV, the figure for the initial cost must be represented by a negative number because, as a cash outflow, the initial cost is deducted from the present value of future cash inflows.
All the costs from year 3 to year 15 have exceeded the 5.0 mark.
Benefit and cost ratio of the rehabilitation proposal of the armory of the State of Massachusetts.
There are any foreseeable cost benefits that are linked with the rehabilitation proposal for the armory. The reason behind is; the investment of $ 4,000,000.00 embodies a stipend of 359,764.40 against the existing annuity of $ 275,000.00.The contrary analysis indicates that the current stipend of $ 275,000.00 is representative to the present value of $3,057,557 as opposed to the rehabilitation cost of $ 4,000,000.00.
The project takes a specific number of steps to reach fruition. The steps that are involved in the project are as follows:
The analysis of the requirements with a view to conceptualize the project and understand the problem.
The next step demands that the various stakeholders that are party to the project have to be involved. The State of Massachusetts and the execution team are the ones that carry out the day to day activities.
The formulation of the problem and the consequent development of the technical visualization of the problem.
Assembling all the components that are vital to solving the problem through purchase and lease.
The implementation of all the specific activities that are crucial to carrying out the work that is required.
The last stage is that of testing the solution to see how effective the problem is in terms of solving the problem initially identified.
In their premises, as it is, the financial opportunity brought in by the rehabilitation is not very convenient for the state of Massachusetts. It is hence vital to say that, the current income of $275,000.00 has to remain the same for over the next fifteen years. The discount factor (DF) is the figure used in determining the present value of any future cash flow (Zarinpoush, 2006).
In conclusion, the task of generating a fully-fledged evaluation is a process that requires a good review of the financial statements. The financial statements are what give the good overview of the objectives required in the task. The task has the expenses of the project categorized and to make sense of the data needs some calculations to be conducted and the data analyzed.
Grier C. I, and Sev V. (2000). CIM justification and optimization. London: Taylor & Francis. p. 36. ISBN 0-7484-0858-4.
Jonathan D. and David P.S (2015). Corporate Finance (3rd Canadian Edition ed.). Toronto: Pearson Canada. p. 64. ISBN 978-0133552683.
Jonathan N. and Shimshon B. (2009), Capital as Power. A Study of Order and Creorder., RIPE Series in Global Political Economy, New York and London: Rutledge.
NYU (1997). Project Evaluation Guidelines. NYU. Retrieved from http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/PROJGUID.PDF
Zarinpoush, F. (2006). Project Evaluation Guide for nonprofit organizations, Fundamental methods and steps for conducting project evaluation. Imagine Canada. Retrieved from: http://http://sectorsource.ca/sites/default/files/resources/files/projectguide_final.pdf