MISSION COMPLETE

Ahhhh.....

ASSIGNMENT AND SEMESTER COMPLETE..

My work here is done!!

Ass 3: Step 2

Step 2: Capital Investment Decision

Develop a capital investment decision

A capital investment is a decision to invest in or purchase an asset, invest in capital or invest in infrastructure to gain a return in the future.  The following are two proposals that Morgan Sindal would see during their financial year and within their scope of project opportunities.  These are two different projects that could be undertaken by different Divisions within Morgan Sindal.

PROPOSAL SCENARIO 1:

Morgan Sindal Group has been presented with a proposal to invest £M49.9 in a full Regeneration Project of affordable and energy efficient housing development in England and Scotland under their Affordable Housing Division; partners in the investment include existing partners on current projects; Capital for project is £M49.9 with an expected average future cash flow return annually of17% per year (calculated as £M8.483; full project estimated life being 7 years after which MS will sell their property portion.

PROPOSAL SCENARIO 2:

Morgan Sindal Group has been presented with a proposal for their Investment Division to invest £M8.9 in a 50:50 joint investment venture in freehold office building asset with an existing partner; Capital investment for project is £M8.9 (including fit out expenses) with an expected average future cash flow return of lease return annually of £M2.5; estimated life of the investment project being 8 years.

Calculate the payback period, net present value and IRR

See Excel Spreadsheet for full calculations

SCENARIO 1	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7
£M	(49,900,000)	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000
NPV	$9,481,000
	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7
	(49,900,000)	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000	8,483,000
IRR	5%
	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7
PAYBACK PERIOD	(49,900,000)	8,483,000	8,483,000	8,483,000	8483000	8483000	8,483,000	8,483,000
Cumulative Cash Flows		(41,417,000)	(32,934,000)	(24,451,000)	(15,968,000)	(7,485,000)	998,000	9,481,000
			Payback occurs in		10.6	months of year 6

SCENARIO 2	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7	Yr 8
£M	(8,900,000)	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000
NPV	$11,100,000
	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7	Yr 8
	(8,900,000)	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	2,500,000	500,000
IRR	21%
	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7	Yr 8
PAYBACK PERIOD	(8,900,000)	2,500,000	2,500,000	2,500,000	2500000	2500000	2,500,000	2,500,000	2,500,000
Cumulative Cash Flows		(6,400,000)	(3,900,000)	(1,400,000)	1,100,000	3,600,000	6,100,000	8,600,000	11,100,000
			Payback occurs in		6.7	months of year 4

Discuss your thought process

The first step in the process of decision making is to look at the comparisons in NVP, IRR and payback period.

	Scenario 1	Scenario 2
NVP	Lower  Investment £M 49,900,000 £M 9,841,000	Higher Investment £M 8,900,000 £M 11,000,000
IRR	5%	21%
Payback	Mid Oct year 6	Mid June year 4

NVP:

For scenario 1, the NVP over the 8 years of the estimated life of the project is £M9.481 on and investment of £M49.9.  Scenario 2 has a NVP of £M 11.1 on an original investment of £M8.9.  Scenario 2 provides a much higher NPV.  Interestingly the amount is also higher than that of the higher investment capital scenario.

IRR:

IRR is much higher for scenario 2 than scenario 1 at 21% compared to 5%.  Scenario 1’s IRR is still lower than the cost of capital of 10%, whilst scenario 2 is double which is a high factor in decision making process.

PAYBACK PERIOD:

Payback period for Scenario 1 is just over 2 years longer than Scenario 2 meaning that it will take longer to pay the original investment back.  Scenario 2 will only take just under four and a half years to pay back the original investment.

DECISION:

On these factors I would advise Morgan Sindal’s Board of Directors to undertake Scenario 2’s project proposal due to the higher NVP, higher IRR which is twice the cost of capital rate, and will take a shorter period of time to payback the existing investment.  This investment’s initial outlay of capital is much lower that scenario 1 and will give a greater NVP in a shorter amount of time and is the superior proposal.

Another factor to consider is the projects themselves and the current history and economic climate that Morgan Sindal is experiencing.  Given the nature of the a number of large infrastructure projects running over time and having increased expenses associated with this, a similar project has the same potential risks.  As Morgan Sindal has not been performing as well given the ratio analysis discussion the return offered for the lower investment project that Scenario 2 proposal offers, this adds to the qualitative reasoning and decision making processes. 

Strengths of analysis

There are some great strengths in using NPV and IRR in accepting project proposals to take on for Companies.

NVP:

·        NVP is a direct measure of the dollar contribution to the shareholders

·        Accounts for the value of a dollar today is more than the value of a dollar received a year from now

·        The leading decision making ratio in terms of conflicting results, the higher the NPV should be accepted

IRR:

·        Shows the return on the original money that was invested

·        Easy to measure and calculate and can give an easy snapshot of projects outcomes for comparison

·        Easy to select potential projects where the IRR exceeds the estimated cost of capital, e.g. for this Assignment cost of capital was estimated at 10% and scenario 2 provided an IRR of 21%.

Weaknesses of analysis

There are however inherent weaknesses in using NVP and IRR also

NVP

·        The size of the project is not measured nor taken into consideration

·        Does not give identify how long a project will take to generate a positive NPV due to the calculations simplicity (this is where IRR is used)

IRR

·        it can give you conflicting answers when compared to NPV for mutually exclusive projects

·        only deals with cash flows generation the capital outlay and does not consider other costs, e.g. with MS a number of projects in 2013 and 2014 financial years had suffered project slip in timeframes thus resulting in additional expenses, these are not taken into consideration and can greatly impact upon overall return