Turbine Power Project: The Net Present Value Technique

Introduction

Investment Projects are decisions that companies face when conducting business. It is of essence to carry out proper project analysis before injecting funds into a venture. This is because investment projects require a lot of capital. Also, they are irreversible, that is, once a project kicks off, it is hard to stop it since a lot of company resources will have been put to it. In addition, time value of money is of essence when evaluating investment projects since market uncertainties such as inflation and political climate distort the value of money. This paper evaluates the Turbine Power Project using net present value technique. It gives finding and a recommendation to the operations manager.

Aims and objectives

This paper evaluates the Turbine Power Project using net present value technique. Based on the results of the net present value, the Operations Manager of the project will be advised on whether to move the project from Tamworth site to Tasmania or not.

Methods and data source

The sources of data for the project appraisal are the historical accounting records of the company and current market value for the property, machines and other equipment involved. Australian taxation law and guidelines on depreciation will be used. Net present value will be used to appraise the project as discussed below.

Net present value

“Net present value measures the difference between the present value of cash inflow and the present value of cash outflow” (Shapiro, 2005). That is, it measures the present value of net benefit from a project. This technique looks at both benefits and cost of a project. Also, it takes into account the time value of money. This is necessary because one dollar now might not have the same value in the future. It may happen due to market uncertainties such as inflation, change of consumer preferences and change in political climate among other factors. Incremental cash flow expected from a project needs to be computed when using this approach. The total of the present value of the net incremental cash flow for the life of the project forms the basis for making decision. A project is accepted if the net present value of total incremental cash flow is positive. However, if the total is negative, the operations manager needs to reject the project (Shapiro, 2005).

Table 1.0 Summary of computation of NPV.

Year 0 1 2 3 4 5
Cash flow -6,147,000 859,500 885,180 911,887 939,662 968,549
Discounting factor at 8% 1.00 0.9259 0.8573 0.7938 0.7350 0.6806
Net present value -6,147,000 795,833 758,899 723,885 690,680 659,178

Continuation.

Year 6 7 8 9 10 Total
Cash flow 1,028,591 1,059,834 1,092,328 1,126,121 3,235,278 5,959,932.99
Discounting factor at 8% 0.6302 0.5835 0.5403 0.5002 0.4632
Net present value 648,186 618,403 590,150 563,341 1,498,559 1,400,118.60

Explanation on how to compute net present value

The first row shows net cash flow that is, cash inflow less cash outflow, from year zero to year ten. The net cash flow for each year is multiplied by the discounting factor at 8% to obtain the present value of the net cash flow for each year. The sum of the present value of the net cash flow for each year gives the net present value of the project. This amounts to $1,400,118.60.

Key findings

From the above table, the total net cash flow (not discounted) for the new project amounts to $5,959,932.99. This cash flow is discounted at the required rate of return of 8% per annum. The net present value of the proposed 10 year project is $1,400,118.60.

Conclusion

The above analysis indicates that the project has a positive net present value of $1,400,118.60. This implies that the project promises a positive return at the end of the period. From the above decision criterion, a positive net present value implies that the project is viable. However, the use of one tool only to appraise the viability of the project is not adequate. In as much as net present value technique is reliable for appraising a project; it might give inconsistent results in comparison with other techniques. Therefore, the operations manager of the project should use various tools and ensure that he gets consistent results. He should also consider using internal rate of return, discounted payback period, inspection of the cash flow pattern, and accounting rate of return.

All the above mentioned tools review the financial viability of a project. However, proper project appraisal requires a feasibility study of all aspects of the project and not only the financial aspect. Some of the other aspects that need to be taken into consideration include economic, technical, organizational, managerial, market, and commercial aspect. A project is viable if the result of the comprehensive feasibility study is positive (Shapiro, 2005).

Recommendation for action

From the above analysis, the net present value approach shows a positive result. This implies that the project is viable. However, it is advisable to use a variety of techniques to appraise the financial aspect of the project. In addition, he also needs to comprehensively review other aspects of the project before pursuing the project.

Reference

Shapiro, A. C. (2005). Capital Budgeting and Investment Analysis. India: Pearson Education India.