Business Finance (Essay Sample)

Calculation of NPV, IRR, Simple payback and discussion of outsourcing the central office functions and capital budgeting effectiveness and rationale
Erick Mwangi Maina
Kenyatta University
(Q1)Calculation of Net Present Value
Net present value is a technique for appraising investments. It discounts all cash flows at the project cost of capital and then sums these cash flows. Net present is defined mathematically as the present of cash flows less the initial cash outflow.
Net present value = ‑_(t=1)^n ct/((1+k)^t )-I_o
Where: Ct- is the cash flow.
k- Opportunity cost of capital.
Io-Initial cash outflow.
n- Useful life of the project.
Initial cash outflow is $1,000,000 and the incremental cash flows are: yr1-$ 450, 000, yr2-350, 000, yr3 $300,000, yr4-$250,000. The opportunity cost of capital is 8%.
Discounting factor = 1― (1+r―100) t.
Year.

Discounting factor.

Cash flows.

Present value.

1

0.9259

$450,000

$416,655

2

0.8573

$350,000

$300,055

3

0.7938

$300,000

$238,140

4

0.7350

$250,000

$183,750

TOTAL



$1,138.600

Net present value= present value of cash flows-initial cash outlay
$1,138,600- $1,000,000= 138,600Since the NPV is positive the company should pursue this project because it will be profitable.
As a result, it means that the project is profitable and should be implemented or accepted.
Decision rule under the NPV requires: If the net present value is negative reject the project if the present value is positive take the project and finally if the project is zero the management will be indifferent.
Calculations of Internal rate of return
Internal rate of return involves calculation of the discount rate that will give the net present value of zero. Calculation of IRR is not straightforward, but an approximate value can be obtained using either graphical or linear interpolation. For both methods, you need to calculate the NPV for two different discount rates. For greatest accuracy, the NPVs should be small, and preferably one should be negative and the other positive. Internal rate of return is that ratio that makes the present value of Cash flows equal to the initial capital outlay. After calculation of two discount rates, we use the following formulae to get the internal rate of return.
IRR = NPv1 R2- Npv2 R1Npv1-Npv2
Npv1= -14590; Npv2=3845; R1 =14%; R2= 15%
IRR= -14590 x 15- (3845 x 14)-14,590-3,845
=14,791
IRR= 14.79% and since the IRR exceed the cost of capital which is 8% the company should accept the project.
The decision rule under the IRR requires that:
If IRR>Opportunity cost of capital, accept the project.
IRR
IRR=Opportunity cost of capital, it's indifferent.
Calculation of payback
Payback method involves the calculation of the time taken to recoup or recover the initial cash outlay.
Year 1- $450,000
Year 2-$350,000
$800,000
$200,000 remaining to repay the initial cash outflow of $1,000,000 the company will recover in the third year. For this reason, the payback period is:
=2+200,000―300,000= 8/3=2 2―3
The decision rule on a payback basis prefers those investment projects with shorter payback period to those with longer payback period. Projects that exceed the maximum payback period set by the company are not viable because of the concept of the time value of money.
(Q2) outsourcing the central office functions.
Outsourcing is the use of suppliers outside the organization to perform a number of services or produces certain goods that the company produces internally. Outsourcing involves a licensee entering into an arrangement with another party to perform a business activity that is presently the duty of the licensee itself. Outsourcing a company's central office is the most crucial decision any organization can decide to enter. It reduces the cost of operating the business and help in improving the quality of the products and services. Outsourcing the company central office functions will enable a firm more control and more time of other activities through increased flexibility. The company can mitigate potential risks because the organization will only enter into a contract if the concerned party quality services. The high technology and automation used by the outsourcing organization will benefit the outsourcing company with economies of scale thus a reduction in the cost of production.
Outsourcing leads to increased operation efficiency. Efficiency, in this case, is in terms service quality that the company achieves so as to keep existing customers and attract more customers hence increased revenue for the business organization. Outsourcing ensures the right amount of resources has been used to deliver goods, service or an activity. An efficient firm or an organization achieves its objectives with the minimum amount of time, money, people or other resources. With optimal allocation of resources, there is a reduction in overhead cost and high-quality product. Lower and more predictable cost of operation is another important benefit that a firm will enjoy as a result of outsourcing its central office functions either partially or wholly. Saving is as a result of saving on the cost of labor and still attains set goals and objectives of the organization from professionals who are highly skilled. The firm that outsources will have ample time at its disposal and reduced cost of marketing.
Outsourcing the central office functions implies working with highly knowledgeable and experienced specialists. The workers f...