Essay on Finance: Net Present Value and Rio Tinto

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INTRODUCTION Sovereign Mines is willing to purchase a new drilling machine to drill for iron ore. This report is going to analyse whether Machine A or Machine B would be chosen according to different techniques. There appears to raise four parts analyses to help Sovereign to make the correct decision. PART 1 Net present value (NPV), internal rate of return (IRR) and equivalent annual annuity approach (EAA) are used to analyse and determine which machine is better choice for Sovereign Mines to purchase. When using NPV rule, ‘all expected cash inflows and outflows are discounted to determine the value of a project in present-value terms with the purpose of maximization of shareholders wealth‘(Frino, Hill and Chen 2009). In addition, ‘IRR technique is used to compare with the cost of the capital in order to make project evaluation’ (Frino, Hill and Chen 2009). However, projects like machine B that have longer periods would like to generate the larger annual cash flows than other projects like machine A that have the short periods. This issue is not taken into account by both NPV and IRR. Therefore EAA is used to generate the equal cash flows for each period in order to fairly compare these two projects that have different lifetimes (Frino, Hill & Chen, 2009). Capital asset pricing model (CAPM) is used to calculate the responsiveness of a securities returns to market returns (β) and the expected rate of return (Er). β =Covariance (ASX200, Sovereign Mines) / Variance (ASX 200) = 0.06 / 0.252 = 0.96 Er = rf + [rm - rf] β = 0.07 + [0.12-0.07](0.96) = 0.118 or 11.8% TABLE1: Calculation of free cash flows of two machines

Table 1 shows the calcuation of free cash flows of two machines when the tax on profit is 30%. ‘Working capital is funds that set aside to ensure that the company has sufficient cash flows to maintain operations whilst undertaking the project’ (Frino, Hill and Chen 2009). Working capital of Machine A and Machine B is $80,000 and $70,000 payments respectively in the year 0, and the payments will be recovered at the end of investment period e.g. the 6th year and 10th year. Further, the market analysis at a cost of $5000 is recognized as sunk cost because it incurred in the past and does not affect present

decision, therefore it should be ignored. In addition, the salvage value is the profit on disposal of assets in the sixth year, which is $5000 inflows for Machine A and $2000 for Machine B. In addition, the annual depreciation expense is calculated by the total of initial cost plus the instalment divided by useful years as it uses the straight-line method and there is no residual value. The depreciation expense for Machine A and Machine B is $17,500 and $15,400 respectively. Finally, the10% loan repayment is finance charge and therefore should be excluded from free cash flow. Calculation of NPV, IRR and EAA for two Machines with the Tax of 30% NPVof Machine A NPV =ΣCFt / (1+r)t= $38,850/(1+0.118)1 +$38,850/(1+0.118)2 + $38,850/(1+0.118)3 + $38,850/(1+0.118)4 + $38,850/(1+0.118)5 +$122,350/(1+0.118)6 – $185,000 = $18,396.84 IRR of Machine A 0=ΣCFt / (1+irr)t= $38,850/(1+irr)1 + $38,850/(1+irr)2 + $38,850/(1+irr)3 + $38,850/(1+irr)4 + $38,850/(1+irr)5 +$122,350/(1+ irr)6 – $185,000 irr = 15% EAA of Machine A
-n NPV = A [1-(1+re) ] / Re

$18,396.84=A [1-(1+0.118)-6]/0.118 A=$4,449.27 NPV of Machine B NPV =ΣCFt/(1+r) t= $46,620/(1+0.118)1 + $46,620/(1+0.118)2+$46,620/(1+0.118)3 +$46,620/(1+0.118)4 +$46,620/(1+0.118)5 +$46,620/(1+0.118)6 +$46,620/(1+0.118)7 +$46,620/(1+0.118)8 +$46,620/(1+0.118)9 +$118,020/(1+0.118)10 -$224,000 =$64,987.48 IRR Of Machine B 0= ΣCFt/ (1+irr)t= $46,620/(1+irr)1 + $46,620/(1+irr)2+$46,620/(1+irr)3 +$46,620/(1+irr)4 +$46,620/(1+irr)5 +$46,620/(1+irr)6 +$46,620/(1+irr)7 +$46,620/(1+irr)8 +$46,620/(1+irr)9 +$118,020/(1+irr)10 -$224,000 irr = 18% EAA of Machine B
-n NPV = A [1-(1+re) ] / Re

$64,987.48= A [1-(1+0.118)-10] /0.118 A=$11,407.75 Conclusion for Part 1 Three techniques all
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