Table of Contents
- The Pros and Cons of the Net Present Value and Payback Period Methods of Project Appraisal
- Identify Project Categories and Criteria (Derivative, Platform, Breakthrough, and R&D Projects)
- Reduction of the Project and Criteria Set
- The Strategic Acquisition
- Pan Europa’s Spending Cap of €80 Million
- The Weighted Scoring Model
- Related Management essays
The Pros and Cons of the Net Present Value and Payback Period Methods of Project Appraisal
The management of Pan- Europa Foods S.A. uses the payback period and the net present value approaches to carry out capital budgeting decisions. These two methods are useful in determining the viability of the eleven proposed projects that are to be undertaken in the forthcoming financial year. From exhibit 3 of the Pan-Europa Case, the Eastward Expansion project is the most viable investment with a positive NPV of €11.99M. The least feasible project is the Automation and Conveyor systems project that has a negative NPV of -€0.87M. Thus, the net present value technique is advantageous as it enables Pan-Europa’s management to rank projects in terms of their current net worth.
The NPV method is also advantageous as it employs the time value of money concept in project appraisal thus making it easier to derive the incremental shareholder’s wealth gained after the successful implementation of the project. It is evident in the Pan-Europa Case in which the free cash flows are discounted using the company’s weighted average cost of capital of 10.5%. In addition to this, the NPV method used by the Pan-Europa recognizes the effect of risk on the future profits, cost savings, depreciation, and tax. It is evident from the fact that the company has recalculated the net present values for the eleven using the minimum required rate of return on the firm’s investment.
The NPV method is however, disadvantageous as it may lead to wrong investment decisions. The company may accept a project that should have been rejected based on the NPV rule, and it may also dismiss a project that should have been implemented. It also fails to rank those projects that have unequal lives. From exhibit 3 of the Pan-Europa Case, the problem is evident since most of the projects have unequal lives. Projects one and five have a useful life of seven years, on the other hand, project ten has four years of useful life while the rest have 10 years useful life. Ranking of these projects using the NPV technique thus becomes difficult.
The Payback period is advantageous as it determines the period within which the Company can recoup its initial outlay cost. The decision to accept or reject a project proposal is dependent on the management’s benchmark with regards to similar projects. It is evident from exhibit 3 that only projects seven, eight through eleven meet the company’s specified criterion on the maximum payback accepted. It however faces shortfalls in that as it ignores the free cash flows after the payback period. The method also fails to consider the time value of money concept and this makes it unreliable for decision making with regards to the implementation of the eleven proposed projects.
Identify Project Categories and Criteria (Derivative, Platform, Breakthrough, and R&D Projects)
The first project, the Replacement and expansion of the company’s truck fleet lies in the derivative category. Derivative development projects usually involve augmentation and addition to the existing products. The addition and augmentation of a firm’s products can be done using incremental process and product changes. Project number one falls in this category because it involves the incremental product changes implementation in the company’s existing truck fleet. The purchase of 100 new refrigerated tractor-trailer trucks will increase the company’s ability to serve a wider geographical base. It will also result in incremental process changes as the replacement of truck fleet will ensure that there is efficient routing and servicing of the fleet. The project also falls in the derivative category as it will lead to efficient fuel usage and maintenance.
The project number two involves the construction of a new plant at a cost of €25 million. It falls in the platform category of development projects. According to this classification, the company undertakes major changes that are different from the existing products. The changes create a platform that is essential for the future growth of the company due to improved performance, increased quality, and effective cost management. The construction of a new plant is proposed by Maarten Leyden and it seeks to cut the shipping costs in the expanded markets. The project is also classified as a market extension as it will result in low delivery costs, increased free cash flows production efficiency.
The project number three is classified as a market extension project as it involves the expansion of an existing plant. The expansion of the plant falls in the derivative category of development projects. It is categorized as part of derivative projects as involves improvement of work on the plant located in Nuremberg, Germany. The expansion aims at improving the maintenance of equipment, and eliminating production-scheduling and deadline problems.
The project number four involves the development and introduction of new artificially sweetened yogurt and ice cream. The investment is categorized as a breakthrough development project because it includes the design and development of brand new products that have the ability to define the industry. The classification to the breakthrough category is also supported by the management’s decision to include it in the new-product category of investments.
The project number five involves the automation of plant and conveyor systems. The capital investment project is categorized in the efficiency category by the Pan-Europa management. The investment falls in the derivative category of capital projects. The classification to the derivative field is evidenced by the improvements done on the company’s production lines in the six old plants. It also involves the implementation of incremental process changes to the company’s plant and conveyor systems.
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The sixth investment involves the effluent water treatment of four company’s plants. The Pan-Europa Company classifies this investment as part of the organizational environmental projects. The effluent treatment of four Pan-Europa’s plants can be categorized as a derivative capital project. It is because the implementation of the project results in a better company image in the public’s eyes while reducing the pollution levels in the Seine and Rhine rivers.
The seventh and eighth projects involve the eastward and southward market expansion proposed by Marco Ponti. The Pan Europa Company categorizes the two projects in the new market strategy. It is because of this that the projects fall in the platform category of capital projects. The successful launch in new markets will also enhance the competitiveness of Pan-Europa in addition to increasing its market share in the yoghurt and ice cream industry.
The development and roll-out of snack foods is classified as a platform project as it involves the development of totally new products.
The tenth project is classified by the management as part of the efficiency project proposals. In the development project categories, it falls in the breakthrough projects class. It involves the application of the latest technology in undertaking inventory control for field representatives and warehouses.
The last investment falls in the platform projects class of capital projects as it enables Pan-Europa Company to meet the specific customer needs in consumer packaged goods industry.
Reduction of the Project and Criteria Set
|Project||Annuity Equivalent||Initial Outlay||Rank||Allocation||Explanation|
|1||-0.02||11.4||10||0||Project cannot be undertaken due to internal capital rationing|
|2||0.3||30||9||0||Project cannot be undertaken due to internal capital rationing|
|3||0.09||10||7||0||Project cannot be undertaken due to internal capital rationing|
|4||0.69||5||3||5||Undertake 100% project implementation since it lies within the budget|
|5||0.06||14||8||0||Project cannot be undertaken due to internal capital rationing|
|7||1.75||20||2||20||Undertake 100% project implementation since it lies within the budget|
|8||1.25||20||6||10||Undertake only 50% of the project|
|9||1.29||18||5||18||Undertake 100% project implementation since it lies within the budget|
|10||0.69||12||3||12||Undertake 100% project implementation since it lies within the budget|
|11||7.33||15||1||15||Undertake 100% project implementation since it lies within the budget|
The Strategic Acquisition
The strategic acquisition proposal is very beneficial to the Pan-Europa Company but it is too risky to be undertaken. The investment is viable to the company because it generates a positive net present value of €47.97 million. The NPV at minimum ROR for the strategic acquisition project is €41.43 million thus indicating that the project will give the investors adequate returns. Also, given that it has a payback period of five years, the project meets the management’s benchmark payback period of six years. However, the project is too risky for the Pan-Europa Company since it has a very large spread of 16.7% amongst the eleven proposals. It means that there would be great variation between the actual cash flows generated in future and the expected free cash flows.
Pan Europa’s Spending Cap of €80 Million
In order to confirm whether the six projects selected for Pan-Europa fall in the spending cap of €80 million, the ratios of the projects’ initial outlay cost are compared to that of the total amount available of €80 million. The six projects will be fully implemented except for project number eight which will be allocated for only 50% of its initial outlay cost. The selection falls under the spending cap as shown below:
The Weighted Scoring Model
The weighted scoring model will be useful in enhancing the selection process for the Pan-Europa Company. It involves the identification of the non-monetary variables for all the eleven projects. The attributes will then be assigned weights relative to their importance and the strengths of each project. The weighted scores are then calculated and the results tested for robustness before interpretations are made. The model will increase the quality of decision making in terms of the viable projects that will be selected since it also considers the non-monetary attributes that affect the project implementation. Using numerical evaluation techniques such as the NPV and payback period, projects four and ten appear to be optional. However, upon considered factors such as changes in customer demand, customer loyalty, and value chain systems, the projects are very essential in increasing the company’s market share.