W9_ANG_ERR for Student Pick-up Service

Problem Statement

Following my previous blog posting, on this posting I would discuss to determine “GO” or “NO go” for Student pick-up service business investment using ERR calculation. I would use most likely approach assumption as discussed on my week 5th posting. This also to satisfy myself that in fact I had problem calculate rate of return using IRR formula based on most likely approach for my week 8th posting, that’s why yesterday I changed it to be based on pessimistic approach.

On this posting, I put three scenarios: 1st is fully using equity fund, 2nd is using mixed equity and debt which ten million rupiah of investment (21.74%) is using debt and 3rd is also mixed which forty million rupiah of investment (86.96%) is using debt.

Feasible Alternatives

The feasible alternatives are 1st: using full equity, 2nd: mixed fund with 21.74% of investment using debt and 3rd: mixed fund with 86.96% of investment using debt.

Outcomes/ Calculations

Scenario 1

MARR= ea = 17.90% refer to my week 7th blog posting

ERR = 39.67% based on the following calculation

Scenario 2

MARR= WACC
= 17.90%, refer to my week 8th blog posting

ERR = 43.77% based on the following calculation

Scenario 3

MARR= WACC
= 17.91% refer to my week 8th blog posting

ERR = 97.33% based on the following calculation

Setting Minimum/ Selection Criteria

The Minimum criteria is the ERR has to be higher than the hurdle rate MARR and the selection criteria for choosing the investment scheme is the highest ERR scenario.

Analysis/ Comparison of the Alternatives against the Criteria

From the calculation above, the cost of debt rate is not much higher than cost of equity rate (25.59% vs 17.90%), that’s why on this case the change of debt composition ratio does not impact on the change of WACC rate.

Refer to the following calculation that tax is deducted from Income after tax:

25.59% * (1-30%) = 17.91% ! shown that even with 100% debt, the WACC or MARR is still 17.91% ! from this perspective, I can say the debt rate is still relatively okay.

The phenomena of scenario 3 is also interesting, the monthly revenue is less than the debt installment that we have to pay, the ERR is still best considering at the end of 24th month we sell the car with estimated value forty million rupiah. For scenario 3, the investor is like saving by invest six million rupiah at the beginning, pay monthly only about one hundred and five thousand rupiah and get about forty-one million nine hundred thousand at the end 24 month.

Selection of the Best/ Preferred Alternative Compared against the Criteria

Based on the ERR rate, the best rate of return is scenario 3.

Performance Monitoring and Post Evaluation of Result/ Follow up Assessment

The chosen of scenario 3 considering its highest ERR rate number can be dispute in fact the investor has negative cash flow for 23 months duration from this investment.

But by choosing scenario 3, the investor has to anticipate the negative cash flow by cover it from the cash flow of other investments/ income, otherwise he has to choose scenario 2.

References:

1. Sullivan, William G., Wick, Elin M., Koelling, C. Patric. (2012), Engineering Economy. 15th ed. Chapter 5: Evaluating a Single Project, page 178-225, Chapter 13: The Capital Budgeting Process, page 522-550, USA: Pearson Higher Education, Inc.
2. Amos, Scott PE. (2012), Skill & Knowledge of Cost Engineering. 5th ed., USA: AACE International.
3. Humphreys, Gary C. (2002), Project Management Using Earned Value. 2nd ed., USA: Humphreys & Associates, Inc.
4. Taborda, Joana (2013). Bank Indonesia Keeps BI rate On Hold at 7.25% . [ONLINE] Available at: http://www.tradingeconomics.com/indonesia/interest-rate. [Last Accessed 24 October 2013].
5. Damodaran, Aswath (2013). Country Default Spreads and Risk Premiums. [ONLINE] Available at: http://pages.stern.nyu.edu/~%20adamodar/New_Home_Page/datafile/ctryprem.html. [Last Accessed 24 October 2013].
6. (2013). Cipaganti Citra Graha Tbk PT (CPGT.JK). [ONLINE] Available at: http://www.reuters.com/finance/stocks/financialHighlights?symbol=CPGT.JK. [Last Accessed 24 October 2013].
8. (2013). Suku Bunga PT. Bank Mandiri (Persero) Tbk. Berlaku Mulai Tanggal 19 September 2013 Deposito Rupiah. [ONLINE] Available at: http://www.bankmandiri.co.id/resource/bunga_02122011.asp. [Last Accessed 24 October 2014].
9. (2013). Indonesia Inflation Rate. [ONLINE] Available at: http://www.tradingeconomics.com/indonesia/inflation-cpi. [Last Accessed 24 October 2013].
10. Panin Bank (2013). Kredit Express. [ONLINE] Available at: http://www.panin.co.id/pages/158/kredit-express. [Last Accessed 30 October 2013].