Performance measurement

Can you advise where the NPV is coming from please ?
Cheers

Example 4

PQR plc is considering opening a new division to manage a new investment project. Forecast cashflows of the new project are as follows:
Year 0 1 2 3 4 5
Forecast net cash flow $m (5.0) 1.4 1.4 1.4 1.4 1.4

PQR’s cost of capital is 10% pa. Straight line depreciation is used.

Required: Calculate the project’s net present value and its projected ROI and residual income over its five-year life.

NPV
Year 0 1 2 3 4 5
Forecast net cash flow $m (5.0) 1.4 1.4 1.4 1.4 1.4
Present value factors at 10% 1.00 0.91 0.83 0.75 0.68 0.62
Present value (5.0) 1.27 1.16 1.05 0.95 0.87
NPV = $0.30m

ROI
Year 1 2 3 4 5
1 Opening investment at net book value 5.0 4.0 3.0 2.0 1.0
2 Forecast net cash flow $m 1.4 1.4 1.4 1.4 1.4
3 Straight line depreciation (1.0) (1.0) (1.0) (1.0) (1.0)
4 Profit 0.4 0.4 0.4 0.4 0.4

ROI (4 ÷ 1 x 100) 8% 10% 13% 20% 40%

Residual income
Year 1 2 3 4 5
Profit (as above) 0.4 0.4 0.4 0.4 0.4
Imputed capital charge (opening investment x 10%) 0.5 0.4 0.3 0.2 0.1
Residual income (0.1) 0.0 0.1 0.2 0.3

Comment: this example demonstrates two points. Firstly, it illustrates the potential conflict between NPV and the two divisional performance measures. This project has a positive NPV and should increase shareholder wealth. However, the poor ROI and residual income figures in the first year could lead managers to reject the project. Secondly, it shows the tendency for both ROI and residual income to improve over time. Despite constant annual cashflows, both measures improve over time as the net book value of assets falls. This could encourage managers to retain outdated assets.