FIN622 Solution May 11,2010

[viki]

Solution:
(i) Applying Capital Budgeting Techniques
a) Pay back period.
Project A Initial value = 57000
Years 1 2 3 4
Cash Flows(Rs.) 20000 20000 20000 20000
Cumulative CF 20000 40000 60000 80000
Payback Period for this project is somewhere between 2 and 3 years cost recovers in
between these years. At the end of year 2, Rs 40000 has been recovered and Rs 17000 are
to be covered from next year’s cash flow of Rs 20000.
Payback period = 2 + 17000/20000 = 2.85 years
Project B initial value = 54000
Years 1 2 3 4
Cash Flows(Rs.) 22000 20000 18000 16000
Cumulative CF 22000 42000 60000 76000
Payback Period for this project is somewhere between 2 and 3 years cost recovers in
between these years. At the end of year 2, Rs 42000 has been recovered and Rs 12000 are
to be covered from next year’s cash flow of Rs 18000.
Payback period = 2 + 12000/18000 = 2.67 years
Net Present Values
Project A = Discount Rate = 14%
NPV= -IO+_CFt/ (1+i) t
NPV= -IO+ CF1/ (1+i) 1 + CF2/ (1+i) 2 + CF3/ (1+i) 3 + CF4/ (1+i) 4
NPV= -57000+ 20000/ (1+0.14) 1 + 20000/ (1+0.14) 2 + 20000/ (1+0.14) 3 + 20000/
(1+0.14) 4
NPV= -57000+ 20000/ (1.14) 1 + 20000/ (1.14) 2 + 20000/ (1.14) 3 + 20000/ (1.14) 4
NPV= -57000+ 20000/ 1.14 + 20000/ 1.2996 + 20000/ 1.481544 + 20000/ 1.68896016
NPV= -57000+ 17544 + 15689 + 13500 + 11841
NPV= -57000 + 58574
NPV= 1574

Project B = Discount Rate = 14%
NPV= -IO+_CFt/ (1+i) t
NPV= -IO+ CF1/ (1+i) 1 + CF2/ (1+i) 2 + CF3/ (1+i) 3 + CF4/ (1+i) 4
NPV= -54000+ 22000/ (1+0.14) 1 + 20000/ (1+0.14) 2 + 18000/ (1+0.14) 3 + 16000/
(1+0.14) 4
NPV= -54000+ 22000/ (1.14) 1 + 20000/ (1.14) 2 + 18000/ (1.14) 3 + 16000/ (1.14) 4
NPV= -54000+ 22000/ 1.14 + 20000/ 1.2996 + 18000/ 1.481544 + 16000/ 1.68896016
NPV= -54000+ 19298 + 15689 + 12150 + 9473
NPV= -54000 + 56610
NPV= 2610
Decision:
Project A = 1574 NPV
Project B = 2610 NPV
According to the NPV of both projects, I will recommend project B due to greater NPV
of project B from A.
Project A = 2.85 years Payback Period
Project B = 2.667 years Payback Period
According to the Payback period of both projects, I will also recommend Project B,
because in Project B the payback period (PP) is little than Project A.

[Guru]

SOLUTION

1) The payback period of each project



THE PAYBACK PERIOD (PP); For the Project A that has equal receipts



= Initial Investment / Cash Flow (I0/Ct)

= 57000/20000

= 2.85year



THE PAYBACK PERIOD (PP); For the Project B



Payback period lie between 2nd year and 3rd year

Sum of the money recovered by the end of second year

= (22000+20000)

= 42000



Sum of money recovered by the end of 3rd year

= (54000 – 42000)

= 12000

= [2+ 12000/18000) years

= 2.667 years



2) The Net present value (NPV) of each project.



NPV for project A;

Formula:

(CFn * PVFA at 14% for 4 years) – Initial Investment



PVFA at 14% for 4 years:



= [1/ (1+i) ^ n + 1/ (1+i) ^ n + 1/ (1+i) ^ n + 1/ (1+i) ^ n]



= [1/ (1+0.14) ^1 + 1/ (1+0.14) ^2 + 1/ (1+0.14) ^3 + 1/ (1+0.14) ^4]



= [0.8772 + 0.7695 + 0.6749 + 0.5920]

= [2.9136]



By putting values in Formula:

= (20000 * 2.9136) – 57000

= 1272



NPV for project B;

Formula:

Sum of the NPV (CFn) – Initial investment



Sum of the NPV (CFn)

= [CF1/ (1+i) ^ n + CF2/ (1+i) ^ n + CF3/ (1+i) ^ n + CF4/ (1+i) ^ n]



= [22000/ (1+0.14) ^1 + 20000/ (1+0.14) ^2 + 18000/ (1+0.14) ^3 + 16000/ (1+0.14) ^4]

= 19298.246 + 15389.352 + 12149.487 + 9473.284

= 56310.368

By putting values

= 56310.368 – 54000

= 2310.368



3) Decision


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