Question

Mr. James, an ardent photographer has decided to take his for steps on realizing his entrepreneurial dream. He has been mulling over various options and has narrowed them down to 2 options. Mr. James asks for your assistance in resolving the dilemma that he faces. Option 1 Rent an office at La Lucia Mall and purchase photo developing equipment and other devices necessary for this venture. This will involve the actual printing/development of photos, “burning” of CDs/DVD’s, etc. Option 2 Purchase a state of the art Nikon Camera Kit and take photos/record videos of special events (weddings, birthdays, anniversaries, etc.). This will entail spending on an advertising campaign in order to aggressively seek market share. Project cost and other data Option 1 Option 2 Cost of investments (Total) 400 000 90 000 Expected useful life 5 years 5 years Salvage value 50 000 10 000 Cost of capital (After tax) 9% Project Revenues Year 1 150 000 20 000 Year 2 130 000 30 000 Year 3 80 000 50 000 Year 4 60 000 30 000 Year 5 40 000 15 000 Required: 2.1 If James requires a payback period of no more than 3 1/2 years which project should he choose? Show calculations. (8) 2.2 Suggest flaws in the valutitaion method (payback period).(2) 2.3 Use the NPV method to test which project is more viable. (10)

Answer 1

2.1 Below table shows the Cashflows and Cumulative Cashflows details across project life:

Years	Cashflows		Cumulative Cashflows
	Option 1	Option 2	Option 1	Option 2
Year 0	-400000	-90000	-400000	-90000
Year 1	150000	20000	-250000	-70000
Year 2	130000	30000	-120000	-40000
Year 3	80000	50000	-40000	10000
Year 4	60000	30000	20000	40000
Year 5	40000	15000	60000	55000

Calculation of Payback Period

For Option 1:

= Year 3 + Proportion of Amount received in Year 4

Payback Period for Option 1 = 3 + (40000/60000) = 3 + (2/3) = 3.67 years = 3 years and 8 months

For Option 2:

= Year 2 + Proportion of Amount received in Year 3

Payback Period for Option 2 = 2 + (40000/50000) = 2 + (4/5) = 2.80 years = 2 years 9 months and 18 days

	Option 1	Option 2
Pay Back Period	3.67 years	2.80 years

If James doesn't want to go beyond Payback period of 3.5 years, then James should go with Option 2 as it has Pay Back Period of 2.80 year which is less than 3.50 years.

2.2 Flaws in Valuation Method: In the above part, we have calculated Simple Payback Period which violates the principle of Time Value of Money. To overcome this, one should consider Discounted Pay Back Period instead of Simple Pay Back Period.

2.3 Below table shows the NPV of both Options respectively, along with it's working calculation:

Years	Cashflows		Present Value Factor	Present Value of Cashflows
	Option 1	Option 2		Option 1	Option 2
Year 0	-400000	-90000	1	-400000	-90000
Year 1	150000	20000	0.9174	137614.6789	18348.6239
Year 2	130000	30000	0.8417	109418.3991	25250.3998
Year 3	80000	50000	0.7722	61774.6784	38609.1740
Year 4	60000	30000	0.7084	42505.5127	21252.7563
Year 5	40000	15000	0.6499	25997.2555	9748.9708
Year 5 (Realization of Salvage Value)	50000	10000	0.6499	32496.5693	6499.3139
Net Present Value				9807.0939	29709.2386

Present Value Factor = 1 / (1+r)^n

where, r = Cost of Capital ( After tax); n = No. of Year

Present Value of Cashflow = Cashflow of Respective option * Present Value Factor

Therefore, the NPV of Option 1 is 9,807.09 whereas NPV of Option 2 is 29,709.24.

Hence, Option 2 will be advisable to go with - by using NPV approach.