Question

Question 3 Kavango drilling Limited is a Rundu based mining company that provides drilling services to mines in Namibia. They have been in business for the past five years and their success has been anchored on carrying out proper investment appraisals. However, their management accountant with whom they have worked with for the past five years has been offered a job with another company. This has happened at the time when they are considering two important projects. They have been referred to you by your lecturer to help them decide which project would be beneficial to them. The details of the projects under consideration are as follows: Project Kavango Project Katima N$ N$ Initial capital cost of equipment 520 000 1 000 000 Estimated net annual profits/(loss): Year 1 150 000 (150 000) Year 2 100 000 110 000 Year 3 40 000 150 000 Year 4 (60 000) 170 000 Life of project 4 years 4 years Anticipated re-sale value of equipment at the end of Year 4 120 000 nil It is company policy to depreciate noncurrent assets on straight line basis. The cost of capital applicable to this project is 8%. Requirement: a) Assuming cash flows are accrued evenly throughout the year, determine the payback of each project. b) Determine which project should be chosen on the basis of net present value. Assume cash inflows occur at the end of each year. c) Explain why the net present value (NPV) and the internal rate of return (IRR) may give conflicting decisions. No calculation are needed on this requirement.

Answer 1

	Pay back Period
Year	Expected Cashflow	Cumm.Cash flow	Expected Cashflow	Cumm.Cash flow
0	-520000	-520000	-1000000	-1000000
1	280000	-240000	100000	-900000
2	230000	-10000	360000	-540000
3	170000	160000	400000	-140000
4	70000	230000	420000	280000
	Pack back Period(Years)	2.06		3.33

		Particulars	Kavango		Katima
		Initial Cost of Equipment	520000		1000000
		Estimated Profit/Loss
Year	PVF@8%	Cash Flows= Profit + Dep	Disc. Cash	Cash Flows= Profit + Dep	Disc. Cash
1	0.9259	280000	2,59,259.26	100000	92,592.59
2	0.8573	230000	1,97,187.93	360000	3,08,641.98
3	0.7938	170000	1,34,951.48	400000	3,17,532.90
4	0.7350	70000	51,452.09	420000	3,08,712.54
4	0.7350	120000	88,203.58	0	-
		(Resale value)
		Present value of cash in flows	7,31,054.34		10,27,480.00
		Present value of cash outflows	-5,20,000.00		-10,00,000.00
		Net Present Value($)	2,11,054.34		27,480.00

Decision :

Since NPV is higher and lower payback period for Kavango Project it should be accepted

c)NPV vs IRR conflict also arises due to the different cash flow distribution. IRR inherently assumes that any cash flows can be reinvested at the IRR. This assumption is unrealistic because there is no guarantee that reinvestment at IRR can be achieved. NPV on the other hand assumes reinvestment at the cost of capital, which is conservative and realistic.