Question

1.1 A company with a cost of capital of 20% has identified projects with the following cash flows:

Year	Project C	Project D
0	-N$100 000	-N$30 000
1	40 000	10 000
2	45 000	15 000
3	50 000	20 000
4	55 000	25 000

Required 1:
a. Calculate the payback period of each project.
b. Calculate the NPV and IRR of each project.
c. Which project would you accept on basis of NPV? On basis of IRR?
d. Compare and contrast NPV and IRR by listing advantages and disadvantages of each method. Based on the comparison, which of the two projects would you recommend?

2.2 A firm has total financing of N$20.06 million made up of N$14.46 million worth of equity and N$5.6 million worth of debt. The after tax cost of debt is N$12.8%. The next dividend is expected to be 10 cents, the current price is 50 cents ex-dividend and the growth rate is 8%. The firm is planning to raise N$5 million in new equity capital at 50 cents with floatation costs of 2 cents per share.
Required 2:
Calculate the firm’s WACC.

Answer 1

a. Payback Period for Project A = 2 + (100000-85000)/50000 = 2.3 years

Payback Period for Project B = 2 + (30000-25000)/20000 = 2.25 years

b. Project A

Time Years		0	1	2	3	4
Cash Flows(A)		-100000	40000	45000	50000	55000
Discounting Rate(B)	1.2	1	0.8333333	0.69444444	0.5787037	0.4822531
Discounted CashFlows (A*B)	0	-100000	33333.333	31250	28935.185	26523.92

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows = $ 20,042.44

In case of IRR, present value of cash inflows = present value of cash outflows

or,

Solving using excel,

IRR = 29.67%

Project B

Time Years		0	1	2	3	4
Cash Flows(A)		-30000	10000	15000	20000	25000
Discounting Rate(B)	1.2	1	0.8333333	0.69444444	0.5787037	0.4822531
Discounted CashFlows (A*B)	-30000	8333.3333	10416.6667	11574.074	12056.327

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows = $ 12,380.40

In case of IRR, present value of cash inflows = present value of cash outflows

or,

Solving using excel,

IRR = 37.30%

c. On the basis of NPV, Project A should be accepted because it is higher is compared to Project B. On the basis of IRR, Project B should be accepted because it is higher is compared to Project A.

d. The main advantage of NPV is that it factors in time value of money and also enables decision making process for companies. It is an critical method for evaluating projects. The main disadvantage of NPV is that there is no set guideline to calculate required rate of return and also the cash flows which are predicted might not be accurate. There might be hidden costs which have not factored in while computing NPV of the project.

The main advantage of IRR is that it also factors in the time value of money and is also simple to interpret. The major disadvantage of IRR is that economies of scale is ignored and cash outflows incurred in the later project timeline which causes multiple IRRs. Hence, it is not reliable.

NPV should be chosen over IRR because it is a better estimate of the project's worthiness