Question

2. You are the CFO of Black Gold Mining Ltd, which is offering an investment in two (2) large projects with the cash flows presented in the table below. Your company can only choose one of the projects (I or II), as shown in the table. (9.5 marks in Total) Project I Project II Cost $550 000 $640 000 Future Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 230 000 210 000 200 600 150 000 120 000 330 000 300 000 250 000 180 000 150 000 Required: Undertake the project evaluation and identify which project Black Gold Mining should choose, using: a) The Net Present Value (NPV) method with the discount rate of 12% b) The Payback Period (PBP) method with benchmark of maximum 2 years (3.5 marks) c) If there is a conflict between the NPV method and the PBP method, which investment criteria should the company use to make the final capital budgeting decision and why? (1 mark).

Answer 1

A) NET PRESENT VALUE METHOD
			Project 1	Project 2
Year	Cash Flow	PV Factor	Amount	Present Value	Amount	Present Value
0	Cost	1	-5,50,000	-550000	-6,40,000	-640000
1	Cash Flow	0.89	2,30,000	2,05,357	3,30,000	2,94,643
2	Cash Flow	0.80	2,10,000	1,67,411	3,00,000	2,39,158
3	Cash Flow	0.71	2,00,600	1,42,783	2,50,000	1,77,945
4	Cash Flow	0.64	1,50,000	95,328	1,80,000	1,14,393
5	Cash Flow	0.57	1,20,000	68,091	1,50,000	85,114
	NPV			1,28,970		2,71,253
	NPV of Project 2 is more, Hence Project 2 should be selected

B) PAY BACK PERIOD METHOD
		Project 1	Project 2
Year	Cash Flow	Amount	Cumulative Cashflow	Amount
0	Cost	-5,50,000		-6,40,000
1	Cash Flow	2,30,000	2,30,000	3,30,000	3,30,000
2	Cash Flow	2,10,000	4,40,000	3,00,000	6,30,000
3	Cash Flow	2,00,600	6,40,600	2,50,000	8,80,000
4	Cash Flow	1,50,000	7,90,600	1,80,000	10,60,000
5	Cash Flow	1,20,000	9,10,600	1,50,000	12,10,000
	Project 1
	Pay Back Period	= 2 + (550000-440000)/200600
		2.55	Years
	Project 2	= 2 + ( 640000-630000 ) / 250000
		2.04	Years
	Payback period of Project 2 is less. Hence Project 2 should be selected

C) Conflict Between NPV and PBP Method
NPV should be selected since PBP has following Drawbacks
1. Ignore Time Value of Money
2. Does not consider Cashflo after PBP