Question

In: Finance

Babadeni Ltd. is a highly geared company that wishes to expand its operations. Six possible capital...

  1. Babadeni Ltd. is a highly geared company that wishes to expand its operations. Six possible capital investments have been identified, but the company only has access to a total of Sh.620,000,000. The projects are divisible and may not be postponed until a future period. After the project's end it is unlikely that similar investment opportunities will occur.

Expected net cash inflows (including salvage value)

Project

Year 1

Year 2

Year 3

Year 4

Year 5

Initial Oulay

Sh. “000”

Sh. “000”

Sh. “000”

Sh. “000”

Sh. “000”

Sh. “000”

A

70,000

70,000

70,000

70,000

70,000

246,000

B

75,000

87,000

64,000

    -

   -

180,000

C

48,000

48,000

63,000

73,000

175,000

D

62,000

62,000

62,000

62,000

180,000

E

40,000

50,000

60,000

70,000

40,000

180,000

F

35,000

82,000

82,000

150,000

Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company's existing capital investments.

Babadeni Ltd. cost of capital is 12% a year.

Required

Using Profitabilty index criteria rank the projects and establish the optimal way of investing the available funds.

Solutions

Expert Solution

Present Value(PV) of Cash Flow:
(Cash Flow)/((1+i)^N)
i=discount rate =Cost of Capital=12%=0.12
N=Year   of Cash Flow
CASH FLOW ANALYSIS OF PROJECTA
IC Initial Outlay                246,000
N Year 1 2 3 4 5
CF Cash Inflows                  70,000                  70,000                  70,000           70,000          70,000 SUM
PV=CF/(1.12^N) Present Value of Cash Inflow                  62,500                  55,804                  49,825           44,486          39,720    252,334
SUM Sum of PV of Cash Inflows                252,334
PI=SUM/IC Profitability Index=(Sum of PV of Cash Inflows)/(Initial Outlay)
PI=SUM/IC Profitability Index of Project A=                  1.0257
CASH FLOW ANALYSIS OF PROJECT B
IC Initial Outlay                180,000
N Year 1 2 3
CF Cash Inflows                  75,000                  87,000                  64,000 SUM
PV=CF/(1.12^N) Present Value of Cash Inflow                  66,964                  69,356                  45,554        181,874
SUM Sum of PV of Cash Inflows                181,874
PI=SUM/IC Profitability Index of Project B=                  1.0104
CASH FLOW ANALYSIS OF PROJECT C
IC Initial Outlay                175,000
N Year 1 2 3 4
CF Cash Inflows                  48,000                  48,000                  63,000           73,000 SUM
PV=CF/(1.12^N) Present Value of Cash Inflow                  42,857                  38,265                  44,842           46,393       172,357
SUM Sum of PV of Cash Inflows                172,357
PI=SUM/IC Profitability Index of Project C=                  0.9849
CASH FLOW ANALYSIS OF PROJECT D
IC Initial Outlay                180,000
N Year 1 2 3 4
CF Cash Inflows                  62,000                  62,000                  62,000           62,000 SUM
PV=CF/(1.12^N) Present Value of Cash Inflow                  55,357                  49,426                  44,130           39,402       188,316
SUM Sum of PV of Cash Inflows                188,316
PI=SUM/IC Profitability Index of Project D=                  1.0462
CASH FLOW ANALYSIS OF PROJECT E
IC Initial Outlay                180,000
N Year 1 2

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