Question

1. Your firm has the opportunity to expand into one of two new markets, and you have been asked to conduct the financial analysis. The firm can enter only one of these markets now, so the projects are mutually exclusive. The initial outlays are $240,000 for Project A and $225,000 for Project B. The forecast cash flows are shown below.

	year1	year 2	year 3	year 4
PROJECT A	20000	50,000	100,000	150,000
PROJECT B	145,000	60,000	40,000	30,000

 

1. What is the NPV of each project at discount rates of 6%, 12% and 18%.
2. Work independently and Clearly explain the conclusions to be drawn from the NPV profile.

PART II.CRITICAL THINKING SKILLS 

2. a. Evaluate the capital budgeting method for analysis with suitable examples.

 

b. The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it would be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p.a. Evaluate the yearly cash flow from the plant.

Answer 1

1.

a)

WHEN DISCOUNT RATE = 6%

PROJECT A = 26143.72

PROJECT B = 22539.82

	PROJECT A
YEAR	NET CASHFLOWS	PVIF @6%	PV OF CASH FLOWS
0	(240000.0)	1	-240000.00
1	20000.0	0.9434	18867.92
2	50000.0	0.8900	44499.82
3	100000.0	0.8396	83961.93
4	150000.0	0.7921	118814.05
discount rate	6.00%	NPV =	26143.72

 

	PROJECT B
YEAR	NET CASHFLOWS	PVIF @6%	PV OF CASH FLOWS
0	(225000.0)	1	-225000.00
1	145000.0	0.9434	136792.45
2	60000.0	0.8900	53399.79
3	40000.0	0.8396	33584.77
4	30000.0	0.7921	23762.81
discount rate	6.00%	NPV =	22539.82

 

When discount rate is 12%

PROJECT A = -15777.43

PROJECT B = -167.33

	PROJECT A
YEAR	NET CASHFLOWS	PVIF @12%	PV OF CASH FLOWS
0	(240000.0)	1	-240000.00
1	20000.0	0.8929	17857.14
2	50000.0	0.7972	39859.69
3	100000.0	0.7118	71178.02
4	150000.0	0.6355	95327.71
discount rate	12.00%	NPV =	-15777.43

 

	PROJECT B
YEAR	NET CASHFLOWS	PVIF @12%	PV OF CASH FLOWS
0	(225000.0)	1	-225000.00
1	145000.0	0.8929	129464.29
2	60000.0	0.7972	47831.63
3	40000.0	0.7118	28471.21
4	30000.0	0.6355	19065.54
discount rate	12.00%	NPV =	-167.33

 

When discount rate is 18%

PROJECT A = -48910.21

PROJECT B = -19208.68

	PROJECT A
YEAR	NET CASHFLOWS	PVIF @18%	PV OF CASH FLOWS
0	(240000.0)	1	-240000.00
1	20000.0	0.8475	16949.15
2	50000.0	0.7182	35909.22
3	100000.0	0.6086	60863.09
4	150000.0	0.5158	77368.33
discount rate	18.00%	NPV =	-48910.21

 

	PROJECT B
YEAR	NET CASHFLOWS	PVIF @18%	PV OF CASH FLOWS
0	(225000.0)	1	-225000.00
1	145000.0	0.8475	122881.36
2	60000.0	0.7182	43091.07
3	40000.0	0.6086	24345.23
4	30000.0	0.5158	15473.67
discount rate	18.00%	NPV =	-19208.68

 

b)

If the discount rate is between 0 to 7% project A should be selected , when the discount rate is between 7% to 12% project 12% should be accepted

 

2.

a)

Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery.

 

Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders' wealth.

 

However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project.

 

For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.

 

b)

Depreciation = 500000 /5 = 100000

Cash flow = net income + depreciation

                  = 175000 + 100000

                 = 27500

1. (a) When discount rate is 12%

PROJECT A = -15777.43

PROJECT B = -167.33

When discount rate is 18%

PROJECT A = -48910.21

PROJECT B = -19208.68