Question

In: Finance

Home Ltd. has the option of investing in the following two projects of equal risk; they...

Home Ltd. has the option of investing in the following two projects of equal risk; they are mutually exclusive alternatives for expanding the firm’s capacity.  The firm’s cost of capital is 12%.  The cash flows for each project are given in the following table.

PROJECT A

PROJECT B

Initial investment

545,000

300,000

Year

Net cash inflows

Net cash inflows

1

135,000

200,000

2

185,000

120,000

3

220,000

92,000

4

280,000

Home Ltd. has incurred a research and development expenditure of $35,000 initially for project A and $25,000 for project B, both of which are considered sunk costs for the business. Due to seasonal demand, business believes for project A only, they will have to incur additional electricity charge of $1,000 each year till year 4. At the end of year 4, the business believes that they could sell project A for $60,000 and at the end of year 3, project B for $50,000. The finance manager has also suggested that any investment that takes more than 4 years to pay back the initial investment should be rejected.

1: Calculate the net present value for each project.  Using the net present value criterion, which project is preferable and why?

2: Calculate the payback period of each project. Using the payback period criterion which project is preferable and why?

3: Calculate the profitability index for each project.  Using the profitability index criterion which project is acceptable and why?

4: Calculate equivalent annual value for each project. Using the equivalent annual value method which project is acceptable and why?

Solutions

Expert Solution

(a) Calculation of Net present value

Since the NPV of Project A is higher as compared to NPV of Project B, hence Project A should be selected.

(b) Calculation of payback period

Net cash flows Simple cumulative cash flows
Year Project A Project B Project A Project B
0       (545,000) (300,000)              (545,000)          (300,000)
1         134,000      200,000              (411,000)          (100,000)
2         184,000      120,000              (227,000)               20,000
3         219,000      142,000                   (8,000)             162,000
4         339,000                 -                  331,000                        -  

Payback period of Project A = 3 + (8,000 / 339,000)

= 3.02 years

Payback period of Project B = 1 +(100,000 / 120,000)

= 1.83 years

Lower the payback period, better the investment project. Hence Project B should be selected.

(c) Calculation of profitability index

Profitability index of Project A = Present value of cash inflows / Initial investment

= 637,647 / 545,000

= 1.17

Profitability index of Project B = Present value of cash inflows / Initial investment

= 375,307 / 300,000

= 1.25

Higher the profitability index, better the investment project. Hence Project B should be selected.

(d) Calculation of equivalent annual value of each project

Equivalent annual value of Project A = NPV of Project A / PVAF(12%, 4 years)

= 92,647 / 3.0373

= $30,502.59

Equivalent annual value of Project B = NPV of Project B / PVAF(12%, 3 years)

= 75,307 / 2.4018

= $31,354.20

Since the equivalent annual value of Project B is higher than Project A, hence Project B should be selected.


Related Solutions

Home Ltd. has the option of investing in the following two projects of equal risk; they...
Home Ltd. has the option of investing in the following two projects of equal risk; they are mutually exclusive alternatives for expanding the firm’s capacity. The firm’s cost of capital is 12%. The cash flows for each project are given in the following table. PROJECT A PROJECT B Initial investment 545,000 300,000 Year Net cash inflows Net cash inflows 1 135,000 200,000 2 185,000 120,000 3 220,000 92,000 4 280,000 Home Ltd. has incurred a research and development expenditure of...
You are contemplating investing into two different projects. Both projects are of equally low risk and...
You are contemplating investing into two different projects. Both projects are of equally low risk and their cash flows are provided below. Year Project “Gold” Project “Blue” 0 -$50,000 -$25,000 1 $22,500 $3,000 2 $18,750 $6,000 3 $15,250 $12,000 4 $15,000 $24,000 Determine the NPV of each project at a 6% cost of capital. Which is preferable? Based on the profitability index, which would you prefer? At what discount rate would you be indifferent between the projects (i.e., calculate the...
The following two projects of equal risk are mutually exclusive alternatives for expanding the firm’s capacity....
The following two projects of equal risk are mutually exclusive alternatives for expanding the firm’s capacity. The firm’s cost of capital is 15%. The cash flows for each project are given in the following table. Year Project A Project B 0 210,000 20,000 1 15,000 12,000 2 30,000 10,500 3 32,000 9,500 4 425,000 8,200 Required: a) Calculate each project’s payback period. Using the payback period criterion which project is preferable? b) Calculate the net present value for each project....
The following two projects of equal risk are mutually exclusive alternatives for expanding the firm’s capacity....
The following two projects of equal risk are mutually exclusive alternatives for expanding the firm’s capacity. The firm’s cost of capital is 15%. The cash flows for each project are given in the following table. PROJECT A PROJECT B Initial investment 210,000 20,000 Year Net cash inflows Net cash inflows 1 15,000 12,000 2 30,000 10,500 3 32,000 9,500 4 425,000 8,200
​Mr Ali has an option of investing in one project from the proposed three different projects....
​Mr Ali has an option of investing in one project from the proposed three different projects. The initial investment and cash flows are given below. (r = 12%) years Cf – project 1 Cf – project 2 Cf – project 3 0 (10,000) (28,000) (22,000) 1 1000 3000 4000 2 880 7000 1000 3 6000 8000 1000 4 4000 12000 9000 5 2000 7500 11500 6 3650 6400 8900 a. Calculate payback for all three projects​​​​​[1 marks] b. Calculate discounted...
Mr Ali has an option of investing in one project from the proposed three different projects....
Mr Ali has an option of investing in one project from the proposed three different projects. The initial investment and cash flows are given below r=12% years Cf – project 1 Cf – project 2 Cf – project 3 0 (10,000) (28,000) (22,000) 1 1000 3000 4000 2 880 7000 1000 3 6000 8000 1000 4 4000 12000 9000 5 2000 7500 11500 6 3650 6400 8900 Calculate payback for all three projects    Calculate discounted payback for all three...
Etisalat is in the process of choosing the better of two equal-risk, independed capital expenditure projects-A...
Etisalat is in the process of choosing the better of two equal-risk, independed capital expenditure projects-A and B. The relevant cash flows for each project are shown in the following table. The firm's cost of capital is 14%.     Project A Project B Initial investment $27000 $25,000 1 $10,000 $11,000 2 $10,000 $10,000 3 $10,000 $9,000 4 $10,000 $8,000 Required: a. Calculate each project's payback period. what are the disadvantages of the payback period? b. Calculate the net present value...
Nihau Tech has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is...
Nihau Tech has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 11%. The CFO, Ms Chen, believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO, Mr. Wu, disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company...
All techniques with NPV profile Mutually exclusive projects   Projects A and​ B, of equal​ risk, are...
All techniques with NPV profile Mutually exclusive projects   Projects A and​ B, of equal​ risk, are alternatives for expanding Rosa​ Company's capacity. The​ firm's cost of capital is 16​%. The cash flows for each project are shown in the following​ table: Initial investment   $130,000   $100,000 Year   Cash inflows   1   $30,000   $30,000 2   $35,000   $30,000 3   $40,000   $30,000 4   $45,000   $30,000 5   $50,000   $30,000 a.  Calculate each​ project's payback period. b.  Calculate the net present value​ (NPV) for each project. c.  ...
Tulsa Company is considering investing in new bottling equipment and has two options: Option A has...
Tulsa Company is considering investing in new bottling equipment and has two options: Option A has a lower initial cost but would require a significant expenditure to rebuild the machine after four years; Option B has higher maintenance costs, but also has a higher salvage value at the end of its useful life. Tulsa’s cost of capital is 11 percent. The following estimates of the cash flows were developed by Tulsa’s controller:   Option A Option B Initial investment $ 320,000...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT