Question

Question 2 (25 marks/Investment Decision Rules and Project Cash Flows) Consider a hypothetical economy that has NO tax. ABC Ltd. is considering investing in a 2-year project which is expected to generate the following year-end cash flows: C1 = $110 million, C2 = $115 million. The yearly discount rate for the project is 10%. The initial cost of the project is $200 million.

(a) Compute the profit and NPV of the project.

(b) Based on the answer of part (a), should the project be accepted? Explain.

(c) ABC’s cut-off period is 2 years. Compute the PI and Payback of the project. Based on these two methods, should ABC accept the project?

(d) Write down the numerical formula for computing the IRR of this project. What is the minimum IRR value that would make this project acceptable? Explain.

(e) Given the recommendations based on the four decision rules above, which project should ABC Ltd. accept?

(f) Now suppose that of the $200m initial expenditure, $50m was used for the purchase of a machine that has an estimated economic life of four years. The machine will be fully depreciated (i.e., zero book value at the end of the machine’s economic life) on a straight-line basis and expected to have a resale value of $35m at the end of the project.

(i) Explain how this will affect the size of the terminal (end-of-project) cash flows.

(ii) How will this affect the NPV and the acceptance/rejection of the project (as compared to part (a))? Show your calculations.

Answer 1

a)		Year0	Year1	Year2
	Cashflows	(200.0)	110.0	115.0
	NPV@ 10%	(5.0)<--Using NPV formula of excel
b)	The project should not be accpeted as it has an Negetive NPV which means than it looses money for the investor
c)	Profitability Index(PI)	1.13	<--(Sum of cashflows at C1 and C2)/Initial cost
		Year0	Year1	Year2
	Cashflows	(200.0)	110.0	115.0
	Cumlative Cashflows	(90.0)	25.0
		As the cumlative cashflows become positive somewhere inyear 2. The payback period will be somewhere between year1 and year2
		Portion of year 2 in wich cash flows will be recovered=90/115
	Total Payback period	1.78	<--=1+90/115
d)	To calculate IRR using a formula, we would set the NPV as zero and solve for the discount rate (r), which is the IRR. Given the nature of this formula, IRR cannot be calculated analytically and we should calculate it through trial-and-error
	The formula is	0=C0 +C1/(1+r)+C2/(1+r)^2
	The minimum aceptable value of IRR would be that which makes the NPV equal to zero. Which means the project doesn’t make a profit either a loss
		Year0	Year1	Year2
	Cashflows	(200.0)	110.0	115.0
	NPV	0.0
	Required IRR	8.2%	<--Calculated using goal seek function of excel

The above table gives the case facts along with the answers.

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