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.Profit =Annual cash inflow-Capital charge

ie.Annual cash inflow-(Initial investment*Cost of capital)

For Year 1-- 110-(200*10%)= $ 90 ln.

For Year 2---115- 20=$ 95 mln.

NPV of the project=Initial Investment+PV of cash inflows

ie. -200+(110/1.10^1)+(115/1.10^2)=

-4.958678

millions

b. NO--the project should not be accepted as the NPV of its cash flows at te required return of 10% is NEGATIVE

c. PI & Payback-period

PI=Profitability Index= 1+(NPV/Initial Investment)

ie.1+(-4.958768/200)=

0.98

As the PI < 1, the project should not be accepted.

Year	Cash flow	Cumulative CF
0	-200	-200
1	110	-90
2	115	25

Payback period= 1+(90/115)=

1.78

yrs.

As the project pays back within 2 yrs.it can be accepted.

d. IRR is the discount rate at which the NPV of the project's cash flows exectly equal 0 (Zero)

ie.-200+(110/(1+r)^1)+(115/1+r)^2)=0

Solving for r, we get the project's IRR as

8.16%

So, the discount rates or cost of capital > IRR, 8.16% will fetch only negative NPVs.

The minimum IRR value that would make this project acceptable = 8.16%

The hugher the IRR from the cost of capital, the better the profits & nPV.

e. the project is not acceptable for the foll. Reasons:

NPV= Negative

PI=< 1

IRR 8.16% < COC 10%

The project is acceptable only for it's payback period of 1.78 years being < 2 yrs.(the life of the project)

But NPV rule is the decider for projects.

So, REJECT

f. Now the NPV of the project will be =Initial Investment+PV of yrs. 1&2 cash inflows+PV of yr. 4 m/c alvage

ie. -200+(110/1.10^1)+(115/1.10^2)+(35/(1.1^4)=

18.946793

millions

i.There will be a terminal cash inflow of $ 35 million at the end of year 4 --which will add to the projet's cash flows

ii.As the project's NPV , now becomes POSITIVE, the project shuold be ACCEPTED.