Question

Question 5

1. Given the following cash flows, for the two independent projects A and B, calculate
   1. Payback Period                                                               
   2. Accounting rate of return                                               
   3. Net Present Value                                                         
   4. Profitability index                                                          

And recommend acceptance or rejection of projects considering individual techniques of capital budgeting. A rate of 10 % has been selected for the NPV analysis.

	Project A	Project B
Initial outlay	$50,000	$100,000
Cash inflows
Year 1	$10,000	$ 25,000
Year 2	15,000	25,000
Year 3	20,000	25,000
Year 4	25,000	25,000
Year 5	30,000	25,000

                                                                     

2. Explain the distinctive features of capital budgeting decisions.                                                                                                       

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=10%=0.1
		N=Year of Cash Flow
		ANALYSIS OF PROJECT A
	N	Year	0	1	2	3	4	5	SUM
	CF	Cash Flow	($50,000)	$10,000	$15,000	$20,000	$25,000	$30,000	$50,000
	PV=CF/(1.1^N)	Present Value of cash Flow	($50,000)	$9,091	$12,397	$15,026	$17,075	$18,628	$22,217
		Cumulative Cash Flow	($50,000)	-$40,000	-$25,000	-$5,000	$20,000	$50,000
	NPV=Sumof PV	Net Present Value(NPV)	$22,217
		Payback Period(3+(5000/25000)	3.20	YEARS	(Period in which Cumulative cash flow=NIL)
		Accounting Rate of Return= Average Return/Investment
		TotalReturn =(50000+50000)	$100,000
		Average Return per year=100000/5	$20,000
		Accounting Rate of Return= 20000/50000	0.40
		Accounting Rate of Return= (Percentage)	40%
		Profitability Index =(NPV+Initial Investment)/InitialInvestment
		Profitability Index =(22217+50000)/50000	1.44
		ANALYSIS OF PROJECT B
	N	Year	0	1	2	3	4	5	SUM
	CF	Cash Flow	($100,000)	$25,000	$25,000	$25,000	$25,000	$25,000	$25,000
	PV=CF/(1.1^N)	Present Value of cash Flow	($100,000)	$22,727	$20,661	$18,783	$17,075	$15,523	($5,230)
		Cumulative Cash Flow	($100,000)	-$75,000	-$50,000	-$25,000	$0	$25,000
	NPV=Sumof PV	Net Present Value(NPV)	($5,230)
		Payback Period	4.00	YEARS	(Period in which Cumulative cash flow=NIL)
		Accounting Rate of Return= Average Return/Investment
		TotalReturn =(25000+100000)	$125,000
		Average Return per year=100000/5	$25,000
		Accounting Rate of Return= 25000/100000	0.25
		Accounting Rate of Return= (Percentage)	25%
		Profitability Index =(NPV+Initial Investment)/InitialInvestment
		Profitability Index =(-5230+100000)/100000	0.95
		CAPITAL BUDGETING DECISION:
		Determine the appropriate discount rate based on cost of capital and risk factor
		Find the initial cash flow considering investment in plant & machinery, working capital etc
		Determine annual operating cash flow taking into account depreciation, taxes, effect of the project on other income and expenses
		Determine TerminalCash Flow considering release of working capital,Salavage of equipment etc
		In mutually exclusive projects normally NPV determines which project should be accepted
		Other Evaluation criterian are used to initially short list the projects
		These criterian may be IRR, Payback period, etc