Question

ASSIGNMENT THREE             

A company uses only debt and equity. It can borrow unlimited amounts at a cost of 10.4% as long as it finances at its target capital structure, which calls for 40% debt and 60% common equity. Two mutually exclusive projects are being considered. Both projects are expected to have zero scrap value at the end of 5 years. The projects’ expected net cash flows are as follows:

YEAR                         PROJECT A              PROJECT B

0                                  (4000)                         (6000)

1                                    550                          3,000

2                                     550                          3,000

3                                     550                             500

4                                  2250                              500

5                                  2,250                          500

Required

1. Calculate the pay back period for each project and advise          
2. Calculate the discounted pay back for each project and advise   
3. Calculate the Net Present Value for each project and advise       
4. Calculate Internal Rate of Return for each project and advise     
5. Calculate profitability index for each project and advise               
6. Calculate Accounting Rate of Return for each project and advise.
7. Based on the above calculations,which project should the company undertake and why?                                                             (Total 25 Marks)

Answer 1

Wacc is 10.4%

a) Payback period is the time taken in years for the cumulative cash-flows to become 0

We observe than cumulative cash-flows become 0 for project A after year 4

Payback period for project A = 4 +(-100/(-100-2150)) = 4.044 years

Payback period for project B = 2

Payback period is lesser for project B, hence Project B is better investment.

b) The discounted Payback period is the time taken in years for the cumulative discounted cash-flows to become 0

Discounted payback is found by discounting the individual cash-flows by 10.4%

Discounted payback for project A = 4.82 years

Discounted payback for project B = 4.37 years

Discounted payback is lesser for project B, hence Project B is better investment.

c)

NPV is found by using NPV function in excel

NPV of Project A = 244.76

NPV of Project A = 191.8

According to NPV criterion, Project A is better since it has higher NPV

d)

IRR is found by using IRR function in excel

IRR of Project A = 12.21%

IRR of Project A = 12.28%

According to IRR criterion, Project B is better since it has higher IRR

e)

Profitability index = PV of future cash-flows/Initial investment

Profitability index for A = 4244.76/4000 = 1.06

Profitability index for B = 6191.84/6000 = 1.03

According to Profitability index criterion, Project A is better since it has higher Profitability index

f)

Accounting rate of return = (All future benefits/Initial investment)-1

Accounting rate of return for A = ((550+550+550+2250+2550)/4000)-1 = 61.25%

Accounting rate of return for B = ((3000+3000+3000+500+500)/6000)-1 = 66.66%

According to Accounting rate of return criterion, Project B  is better since it has higher Accounting rate of return

g) According to NPV criterion, Project A must be undertaken. Also, since the IRR of both the project is almost comparable and above the WACC. NPV leads to better decision making than IRR. Rest all the criterion are biased towards one factor or the other.

Hence, project A should be undertaken.