Question

Use the information below to answer the question that follows.Sosiol Distan Singh the owner of Esquire Ltd is considering two technology investment options; Karantina and Barakoa which will require sh. 1,500,000 and sh. 200,000, respectively. The revenues for each option are as follows. Karantina (for year 1 to year 6) 100,000; 350,000; 450,000; 765,000; 1,335,000; 2,150,000. Barakoa (for year 1 to year 3) 300,000; 350,000; 500,000. The expenses increase yearly from the first year by 20% each subsequent year. The figures for expenses in the first year are sh. 150,000 and sh. 20,000 respectively. The rate of inflation is 12%.Required: Advise Mr. Singh which option he should take given: i. Payback period [2 marks] ii. NPV profiles (show your workings)

Answer 1

Solution to the above question(i):-

Payback period is the period or time required to recover the initial cash invested(outflow) in the project.

Formula:  Payback period= Total Initial Capital Investment / Annual expected cash flow

Since Sosiol Distan Singh, the owner of Esquire Ltd, is considering two technology investment options; Karantina and Barakoa. We will calculate payback period for both the options as below-

> For Karantina,

Initial Cash Outflow= Sh. 1,500,000

Karantina
Year	Revenue(Sh.)	Expense (20% increase from year 2 onwards) (Sh.)	Cashflow (Sh.)	cumulative cashflow(Sh.)
1	100,000	150,000	(50,000)	(50,000)
2	350,000	180,000	170,000	120,000
3	450,000	216,000	234,000	354,000
4	765,000	259,200	505,800	859,800
5	1,335,000	311,040	1,023,960	1,883,760
6	2,150,000	373,248	1,776,752	3,660,512
Total	5,150,000	1,489,488	3,660,512

Payback period lies between 4 to 5 years. Since upto 4 years a sum of Sh. 859,800 has been recovered, so balance of Sh. 640,200 (=1,500,000-859,800) shall be recovered in the part (fraction) of 5th year, computation is as follows:

= 640,200 / 1,023,960 = 0.63

Thus, total cash outlay of Sh.1,500,000 shall be recovered in 4.63 years time.

> For Barakoa,

Initial Cash Outflow= Sh. 200,000

Barakoa
Year	Revenue(Sh.)	Expense (20% increase from year 2 onwards) (Sh.)	Cashflow(Sh.)	cumulative cashflow(Sh.)
1	300,000	20,000	280,000	280,000
2	350,000	24,000	326,000	606,000
3	500,000	28,800	471,200	1,077,200
Total	1,150,000	72,800	1,077,200

In Year 1, total cash inflows equals to total cash outlay of Payback period = 200,000 / 280,000

= 0.71 year time.

Summary-

Investment options	Payback period
Karantina	4.63
Barakoa	0.71

Sosiol Distan Singh should take Barakoa options as he will receive his initial cash invested in the 1st year itself. (answer)

Solution to the above question(ii):-

Net Present Value is the difference between the initial cash inflow and the total initial cash invested

Formula:  Net Present Value= Present value of cash inflow (-) total initial cash invested

> For Karantina,

Initial Cash Outflow= Sh. 1,500,000

Karantina
Year	Revenue(Sh.)	Expense (20% increase from year 2 onwards) (Sh.)	Cashflow (Sh.)	Discounting factor@12%(Inflation)	Present value of cash inflow(Sh.)
1	100,000	150,000	(50,000)	0.89	(44,643)
2	350,000	180,000	170,000	0.80	135,523
3	450,000	216,000	234,000	0.71	166,557
4	765,000	259,200	505,800	0.64	321,445
5	1,335,000	311,040	1,023,960	0.57	581,022
6	2,150,000	373,248	1,776,752	0.51	900,158
Total	5,150,000	1,489,488	3,660,512		2,060,062

Net Present Value= Sh. (2,060,062 - 1,500,000)

= Sh. 560,062.

> For Barakoa,

Initial Cash Outflow= Sh. 200,000

Barakoa
Year	Revenue(Sh.)	Expense (20% increase from year 2 onwards) (Sh.)	Cashflow (Sh.)	Discounting factor@12%(Inflation)	Present value of cash inflow(Sh.)
1	300,000	20,000	280,000	0.89	250,000
2	350,000	24,000	326,000	0.80	259,885
3	500,000	28,800	471,200	0.71	335,391
Total	1,150,000	72,800	1,077,200		845,276

Net Present Value= Sh. (845,276 -  200,000)

= Sh. 645,276.

Summary-

Investment options	Net Present Value
Karantina	560,062
Barakoa	645,276

As the net present value for Barakoa is high, Mr.Singh must choose to invest in Barakoa. (answer)