Question

1. A&B Enterprises is trying to select the best investment from among three alternatives. Each alternative involves an initial outlay of S100,000. The company's cost of capital is 10%. The incremental after tax cash inflows for each project are as follows: Year A B 20,000 $50,000 $25,000 2 20,000 40,000 25,000 3 20,000 30,000 25,000 4 30.000 25,000 5 60,000 25,000 8 a) Payback i) Calculate the payback period (1 decimal) for each project (3 marks). ii) Evaluate and rank each alternative (i.e. 1st, 2nd, 3rd) based on payback period. What are the 2 main drawbacks of the payback method? (3 marks) b) Net Present Value (NPV) i) Calculate the NPV for each project (6 marks) ii) Evaluate and rank each alternative (ie. 1st, 2nd, 3rd) based on the net present value. Are there any projects you would not recommend? Why? (3 marks) c) Profitability Index (PI) i) Calculate the PI ( 3 decimals) for each project (3 marks) i) Evaluate and rank each alternative (i.e. 1st, 2nd, 3rd) based on the PI. Why are the rankings for PI the same (or different) as NPV in this case? (2 marks)

Answer 1

Answer: a) Payback Period Project A Cumulative Year Cash Flows Cash Flows 0 $ (100,000) $ (100,000) 1 $ 20,000 $ (80,000) 2 $ 20,000 $ (60,000) 3 $ 20,000 $ (40,000) 4 $ 30,000 $ (10,000) 5 $ 60,000 $ 50,000 Payback Period 4.2 years Rank 3 Project B Cumulative Cash Flows Cash Flows $ (100,000) $ (100,000) $ 50,000 $ (50,000) $ 40,000 $ (10,000) $ 30,000 $ 20,000 $ $ Project C Cumulative Cash Flows Cash Flows $ (100,000) $ (100,000) $ 25,000 $ (75,000) $ 25,000 $ (50,000) $ 25,000 $ (25,000) $ 25,000 $ $ 25,000 $ 25,000 4 years 2 2.4 years I Drawbacks 1. it does not consider Time value of Money 2. It Neglects the cash Flows after payback period for some Projects in last years of Projects Large cash Flows will come

b) NPV Year 0 1 2 Project A Project B Project C Present Cash Flows PVF @ 10% Present Value Cash Flows PVF @ 10% Present Value Cash Flows PVF @ 10% Value $ (100,000) 1.0000 $ (100,000) $ (100,000) 1.0000 $ (100,000 $ (100,000) 1.0000 $ (100,000) $ 20,000 0.9090 $ 18,180 $ 50,000 0.9090 $ 45,450 $ 25,000 0.9090 $ 22,725 $ 20,000 0.8264 $ 16,528$ 40,000 0.8264 $ 33,056 $ 25,000 0.8264 $ 20,660 $ 20,000 0.7513 $ 15,026 $ 30,000 0.7513 $ 22,539 $ 25,000 0.7513 $ 18,783 $ 30,000 0.6830 $ 20,490$ $ 25,000 0.68301 $ 17,075 $ 60,000 0.6209 $ 37,254 $ $ 25,000 0.6209$ 15,523 $ 7,478$ 1,045 $ (5,235) 1 2 3 3 4 5 NPV Rank Conclusion: Project A should be Recommended

C) Profitability Index Profitability Index = PV od Cash Inflows / Cash Outflows Project A Project B Project C Present Year Cash Flows PVF @ 10% Present Value Cash Flows PVF @ 10% Present Value Cash Flows PVF @ 10% Value 0 $ (100,000) 1.0000 $ (100,000) $ (100,000) 1.0000 $ (100,000) $ (100,000) 1.0000 $ (100,000) 1 $ 20,000 0.9090 $ 18,180 $ 50,000 0.9090 $ 45,450 $ 25,000 0.9090 $ 22,725 2 $ 20,000 0.8264 $ 16,528$ 40,000 0.8264 $ 33,056 $ 25,000 0.8264 $ 20,660 3 $ 20,000 0.7513 $ 15,026 $ 30,000 0.7513 $ 22,539 $ 25,000 0.7513 $ 18,783 4 $ 30,000 0.6830$ 20,490$ $ 25,000 0.6830 $ 17,075 5 $ 60,000 0.6209 $ 37,254 $ $ 25,000 0.6209$ 15,523 Present values of Cash Inflows $ 107,478 $ 101,045$ 94,765 Profitability Index 1.07 1.01 0.95 Rank 1 2 3 NPV and Pl uses Present Value of cash Flows so that ranks are Same in case of PI and NPV PI Below 1 should Reject the Project