Question

Question 3 Emalini Trading (Pty) Ltd has been setting aside funds every month for a few years now, with a view to using the saved-up amount for the introduction of a new business unit to expand their enterprise. They've reached their target of saving R1 million, and are now looking at three different projects that they could implement. They have come to you for advice on which one of the three to pursue. Each of the three would cost exactly R1 million to set up, and they have projected the following net cash flows stemming from each project: Project A Project B Project C Year 1 R375,000 R100,000 R800,000 Year 2 R375,000 R200,000 R400,000 Year 3 R375,000 R400,000 R200,000 Year 4 R375,000 R800,000 R100,000 3.1 The directors of Emalini Trading have mentioned that, for them to go ahead with any new projects, their desired payback period is three years or less. Using the payback period as an accept/reject tool, which of the three projects should be accepted, and moved on to the next stage where they will be ranked in terms of preference? (Max. 5 lines) 3.2 Now, for each of the projects that were acceptable in terms of payback period, calculate the NPV and Pl figures. The company's cost of capital is 15%. Calculate your answer by filling in the tables below: Write the project title here: Year Net cash flow PVIF PV of net CF Total PV of cash flows Less initial investment NPV Write the profitability index of this project here:

Answer 1

3.1)Payback period(uneven cash flows) =Years until payback occurs +un recovered cost at beginning of last year /Cash flow during last year

Payback period(equal annual cash flows)=Initial outflow/expected annual inflow

Acceptable period=3 years or less

Initial outflow (same for all 3 )=R 1,000,000

Project A

Inflows =R375,000 per year for 4 years

Payback period =R1,000,000/R375,000=2.66 years

Project B

Inflows =R100,000 year 2 R 200,000 Year 3 R400,000 Year 4 R800,000

After 3 years the project still requires R 300,000 more to recover it's cost.Year 4 inflow =R 800,000 So payback occurs sometime between years 3 and year 4 So payback period =3+300,000/800,000=3.35 years

Project C

Inflows =R800,000 year 2 R400,000 Year 3 R200,000 year4 R100,000

After Year 1 the project requires R 200,000 more to pay for itself the year 2 inflow =R400,000 So payback occurs sometime between years 1 and 2 So payback period =1+200,000/400,000=1.5 years

Ranking them

1.Project C (1.5 years)

2. Project A (2.66 years)

3. Project B (3.35 years)

project A and C are accepted and project B is rejected since it's payback period is higher than the desired payback period.

3.2 NPV =Total PV of Inflow -Initial Outflow

PI =PV of inflows/Initial Outflows

Projects A and C are the ones deemed acceptable according to payback period .so their NPVs are as follows

Project A

Discount rate =15% Initial outflow is R1,000,000 for both projects

PVIF's are underlined

Inflow =R375,000 per year for 4 years PV of inflows =R 375,000*.8696+375000*.7561+375000*.6575+375000*.5718=Year 1 326,062.5+Year 2 283,537.5+Year 3 246,562.5+Year 4 214,425=R1,070,587.5

NPV =R 1,070,587.5- R 1,000,000= R 70,587.5

PI =Pv of inflows /initial Outflow

Pv of inflows =R1,070,587.5 Initial outflow = R1,000,000

PI =1,070,587.5/1,000,000=1.070

Project C

PVIF's are underlined

PV of inflows =R800,000*.8696+R 400,000*.7561+R200,000*.6575+R100,000*.5718=year 1 695,680+ year 2 302,440+year 3 131,500+Year 4 57,180= R 1,186,800

NPV =R 1,186,800- R 1,000,000= R 186,800

PI =pv of inflow/initial outflow

Pv of inflows =R 1,186,800 Outflow =R 1,000,000

PI =1,186,800/1,000,000=1.1868

3.3 Project C Should be the first choice of implementation

Project C has the smallest payback period among the three that implies less time to recover it's cost

Project C has the highest NPV ,that implies the highest positive value addition to the firm

Project C has the highest PI

3.4

Limitations Of NPV Payback and PI(capital budgeting methods used)

The payback period does not take into consideration the present value of inflows ,and does not give indication of profitability.payback period method tends to favor projects with shorter life span if payback period is short.In our case the Project B is being rejected based on payback period that does not consider the present value of inflows.

The Net Present value method doe not factor the critical costs and hidden costs that may have an impact on the project.The project chosen based on NPV is project C .But the sunk cost associated with C are not taken into consideration.

Profitability index (PI) does not give an indication of the scale of the project being evaluated and is not reliable in the case of mutually exclusive projects.It does not factor in sunk costs.