Question

QUESTION 3: CAPITAL BUDGETING [30 MARKS]
Swee Rien Roofing Materials, Inc., is considering two mutually exclusive projects, each with an initial investment of RM1,500,000. The company’s board of directors has set a maximum 4-year payback requirement and has set its cost of capital at 9.50 percent. The cash inflows associated with the two projects are shown in the following table.

Cash inflows (CFt)

Year	Project A (RM)	Project B (RM)
1	450,000	750,000
2	450,000	600,000
3	550,000	300,000
4	400,000	350,000
5	450,000	250,000
6	450,000	300,000

a) Find the payback period for each project.
(6 marks)
b) Calculate the NPV of each project at 9.50 percent.
(7 marks)
c) Compute the Profitability Index.
(5 marks)
d) Derive the IRR of each project.
(4 marks)
e) Rank the projects by each of the techniques used. Make and justify a recommendation.
(8 marks)

Answer 1

A) payback period for Project A

Cash inflows (CFt)	(in RM)			(in RM)
Year	cost	Cash flow	working	cost yet to be recovered
0	1500000	0		0
1		4,50,000	(1500000-4500000)	10,50,000
2		4,50,000	(1050000-450000)	6,00,000
3		5,50,000	(600000-550000)	50,000
4		4,00,000	(50000-400000)	-3,50,000
5		4,50,000
6		4,50,000
initial cost = 1500000
as we can see that the cost to be recovered turns negative in the 4th year
that means that the cost is recovered during 3rd and 4th year
Now, Payback period = years before full recovery + (Un recovered investment at start of the year/Cash flow during the year)
Payback period =3 +(50000/400000)
Payback period =3.125 years

Cash inflows (CFt)
Year	cost	Cash flow	working	cost yet to be recovered
0	1500000	0		0
1		7,50,000	(1500000-750000)	7,50,000
2		6,00,000	(750000-600000)	1,50,000
3		3,00,000	(150000-300000)	-1,50,000
4		3,50,000
5		2,50,000
6		3,00,000
initial cost = 1500000
as we can see that the cost to be recovered turns negative in the 4th year
that means that the cost is recovered between 2nd and 3rd year
Now, Payback period = years before full recovery + (Unrecovered investment at start of the year/Cash flow during the year)
Payback period = 2+ (150000/300000)
Payback period =2.5 years

B).

Cash inflows (CFt) of Project A
R= 9.5%
Year	COST	Cash Flow	working	Discount factor = 1/(1+r)^n	Discounted cash Flow= Cash flow * discount value
0	1500000		1/ (1+0.095)^0	1.00	-
1		4,50,000	1/ (1+0.095)^1	0.91	4,10,958.90
2		4,50,000	1/ (1+0.095)^2	0.83	3,75,304.94
3		5,50,000	1/ (1+0.095^3	0.76	4,18,909.62
4		4,00,000	1/ (1+0.095)^4	0.70	2,78,229.72
5		4,50,000	1/ (1+0.095)^5	0.64	2,85,852.45
6		4,50,000	1/ (1+0.095)^6	0.58	2,61,052.47
				Total	20,30,308.09

Net Present Value = Cash Inflows from Investments – Cost of Investments

NPV= 2030308.09-1500000

NPV= RM 530308.09

Cash inflows (CFt) of Project B
R= 9.5%
Year	COST	Cash Flow	working	Discount factor = 1/(1+r)^n	Discounted cash Flow= Cash flow * discount value
0	1500000		1/ (1+0.095)^0	1.00	-
1		7,50,000	1/ (1+0.095)^1	0.91	6,84,931.51
2		6,00,000	1/ (1+0.095)^2	0.83	5,00,406.58
3		3,00,000	1/ (1+0.095^3	0.76	2,28,496.16
4		3,50,000	1/ (1+0.095)^4	0.70	2,43,451.00
5		2,50,000	1/ (1+0.095)^5	0.64	1,58,806.92
6		3,00,000	1/ (1+0.095)^6	0.58	1,74,034.98
				Total	19,90,127.14

Net Present Value = Cash Inflows from Investments – Cost of Investments

NPV= 1990127.14-1500000

NPV= RM 4,90,127.14

C).

Project A

Profitability index= Present value of future cash flow/ Initial investment

as seen in the above table,

Present value of future cash flow = RM 20,30,308.09

initial investment = RM 15,00,000

Profitability index= 2030308.09/1500000

PI= 1.3535

Project B

Profitability index= Present value of future cash flow/ Initial investment

as seen in the above table,

Present value of future cash flow = RM 19,90,127.14

initial investment = RM 15,00,000

Profitability index= 1990127.14/1500000

PI= 1.3267

D)

For calculating IRR, NPV= 0

So, we calculate the NPV at a assumed rate , IRR, which will provide us neither profit nor loss.

IRR is calculated through trial and error

For Project A

if we take IRR as 20%,

NPV= -1500000+ 450000/(1+0.2)^1+ 450000/(1.2)^2+ 550000/1.2^3+ 400000/1.2^4+ 450000/1.2^5+ 450000/1.2^6

= -1500000+1530237 = 30237

which is close to 1500000

now lets try 20.5%

NPV= -1500000+ 450000/(1+0.205)^1+ 450000/(1.205)^2+ 550000/1.205^3+ 400000/1.205^4+ 450000/1.205^5+ 450000/1.205^6

NPV= 11,531

similarly,Now we can try R as 20.8%

NPV= 487.81

So, we have estimated IRR= 20.8% , where NPv is closest to 0

For Project B

For calculating IRR, NPV= 0

So, we calculate the NPV at a assumed rate , IRR, which will provide us neither profit nor loss.

IRR is calculated through trial and error

For Project B

if we take IRR as 20%,

NPV= -1500000+ 750000/(1+0.2)^1+ 600000/(1.2)^2+ 300000/1.2^3+ 350000/1.2^4+ 250000/1.2^5+ 300000/1.2^6

= 1585005 -1500000= 85005

which is not too close to 1500000

now lets try 22%

NPV= -1500000+ 750000/(1+0.22)^1+ 600000/(1.22)^2+ 300000/1.22^3+ 350000/1.22^4+ 250000/1.22^5+ 300000/1.22^6

NPV= 24556

similarly,Now we can try R as 23%

NPV= -4090

So we will noe take a value close to 30%, lets take 22.85%

NPV= 142

So, we have estimated IRR= 22.8% , where NPV is closest to 0

E)

	Project A	Project B	Rank
Payback period	3.125 years	2.5 years	1.Project B 2. Project A
NPV	RM 530308	RM 490127	1.Project A 2. Project B
PI	1.35	1.32	1.Project A 2. Project B
IRR	20.80%	22.80%	1.Project B 2. Project A

The NPV method uses a reinvestment rate which is close to its cost of capital and the reinvestment assumptions of the NPV method much are more realistic than those with the IRR method. Also NPV is more realistic in non even cash flow senarios, because uneven cash flow leads to Many IRR and it is difficult to determine the exact rate,

Thus, NPV is a better indicator of evaluation than IRR

So We recommend Project A , as it has higher NPV and PI as compared to project B.