Question

Page 2 of 9 QUESTION 2 Paradis plc has recently raised $350,000, and the directors are use these funds. Three project (A, B and C) are being immediate purchase of equipment costing $350,000, and the equipment for each project will have a useful life equal ap value. In his report to the chairman, The CEO recommends project C because shows the highest internal rate of retum. The following summary is taken from the CEOS report. All cash flows occur at the end of each year. and the directors are considering three ways to B and C) are being considered, each involving the equipment costing $350,000, One project only can be accepted, or each project will have a useful life equal to that of the project, with Internal Rate of return Project 0 A (350) B (350) C (350) 1 100 40 200 Net cash flows (S'000's) Years 2 110 104 112 100 210 260 150 240 40 138 160 160 - 180 27.5 26.4 33.0 Required: (a) The chairman is accustomed to projects being appraised in terms of payback, and he is consequently suspicious of the use of the internal rate of return as a method of project selection. (i) Calculate the payback period for each project. Ignore income tax considerations. (3 Marks) (ii) Identity and explain two benefits of the payback period project appraisal method. (3 Marks) (iii) Identity and explain two limitations of the internal rate of retur appraisal method (3 Marks) (b) The chairman has decided to commission an independent report on the choice project. Paradis ple's cost of capital is 20 per cent and has a policy of usin line depreciation to write off the cost of equipment in the financial statem (i) Calculate the net present value for each project. Ignore in considerations. (ii) Identity two limitations of the Payback period project appraisal method project. Ignore income tax (9 Marks) (c) On the basis of financial considerations alone, which project recommend? State your reasons. (3 Marks) hich project would you (4 Marks) INTF 6004 The University of the West Indies April 2017

Answer 1

(a): (i):

Years	A's cash flow	Cumulative cash flow of A	B's cash flow	Cumulative cash flow of B	C's cash flow	Cumulative cash flow of C
-	-            350,000	-              350,000	-            350,000	-           350,000	-            350,000	-            350,000
1	100,000	-              250,000	40,000	-           310,000	200,000	-            150,000
2	110,000	-              140,000	100,000	-           210,000	150,000	-
3	104,000	-                36,000	210,000	-	240,000
4	112,000	76,000	260,000		40,000
5	138,000		160,000
6	160,000
7	180,000

A's payback = 3 + 36000/112000 = 3.32 years.

B's payback = 3 years and C's payback = 2 years

(ii): Two benefits of payback are - (1) It is simple both in terms of concept as well as application (2) It is a rough and ready method for dealing with risk. Since earlier cash inflows are emphasized it is good tool when a firm is facing liquidity problems.

(iii) Two limitations of IRR method are: (1): IRR computation becomes problematic when the cash flows are unconventional (2) IRR may lead to incorrect decisions when comparing mutually exclusive decisions

(b): (i): As there are no taxes the impact of depreciation can be ignored as there will be no tax shield on depreciation.

Years	A's cash flow	B's cash flow	C's cash flow	1+r	PVIF	PV of A	PV of B	PV of C
-	-            350,000	-              350,000	-            350,000	1.20	1.0000	-            350,000	-     350,000	-     350,000
1	100,000	40,000	200,000		0.8333	83,333	33,333	166,667
2	110,000	100,000	150,000		0.6944	76,389	69,444	104,167
3	104,000	210,000	240,000		0.5787	60,185	121,528	138,889
4	112,000	260,000	40,000		0.4823	54,012	125,386	19,290
5	138,000	160,000	-		0.4019	55,459	64,300	-
6	160,000	-	-		0.3349	53,584	-	-
7	180,000	-	-		0.2791	50,235	-	-
					NPV	83,197.23	63,991.77	79,012.35

(ii): Two limitations of payback are: (1) It does not account for time value of money (2) It ignores cash flows beyond the payback period

(c): On the basis of financial considerations C should be selected as it has the lowest payback and the highest IRR.