Search

10 March, 2022

Define Payback Period. How Payback Period is used in capital budgeting decision? What are the major constraints of this method?

 Payback Period: The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

 All other things being equal, the better investment is the one with the shorter payback period. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000/$20,000, or five years.

 Calculated as:

 Payback Period = Cost of Project / Annual Cash Inflows 

Payback Period:

 Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a t,.\o year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. The return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasio«ally extended to other uses, such as energy payback period . Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour.

 Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year:

There are some main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.

2. It ignores the time value of money.

3. Additional complexity arises when the cash 9ow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime.

Because of these reasons, other methods of capital budgeting, like net present value, internal rate of return or discounted cash flow, are generally preferred.

Problem-1: The Azad Int. Ltd. is contemplating to invest in a new project that would require procurement of a machine costing Tk. 25,50,000; and a working capital of Tk. 1,00,000. The project is expected provide benefits for five years. The expected profit before depreciation and tax from the project is as below:

Year

Profit before Tax & Depreciation

ls` year

8,50,000

2"a year

7,00,000

3`d year

6,50,000

4"' year

6,00,000

5`h year

4,50,000

 (The policy of the company is to depreciate fixed assets on straight line basis over the period of the asset. Salvage value of the machine is expected to be Tk. 50,000. Assume a 40% tax rate and cost of capital of 10%.)

Required: Determine the acceptability of the project on the basis of

(i) Payback period; (ii) ARR; (iii) NPV; (iv) IRR; (v) Profitability Index.

(The present values of Tk.1 for five years at 10% are 0.9091; 0.8264; 0.7513; 0.6830; 0.6209)

Solution:

Depreciation= Cost-Salvage value/No. of year in lifetime = 25,50,000-50,000/5 = 5,00,000

Total investment= 25,50,000 (Machine price)+1,00,000(Working capital) = 26,50,000

Statement of cash inflow:

Particular

Ist year

2"d year

3`d year

4`h year

5`h year

Profit before Tax & Depreciation

Less Depreciation

8,50,000

5,00,000

7,00,000

5,00,000

6,50,000

5,00,000

6,00,000

5,00,000

4,50,000

5,00,000

Profit before Tax

Less Tax(~,40%

3,50,000

1,40,000

2,00,000

80,000

1,50,000

60,000

1,00,000

40,000

(50,000)

-

Profit after tax

Add depreciation

2,10,000

5,00,000

1,20,000

5,00,000

90,000

5,00,000

60,000

5,00,000

(50,000)

5,00,000

Cash before Terminal cash inflow

Add Salvage value at 5'h year

Add Working capital

7,10,000

-

-

6,20,000

-

-

5,90,000

-

-

5,60,000

-

-

4,50,000

50,000

1,00,000

 

7,10,000

6,20,000

5,90,000

5,60,000

6,00,000

 Required 1:

Pay Back Period (PBP):

Year

Cash inflow

Cumulative cash inflow

1

7,10,000

7,10,000

2

6,20,000

13,30,000

3

5,90,000

19,20,000

4

5,60,000

24,80,000

5

6,00,000

30,80,000

 

PBP= 4+ (Total investment-4`h year cumulative cash inflow)/5`h year cash inflow = 4+ (26,50,000-24,80,000)/6,00,000 = 4.28 years

 

Required-2:

Averaj!e rate of return:

 ARR= (Average annual profit/Average investment)x 100

_({(2, I 0,000+ I,20,000+90,000+60,000-50,000)/5}/(26,50,000+50,000)/2J x 100  (86,000/13,50,000)x]00

= 6.37%

 Required-3:

Net Present Value (NPV) calculation:

Year

Cash flow

Discount factor a,10%

Present value

1

7,10,000

0.9091

6,45,467

2

6,20,000

0.8264

5,12,368

_

5,90,000

0.7513

4,43,267

5,60,000

0.6830

3,82,480

5

6,00,000

0.6209

3,72,540

Present value of cash                                     = 23,56,1 16

Less, investment                                            =(26,50,000)

Net Present Value (NPV)                                 (2,93,884)

 Required-4:

Internal Rate of Return (IRR):

Since the NPV at 10%, discounting rate is negative Let us take lower discounting rate 5%.

Therefore,

Present value={7,10,000/(1+0.05)+6,20,000/(1+0.05)2+5,90,000/(1+0.05)3 +5,60,000/(1+0.05)4+6,00,000/(1+0.05)5}-26,50,000(total investment)

=(6,76,190.48+5,62,358.28+5,09,664.18+4,60,713.39+4,70,115.70) - 26,50,000 (total investment)

= 26,77,488-26,50,000(total investment) =27488.

IRR= A+C/C-D(B-A)

= 5%+27488/27488-(-2,93,884)X(10%-5%)

= 5%+27488/321372x5% = 5%+ 0.0855 X 5%

= 0.05+0.0042 =0.0542 -5.42%

 Required-5:

Calculation of Profitability Index (PI):

P1=PV of cash inflow/PV of investment cost = 23, 56,116/26, 50,000 = 0.889

    = 0.89 (Approximated)

Ans:

i)      Pay Back Period 4.28 years

ii)      ARR= 6.37%

iii)    NPV= (-2,93,884)

iv)     PI = 0.89

Here,

A= Lower discounting rate

B= Higher discounting rate

C= NPV of lower discounting rate

D= NPV of higher discounting rate

 Comments: Out of 5 years project life, the investment will return within 4.28 years, ARR is 6.37% which is lower than cost of capital, PI is less than I and NPV value negative, So the project is not acceptable.

 

Problem-2: The Azom Int. Ltd. is contemplating to invest in a new project that would require procurement of a machine costing Tk. 21,00,000; and a working capital of Tk. 1,00,000. The project is expected to provide benefits for five years. The expected profit before depreciation and tax from the project is as below:

Year

Profit before Tax & Depreciation

1 S` year

7,50,000

2"d year

6,50,000

3`d year

5,50,000

4`" year

5,00,000

5`" year

4,50,000

 

(The policy of the company is to depreciate fixed assets on straight line basis over the period of the asset. Salvage value of the machine is expected to be Tk. 1,00,000. Assume a 50% tax rate and cost of capital of 10%.)

Required: Determine the financial viability of the project on the basis of (i) Payback period; (ii) ARR; (iii) NPV; (iv) IRR; (v) Profitability Index.

(The present values of Tk.1 for five years at 10% are 0.9001; 0.8264; 0.7513; 0.6830: 0.6209)

Solution:

Depreciation= Cost-Salvage value/No. of year in lifetime = 21,00,000-1,00,000/5 = 4,00,000

Statement of investment cost

Total investment= 21,00,000 (Cost of project)+1,00,000(Working capital)

= 22,00,000

Statement of cash inflow

Particular

1'` year

2"' year

3`d year

4`" year

5`" year

Profit before Tax &

Depreciation

Less Depreciation

7,50,000

4,00,000

6,50,000

4,00,000

_

5,50,000

4,00,000

5,00,000

4,00,000

4,50,000

4,00,000

Profit before Tax

3,50,000

2,50,000

1,50,000

1,00,000

50,000

Less Tax cr,50%

1,75,000

1,25,000

75,000

50,000

25,000

Profit after tax

1,75,000

1,25,000

75,000

50,000

25,000

Add depreciation

4,00,000

4,00,000

4,00,000

4,00,000

4,00,000

Cash before Terminal cash

5,75,000

5,25,000

4,75,000

4,50,000

4,25,000

inflow

-

-

-

-

1,00,000

Add Salvage value at 5`h year

-

-

-

-

1,00,000

Add Working capital

 

 

 

 

 

 

5,75,000

5,25,000

4,75,000

4,50,000

6,25,000

 

Required -1:

Pay Back Period (PBP):

Year

Cash inflow

Cumulative cash inflow

1

5,75,000

5,75,000

2

5,25,000

11,00,000

3

4,75,000

15,75,000

4

4,50,000

20,25,000

5

6,25,000

26,50,000

 

PBP= 4+ (Total investment-4th year cumulative cash inflow)/5 Ih year cash inflow = 4+ (22,000,000-20,25,000)/6,25,000 = 4.28 years

 

Required-2:

Average rate of return:

 

ARR= (Average annual profit/Average investment)x 100

= [{(I,75,000+1,25,000+75,000+50,000+25,000)/5}/(22,00,000+1,00,000)/2] x100  

= (90,000/11,50,000)X100

= 7.83%

Required-3:

Net Present Value(NPV) calculation:

Ye

ar

Cash flow

Discount factor@ 10%

Present value

 

5,75,000

0.9091

5,22,732

2

5,25,000

0.8264

4,33,860

3

4,75,000

0.7513

3,56,867

4

4,50,000

0.6830

3,07,350

5

6,25,000

0.6209

3,88,062

Present value of cash inflow                           = 20,08,871

Less, investment                                             =(22,00,000)

Net Present Value (NPV)                                  (1,91,129)

 

 

Required-4:

Internal Rate of Return (IRR):

Since the NPV at 10%, discounting rate is negative, let us take lower discounting rate 5%.

Therefore,

Present value= 5,75,000/(1+0.05)+5,25,000/(1+0.05)2+4,75,000/(1+0.05)3

 

So, NPV

 

+4,50,000/(1+0.05 )4+6,25,000/(1 +0.05)5

= (5,47,619+4,76,406+4,10,331+3,70,218+4,89,735) = 22,94,309

= 22,94,309-22,00,000

= 94,309.

IRR= A+C/C-D(B-A)

= 5%+94,309/94,309-(-1,19,129)X(10%-5%)

= 5%+94,309/2,85,138x5% = 0.05+ 0.0165                

=6.65%

 

Here,

A=Lower discounting rate

B= Higher discounting rate

C=NPV of lower discounting rate

D= NPV of higher discounting rate

Required-5:

Calculation of Profitability Index (PI):

P1=PV of cash inflow/PV of investment cost = 20,08,871/22,00,000 = 0.91 (Approximate)

Comments: Out of 5 years project life, the investment will return within 4.28 years, ARR is 7.83% which is lower than cost of capital, P1 is less than I and NPV value negative, So the project is not financially viable.

Problem-3: The `X' Int. Ltd. is contemplating to invest in a new project that would require procurement of a machine costing Tk.10,00,000; and no working capital. The project is expected to provide benefits for ten years. The expected profit before depreciation and tax from the project is as below:

 

Year

Profit before Tax & Depreciation

151 year

2,50,000

2"d year

4,00,000

3rd year

4,00,000

4`h year

4,00,000

5'n year

3,50,000

6"' year

3,00,000

7`n year

2,50,000

8th year

2,00,000

9th year

1,50,000

10`h year

1,00,000

 

(The policy of the company is to depreciate fixed assets on straight line basis over the period of the asset. No Salvage value of the machine is expected. Assume a 40% tax rate and cost of capital of 15%.)

Required: Determine the financial viability of the project on the basis of (i) Payback period; (ii) ARR; (iii) NPV; (iv) Profitability Index.

(The present values of Tk.l for five years at 15% are 0.87; 0.756; 0.658; 0.572; 0.497; 0.376; 0.432; 0.327; 0.284; 0.247.

Solution:

Depreciation= Cost-Salvage value/No. of year in lifetime

                = 10,00,000-0/10

= 1,00,000

Statement of investment cost

Total investment= 10,00,000 (Cost of project)+0 (Working Capital)= 10,00,000

(Fi ure in Lac)

1 Particulars

1 st

year

' 2nd

year

3rd

year

' 4th

year

5th

year

6th

year

' 7th

year

8th

year

' 9th

year

1Oth

year

Profit before Tax &

2.50

4.00

4.00

4.00

3.50

3.00

2.50

2.00

1.50

1.00

Depreciation

Less Depreciation

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

Profit before Tax

1.50

3.00

3.00

3.00

2.50

2.00

1.50

1.00

0.50

-

Less Tax(a-b,40%

0.525

1.05

1.05

1.05

0.875

0.70

0.525

0.35

0.175

 

Profit after tax

0.975

1.95

1.95

1.95

1.625

1.30

0.975

0.65

0.325

-

Add des reciation

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

Cash before Terminal

-

-

-

-

-

-

-

-

-

-

cash inflow

 

 

 

 

 

 

 

 

 

 

Add Salvage value

-

-

-

-

-

-

-

-

-

-

Add working capital

-

-

-

-

-

-

-

-

-

-

Net cash inflow

1.975

2.95

2.95

2.95

2.625

2.30

1.975

1.65

1.325

1.00

 

Note- Please write full fiaure at exam script Required 1:

Pay Back Period (PBP):

Year

Cash inflow

Cumulative cash inflow

 

1 ,97,500

1,97,000

 

2,95,000

4,92,500

3

2,95,000

7,87,500

4

2,95,000

10,82,500

 

2,62,500

13,45,000

 

2,30,000

15,75,000

 

PBP   = 3 year+ (Total investment-3`d year cumulative cash inflow)/4`h year cash inflow

= 3 year+ (10,00,000-7,87,500)/2,95,000

= 3 year+0.72 = 3.72 years

Required-2:

Avera2e rate of return

ARR   = (Average annual profit/Average investment)x100

= [{(97,500+1,95,000+1,95,000+1,95,000+1,62,500+1,30,000+97,500+65,000+32,500)/10} /(10,00,000/2)] x 100

=(1,17,000/5,00,000)x]00

=23.4%

 

Required-3:

Net Present Value (NPV) calculation

NPV =(1,97,SOOX0.87)+ (2,95,OOOX0.756)+ (2,95,OOOX0.658)+ (2,95,OOOX0.572)+ (2,62,SOOX0.497)+ (2,30,OOOX0.376)+ (1,97,SOOX0.432)+ (1,65,OOOX0.327)+ (I,32,SOOX0.284)+ (1,00,OOOX0.247)] -10,00,000 (total Investment)

= {( l ,71,825+2,23,020+1,94,110+1,68,740+ I ,30,463+99,360+74,260+53,955+3 7,630+24,700)

=11,78,460.50}-10,00,000 (total Investment)

So, NPV =1 1,78,460.50-10,00,000 (total Investment)

= 1,78,460.50

Reg u ired-4:

Calculation of Profitability Index (PI)

P(=PV of cash inflow/PV of investment cost

= 11,78,460.50/10,00,000

= 1.178486

= 1.18 (Approximate)

Statement of present value of payback period

Year

Cash flow

Discount

factoroy 15%

Present value

Cumulative amount of PV~'

1

,97,500

0.87

1 71,825

1,71,825

_

2,95,000

0.756

2,23,020

3,94845

 

2,95,000

0.658

1,94,110

5,88,955

 

2,95,000

0.57?

1,68,740

7,57,695

 

2,62,500

0.497

1,30,463

8,88,158

 

2,30,000

0.376

99,360

9,87,518

7

1,97,500

0.432

74,260

10,61,778

~ 8

1 65,000

0.327

53,955

1 1,15,733

9

,32,500

0.284

37,630

11,53,366

10

1,00,000

0.247

__

24,700

1 1,78,063                  ;

 

PVPE3P= 6 years+(Remaining amount)/PV of 71h year

 

Total Present value

=1 1,78,063

 

=

6 years+ (10,00,000-9,87,518)/74,260

=

6 years+ 0.168

=

6.168 years

=

6.17 years (approx)

 

Ans.:

 

 

v)

Pay Back Period 3.72 Years

vi)

ARR= 23.8%

vii)

NPV= 1,78,460.50

viii)

PI    = 1.18

 

Comments: Out of 10 years project life, the investment will return within 3.72 years, ARR is 23.8% which is higher than cost of capital, PI is greater than I and NPV value positive, So the project is acceptable.

Problem-4 (May11,12): The Chad Int. Ltd. is contemplating to invest in a new project that would require procurement of a machine costing Tk. 18,50,000; and a working capital of Tk. 1,50,000. The project is expected to provide benefits for nine years. The expected profit before depreciation and tax from the project is as below:

Year

Profit before Tax & Depreciation

ls year

3,50,000

2~ year

2,50,000

3" year

3,50,000

4`h year

3,00,000

5 year

2,50,000

6"' year

2,50,000

71h year

3,50,000

8 year

2,00,000

9th year

1,50,000

 

(The policy of the company is to depreciate fixed assets on straight line basis over the period of the asset. Salvage value of the machine is expected to be Tk50,000. Assume a 40% tax rate and cost of capital of 12%.)

Required: Determine the viability of the project on the basis of

(i) Payback period; (ii) ARR; (iii) NPV; (iv) Profitability Index.

(The present values of Tk.l for five years at 12% are 0.8929; 0.7972; 0.7181; 0.6355; 0.5674: 0.5066; 0.4523; 0.4039; 0.3606.

Solution:

 

Here. Depreciation= Cost-Salvage value/No. of year in lifetime - 18,50,000-50,000/9 = 2,00,000

 

Total investment = 18,50,000 (Machine price)+1,50,000(Working capital)

                                = 20,00.000

Statement of cash inflow

(Fi ure in Lac)

Particulars

1st year

2nd

year

3rd

year

4th

year

5th

year

6th

year

7th

year

8th

year

9th

year

Profit before Tax &

Depreciation

Less Depreciation

3.50

2.00

4.50

2.00

4.50

2.00

3.00

2.00

2.50

2.00

2.50

2.00

3.50

2.00

2.00

2.00

1.50

2.00

Profit before Tax

Less Tax(&,40%

1.50

0.60

2.50

1.00

2.50

1.00

1.00

0.40

0.50

0.20

0.50

0.20

1.50

0.60

-

-

(0.50)

-

Profit after tax

Add depreciation

0.90

2.00

1.50

2.00

1.50

2.00

0.60

2.00

0.30

2.00

0.30

2.00

0.90

2.00

-

2.00

(0.50)

2.00

Cash before Terminal

cash inflow

2.90

3.50

3.50

2.60

2.30

2.30

2.90

2.00

1.50

Add Salvage value

-

-

-

-

-

-

-

-

0.50

Add working capital

-

-

-

-

-

-

 

-

1.50

Net cash inflow

2.90

3.50

3.50

2.60

2.30

2.30

2.90

2.00

3.50

 

Note- Please write full figure at exam script]

Required l:

Pay Back Period (PBP)

Year

Cash inflow

Cumulative cash inflow

I

2,90,000

2,90,000

 

3,50,000

6,40,000

3,50,000

9,90,000

 

2,60,000

12,50,000

5

2,30,000

14,80,000

6

2,30,000

17,10,000

 

2,90,000

20,00,000

8

2,00,000

22,00,000

 

3,50,000

25,50,000

Pay Back Period= 7 Years Required-2:

Averaue rate of return

 

ARR= (Average annual profit/Average investment)X100

=[{(90,000+1,50,000+1,50,000+60,000+30,000+30,000+90,000-50,000)/9} /20,00,000/2] X100

= (61,1 1 1 / 10,00,000)X 100

= 6.11%

Required-3:

 

Required-3:

Net Present Value(NPV) calculation

Year

Cash flow

Discount

factor@ 12%

Present value

1

2,90,000

0.8929

2,58,941

2

3,50,000

0.7972

2,79,020

3

3,50,000

0.7181

2,51,335

4

2,60,000

0.6355

1,65,230

5

2,30,000

0.5674

1,30,502

6

2,30,000

0.5066

1,16,518

7

2,90,000

0.4523

1,31,167

8

2,00,000

0.4039

80,780

9

3,50,000

0.3606

1,26,210

Present value of cash                               = 15,39,703

Less, investment                                      =(20,00,000)

Net Present Value (NPV)                           (4,60,297)

 

Required-4:

Calculation of Profitability Index (PI) P1=PV of cash inflow/PV of investment cost

= 15,39,703/20,00,000

= 0.7698

Ans.:

 

 

ix)

Pay Back Period 7 Year

x)

ARR= 6.11%

x0

NPV= (-460297)

xii)

P1 = 0.7698

 

 

Comments: Out of 9 years project life, the investment will return within 7 years, ARR is 6.11% which is lower than cost of capital, Pl is less than I and NPV value negative. So the project is not viable.

Problem-(Nov' 11): A large size Company is considering investment in a project that costs Tk. 4,00,000. The estimated salvage value is zero; tax rate is 35%. The company uses straight line depreciation and the proposed project has cash flows before tax (CFBT) as follows:

Year

Profit before Tax & Depreciation

1" vear

1,00,000

2n`' year

1,00,000                                          ,

3"d year

1 ,50,000

4th year

1,50,000

5`i' year

2,50,000

 

_Required: Determine the following:

(i) Payback period; (ii) ARK; (iii) NPV at 15% ; (iv) Profitability Index; (v) Comments on the basis of result.

PVF at 15% : 0.870; 0.756; 0.658; 0.572; 0.497) Solution:

Depreciation- Cost-Salvage value/No. of year in lifetime

= 4,00.000-0/5

= 80, 000/-

Statement of cash inflow:

 

 

 

 

 

Particulars

 

1st Year

2nd year

3rd year       4th year

5th year

I Profit before tax & Depreciation

 

1_00,000

1.00,000

1.50.000

1.50.000

2.50.000

 Less Depreciation

 

80.000

 

80,000

80.000

80.000

'   80.000

Profit before tax

C Profit beliOrc Tax                                         ~

 

20.000

20,000

70.000

70.000

} 1.70.000

Less tax @ 35%

 

7.000

7,000

24.500

24.500

'_ 5 9.5 00

I Profit after tax

 

13,000

13,000

45,500

45.500

1,10,500

Add depreciation

 

80.000

80,000

'

80.000

80.000

80,000

cash inflow

 

93.000

93,000

1.25,500         125.500

1.90.500

 

Required 1:

Pav Back Period (PBP):

Year

Cash inflow

Cumulative cash inflow

1

93,000

93,000

2

93,000

1,86,000

3

1,25,500

3,11,500

4

1,25,500

4,37,000

5

1,90,500

6,27,500

 

 

PBP = 3+ (Total investment-3rd year cumulative cash inflow)/4th year cash inflow

      = 3+ (4,00,000-3,11,500)/1,;-5,500

= 3+0.705

               =3.71

So,Pay Back Period = 3.71 years

 

Required-2:

Average rate of return:

ARR= (Average annual profit/Average investment)X 100

=({(13,000+13,000+45,500+45,500+1,10,500)/5,1./(4,00,000)/2] x 100

 = (45,500/2,00,000)X 100

= 22.75%

Required-3:

Net Present Value (NPV) calculation:

Year

Cash flow

Discount factor( 15%

Present value

1

93,000

0.870

80,910

     2

93,000

0.756

70,308       -

3

1,25.500

0.658

82,579

    4

1,25,500

0.572                                 1

71,786

   5   1,90,500       I

0.497                                 1

94,679

I Present value of cash                              = 4,00,262

Less investment                                                                                  = (4,00,000

Net present value (NPV)                                                                    = 262

 

Required-4:

Calculation of Profitabilitv Index (PI): P1-PV of cash intlo~e/PV of investment cost

-- 4.00?62/4,00,000

= 0.889

= 1.000655

Ans.:

 

 

i)

Pay Back Period 3.71 years

ii)

ARR=22.75%

iii)

NPV= 262

iv)

P1 =1.000655

 

Comments: Out of 5 years project life, the investment will return within 3.71 years, ARR is 22.75% which is higher than cost of capital, P1 is greater than I and NPV value positive. So the project is acceptable.

 

Problem-5: ABC Company has limited funds available for investment and must ration the funds among five competing projects. Selected information on the five projects are given below:

 

Project

Investmen

t required

Net Present

Value(NPV)

Life of the

project(years)

Internal Rate of

Return (%)

Project C

8,00,000

2,21,615

 

18

Project B

6,75,000

2,10,000

12

16

Project A

5,00,000

1,75,175

7

20

Project D

7,00,000

1,52,544

3

22

Project E

9,00,000

(52,176)

6

8

 

[The ABC company's cost of capital is 10% (the net present values above have been computed using a 10% discount rate.) The wants your assistance in determining which project to accept first which to accept second and so forth.]

 

Solution:

 

(1) Profitability Index Calculation

 

We know,

Profitability Index Calculation

PI=PV of cash inflow/PV of cash outflow

For project A:

Present value= NPV+Investment = 2,21,615+8,00,000 = 10,21,615

So, Pl= 10,21,615/8,00,000 = 1.27 > 1

For project B:

Present value= NPV+Investment = 2,10,000+6,75,000 = 8,85,000

So, Pl= 8,85,000/6,75,000 = 1.31> 1

For project C:

Present value= NPV+Investment = 1,75,175+5,00,000 = 6,75,175

 

So, PI= 6,75,175/5,00,000 = 1.35> 1

 

For project D:

 

Present value= NPV+Investment = 1,52,544+7,00,000 = 8,52,544

 

So, PI= 8,52,544/7,00,000 = 1.22 > 1

 

For project E:

 

Present value= NPV+Investment = 9,00,000+(-52,176) = 8,47,824

 

So, PI= 8,47,824/9,00,000 = 0.94< 1

 

Since ABC has limited funds. So, we have to choose the best alternative and the ranking of preference are:­

Project

Rating

Project A=135

1

Project B=1.31

2

Project C=1.27

_

3

Project D=1.22

4

Pr~ect E=0.94

5

 

Project E should not be accepted because PI is than 1(<1)

(2) Net Present Value(NPV)

(i) Ranking of the 5(five) projects in terms of Net Present Value(NPV) are as follows:­

 

Project

NPV

Rating

Project A

2,21,615

1

Project B

2,10,000

 

Project C

1,75,175

 

Project D

1,52,544

4

Project E

(52,176)

 

 

 

(3) Profitability Index (PI)

(ii) Ranking of the 5(five) projects in terms of Profitability Index (PI) are as follows:­

Project

PI

Rating

Project C

1.35

1

Project B

1.31

2

Project A

1.27

3

Pro'ect D

1.22

4

, Pr~ject E

0.94

5

 

(i) Ranking of the 5(five) projects in terms of Internal Rate of Return(IRR) are as follows:­

Project

NPV

Rating

Project D

-22%

1

Project C

20%

2

Project A

18%

3

Project B

16%

4

Project E

8%

5

 

(4) The ranking in terms of Net Present Value (NPV) should be given preference. Because

(i)      NPV gives accurate results because of consider all cash flows,

(ii)     IRR gives misleading in non conventional investment project.

(iii)     IRR also gives multiple rates.

(iv)    Profitability Index(PI) is crude way to cope up the rate and it gives misleading if investment made reversal time.

 

(5) If capital rationing situation prevails in the company with a budget constraints of the 1.5 million, we should prefer project A and Project D

Because

(i)      Project A gives higher NPV

(ii)     Project D gives highest IRR

(iii)    Since Project B gives second highest NPV but it takes 12 years

(iv)    In considering PI the Project C is the best but some portion of our investment is

being idle if project C is chosen. SO project A and D would be best preference.

(6) The causes of difference in outcomes of the project under NPV and IRR methods are as follows:­

(i) NPV consider cash flows at the cost of capital rate over the year but IRR deals re-investment rate that may not prevail in the market.

(ii) If the outcome or inflows are great in recent year and smaller in later year than IRR gives misleading

(iii) For non conventional project, IRR gives misleading for that reason the difference is made.

on
Labels: