ACC501 Assignment No. 2 idea solution

Question










Keep in to consideration given information. You are required to calculate the following:

1. Calculate Payback period for each project.
2. Calculate NPV for each project.
3. Calculate PI for each project.
4. Rank the projects by each of the used techniques. Also give justification for this ranking.

NOTE:
It is necessary to show formula and complete working. Marks will be deducted if instruction will not be followed.

Assignment Schedule
Opening Date and Time
9th June, 2011 At 12:01 A.M. (Mid-Night)
Due Date and Time
15th June, 2011 At 11:59 P.M. (Mid-Night)

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Solution:-

In the project “A” the initial investment is Rs.
205,000 and the cash flows are Rs. 80,000, 50,000, 45,000, 450000 &
45,000 in five years.
The cash flows over 5 years are Rs. 240,000, so the project pays back sometime in the fifth year.

Year Paid back Remaining
1 60,000 145,000
2 50,000 95,000
3 40,000 55,000
4 50,000 5,000 for 5th year
5 40,000

Note that this Rs. 5,000 is 5,000/40,000 = 5/40 of the fifth year’s cash flows.
Spreading this ratio over 365 days:
5/40 x 365 = 45 days (approx)
Which means, that the payback period is just over 4 year and 1.5 months

In the project “B” the initial investment is Rs. 205,000 and the cash
flows are Rs. 60,000, 50,000, 40,000, 50,000 & 40,000 in all five
years.
The cash flows over 5 years are Rs. 265,000, so the project pays back sometime in the fourth year.

Year Paid back Remaining
1 80,000 125,000
2 50,000 75,000
3 45,000 30,000 to be paid in 4th year
4 45,000
5 45,000

This Rs. 30,000 is 30,000/45,000 = 2/3 of the fourth year’s cash flows.
Spreading this ratio over 12 months:
2/3 x 12 = 8 months
Which means, that the payback period is just over 3 year and 8 months

Idea Solution:
Consider the following investments:
Year Long Short
0 -$250 -$250
1 100 100
2 100 200
3 100 0
4 100 0
•The payback on long is
2 + $50/100 = 2.5 years
•The payback on short is
1 + $150/200 = 1.75 years
•With a cutoff of two years, short is accepted and long is not
•Is payback period rule giving us the right decisions?
•Suppose, we require a 15% return on this kind of investment; NPV for the two investments is:
NPV (Short) =
-$250 +100/1.15 + 200/1.152 = -$11.81
NPV (Long) =
-$250 + 100 x (1 – 1/1.154)/.15 = $35.5
•We can see that the NPV of shorter term investment is negative, which would diminish the value of
shareholders’ equity.
•Longer term investment increases share value
•Whenever we have mutually exclusive investments, we shouldn't rank them based on their returns
•In other words, IRR can be misleading in determining the best investment
•Instead we should look at their relative NPVs to avoid possibility of choosing incorrectly



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