[INVESTMENT APPRAISAL] Tutorial 2

Question 1. What is the payback period for the following set of cash flows? What is the discounted payback period if we use 10 per cent discount rate? What is the main disadvantage of the discounted payback period as a method of investment appraisal? What advantages does the discounted payback have over the ordinary payback? What is the payback period for the following set of cash flows? Year Cash Payback flow 0 (6400) (6400) 1 1600 (4800) 2 1900 (2900) 3 2300 (600) 4 1400 800 5 1000 1800 6 1000 2800 7 1000 3800 Approximately 3.6 years

What is the discounted payback period if we use 10 per cent discount rate? Year Cash Discount Present Cumlative flow @ 10% Value NPV 0 (6,400) 1.0000 (6,400) (6,400) 1 1,600 0.9009 1,441 (4,959) 2 1,900 0.8264 1,570 (3,388) 3 2,300 0.7312 1,682 (1,707) 4 1,400 0.6587 922 (784) 5 1,000 0.5935 594 (191) 6 1,000 0.5346 535 344 7 1,000 0.4817 482 825 Approximately 5.3 years

What is the main disadvantage of the discounted payback period as a method of investment appraisal? The discounted payback method does not consider the timings or size of the inflows or for inflows after the payback period. What advantages does the discounted payback have over the ordinary payback? The discounted payback method does consider the time value of money.

[INVESTMENT APPRAISAL] Tutorial 2

Question 2. An investment project provides cash inflows of 765 per year for eight years. What is the project payback period if the initial cost is 2,400? What if the initial cost is 3,600? What if it is 6,500? Year 0 1 2 3 4 5 6 7 8 Cash Flow 0 765 765 765 755 765 765 765 765 A (2,500) (1,735) (970) (205) 550 1,315 2,080 2,845 3,610 B (3,600) (2,835) (2,070) (1,305) (550) 215 980 1,745 2,510 C (6,500) (5,735) (4,970) (4,205) (3,450) (2,685) (1,920) (1,155) (390)

What is the project payback period if the initial cost is 2,400? Approximately 3.3 years. What if the initial cost is 3,600? Approximately 4.7 years. What if it is 6,500? Approximately 8.6 years.

[INVESTMENT APPRAISAL] Tutorial 2

Question 3. The finance manager of ABC plc is evaluating two mutually exclusive projects with the following cash flows.

Year 0 1 2 3 4 5

Project A

Project B

(110,000) (200,000) 45,000 45,000 30,000 30,000 20,000 50,000 50,000 50,000 100,000 50,000

ABSs cost of capital is 10% and both investment projects have zero scrap value. The companys current return on capital employed is 12% (average investment basis) and the company uses straight line depreciation over the life of projects.

a. Advise the company which project should be undertaken in the following circumstances if:

i. The net present value method (NPV) of investment appraisal is used: ii. The internal rate of return method of investment is used; iii. The return on capital employed method of investment appraisal is used. b. Discuss the problems that arise for the net present value method of investment appraisal when capital is limited and explain how such problems may be resolved in practice.

[INVESTMENT APPRAISAL] Tutorial 2 a. (i) Advise the company which project should be undertaken in the following circumstances if the net present value method (NPV) of investment appraisal is used:

Year 0 1 2 3 4 5

Project A (110,000) 45,000 45,000 30,000 30,000 20,000

Discount @ 10% 1.0000 0.9009 0.8264 0.7312 0.6587 0.5935 NPV

Present Value (110,000) 40,541 37,188 21,936 19,761 11,870 21,296

Cumlative Discount NPV @ 12% (110,000) (69,460) (32,272) (10,336) 9,426 21,296 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674

Present Value (110,000) 40,181 29,646 15,614 12,558 6,735 (5,266)

Cumlative NPV (110,000) (69,820) (40,173) (24,559) (12,001) (5,266)

Year 0 1 2 3 4 5

Project A (200,000) 50,000 50,000 50,000 100,000 50,000

Discount @ 10% 1.0000 0.9009 0.8264 0.7312 0.6587 0.5935 NPV

Present Value (200,000) 45,045 41,320 36,560 65,870 29,675 18,470

Cumlative Discount NPV @ 12% (200,000) (154,955) (113,635) (77,075) (11,205) 18,470 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674

Present Value (200,000) 44,645 32,940 26,023 41,860 16,838 (37,693)

Cumlative NPV (200,000) (155,355) (122,415) (96,391) (54,531) (37,693)

Both Projects have a positive NPV when considering the companies cost of Capital but neither have a positive NPV when considering the companies average return on capital employed. I would advise the company that if they where to choose either project, then to opt for project A for 5 reasons. 1. It has the higher NPV. 2. The payback on investment occurs after 3.5 yrs (whereas Project B takes closer to 5 years). 3. The losses on Project B (when considering the Companies ROCE) is 7 times higher than Project A. 4. Project A would still have a positive NPV after 4 years should the project finish earlier. 5. Project B also relies heavily on cash flow in year 4 should the Projects run into trouble after 3 years then Project B would cause a loss of almost 45% (77,000) of the investment. As opposed to less than 8% (10,000) for Project A.

[INVESTMENT APPRAISAL] Tutorial 2

ii. The internal rate of return method of investment is used; Project A

R1= R2= Npv1= Npv2= 10 12 21,296 (5,266) IRR=R1+ (R2-R1)*NPV1 (NPV1-NPV2) IRR= 11.60%

Project B
R1= R2= Npv1= Npv2= 10 IRR=R1+ (R2-R1)*NPV1 12 (NPV1-NPV2) 18,470 (37,693) IRR= 10.66%

Again both project show a return greater than the cost of Capital; However, the IRR does not show the problems Identified in items 2, 4 and 5 in answer (i) iii. The return on capital employed method of investment appraisal is used.
Year Project A (110,000 ) 45,000 45,000 30,000 30,000 20,000 Sum Average Ave Op AAR= 45,000 45,000 30,000 30,000 20,000 170,000 34,000 12,000 54.55 % 22000 22000 22000 22000 22000 110,000 22000 Operatin g Profit Deprec. Year Project A (200,000 ) 50,000 50,000 50,000 100,000 50,000 Sum Average Ave Op AAR= 50,000 50,000 50,000 100,000 50,000 300,000 60,000 20,000 50.00 % 40000 40000 40000 40000 40000 200,000 40000 Operatin g Profit Deprec.

0 1 2 3 4 5

0 1 2 3 4 5

Again Project A shows a 5% advantage over Project B so Project A would be the better choice; however, neither show any inherent dangers and both appear superb investments.

[INVESTMENT APPRAISAL] Tutorial 2

b. Discuss the problems that arise for the net present value method of investment appraisal when capital is limited and explain how such problems may be resolved in practice.
NPV assumes that future cash flows are known and that the companies cost of capital is fixed, this is unlikely to be true as both are forecasted; however when capital is limited then a profitability index is needed to evaluate the selection of projects and the projects with the higher Profitability Index should be taken. Profitability Index = NPV of cashflows/Initial Capital invested This does in no way guarantee success but reduces the possible risks in undertaking a venture.

Question 4. Explain what is meant by the term capital rationing and differentiate between hard and soft rationing Capital rationing is the process of limiting the capital expenditure. This could be due to Hard Rationing when an outside body limits the amount of capital it is prepared to loan (Gearing) or Soft Rationing when the company itself imposes the limits on expenditure. (Budgeting). All companies are faced with such limitations and managers have to therefore decide which investment opportunities to accept and which, although profitable, they have to reject.