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Table of Contents
Part 1 - Evaluate both the projects:............................................................................................1
Part 2 Evaluation of techniques...............................................................................................5
Part 3 - Multiple Choice Questions and Short Answers.............................................................8
References..................................................................................................................................9
(100)
(30)
20
40
It will take 1 year and [(30 50) x 12] = 7.2 months to pay back which is 1 year and 8
months when we round up.
Project L
Investment
Balance as at first year end
Balance as at second year end
Balance as at third year end
(100)
(90)
(30)
50
It will take 2 years and [(30 80) x 12] = 4.5 months to pay back which is 2 years and 5
months when we round up.
In terms of payback period method we can see that Project S has the shortest payback time
hence Project S is better
Project S
Year
Cash Flow
Present Value
Factor = 1/
Discounted
Cash flow
Balance at the
end of each year
(100)
63.63
41.3
15.03
(100)
(36.37)
4.93
19.96
(1+i)n
0
1
2
3
(100)
70
50
20
1
0.909
0.826
0.751
It will take 1 year and [(36.37 41.3) x 12] = 10.57 months to pay back which is 1 year and
11 months when we round up
Project L
Year
Cash Flow
Present Value
Factor = 1/
Discounted
Cash flow
Balance at the
end of each year
(100)
(100)
(1+i)n
(100)
1
1
10
60
80
0.909
0.826
0.751
9.09
49.56
60.08
(90.91)
(41.35)
18.73
It will take 2 years and [(41.35 60.08) x 12] = 8.26 months to pay back which is 2 years and
9 months when we round up
In terms of discounted payback period method we can see that Project S has the shortest
payback time hence Project S is better
NPV
Project S
Year
0
1
2
3
Cash Flow
Present Value
Factor = 1/(1+i)n
(100)
1
70
0.909
50
0.826
20
0.751
Net Present Value
Discounted
Cash flow
(100)
63.63
41.3
15.03
= 19.96
Balance at the
end of each year
(100)
(36.37)
4.93
19.96
Cash Flow
Discounted
Cash flow
(100)
9.09
49.56
60.08
= 18.73
Balance at the
end of each year
(100)
(90.91)
(41.35)
18.73
Project L
Year
Present Value
Factor = 1/(1+i)n
(100)
1
10
0.909
60
0.826
80
0.751
Net Present Value
0
1
2
3
In terms of NPV project S has a higher NPV value hence project S is better.
NPV a
IRR Formula - r a + NPV a NPV b (r br a)
ra lower discount rate chosen / Na NPV at ra
rb lower discount rate chosen / Nb NPV at rb
Project S
Earlier we calculated the NPV for project S, cost of capital (COC) at 10%. Now we are going
to calculate NPV when COC is 20%.
Year
Cash Flow
Present Value
Factor = 1/(1+i)n
2
Discounted
Cash flow
Balance at the
end of each year
(100)
70
50
20
Net Present Value
1
0.833
0.694
0.579
(100)
58.31
34.7
11.57
= 4.58
(100)
(41.69)
(6.99)
4.58
Discounted
Cash flow
(100)
8.33
41.64
46.32
= (3.71)
Balance at the
end of each year
(100)
(91.67)
(50.03)
(3.71)
Project L
Year
Cash Flow
Present Value
Factor = 1/(1+i)n
(100)
1
10
0.833
60
0.694
80
0.579
Net Present Value
0
1
2
3
MIRR=
Project S
Year
0
-100
1
70
2
50
3
20
84.7
55
-100
159.7
MIRR =
159.7
1=16.88
100
Project L
Year
0
-100
MIRR =
1
10
2
60
3
80
12.1
66
-100
158.1
158.1
1=16.50
100
Project S has the highest MIRR hence project S can be selected to enhance the outcome.
Payback period
The payback period measures the time period (expected number of months or years) it takes
to fully cover the total cost of the investment used. Usual method in this is to subtract cash
flows from the cost until the remainder will be zero. This is usually when companies have a
limit to payback period for all of their investments.
Payback period is easy and can be calculated quickly compared to other methods and will
provide a liquidity measure of the project. It will give a prominent to projects which have
higher cash flows at the beginning than after some more years. This can be important for a
smaller company who have a smaller working capital cycle compared to other companies.
Main drawbacks of this methods are that it ignores the time value of money and also ignores
all cash flows beyond the payback period. A company with a project that exceeds the
predetermined value will not be taken into consideration and these are not based economic
foundation at all. Payback period also doesnt consider risk differences, and this method
calculate using the same way for both riskier and safer projects. This method will make a
company bias towards short-term investment and make it difficult for companies to accept
long term investments.
Discounted payback period is more similar to previous methods but it also considers the time
value of money unlike the previous method. In discounted payback period method since time
value of money is considered economic aspects are covered to some aspects where riskiness
of cash flows are considered. But even with that there are number of disadvantages yet in
these methods. Which are:
a. No strong and firm idea given about decision criteria in which it tells about whether
the investment will increase firms value or not.
b. Cost of capital is an estimation used most of the time hence require more analysis to
be done.
c. As in the previous method it ignores the cash flows beyond the payback period.
a.
b.
c.
d.
Answer
1
False
2
4
2
3
3
3
1
2
2
3
Q13:
Non- systematic risk (specific risk/diversifiable risk/residual risk) An uncertainty type that
comes when investing in a company or in a certain industry. This can be reduced mainly with
investing in different companies or industries (diversification).
Systematic risk (market risk/un-diversifiable risk) this is a type of risk that is inherent to the
whole market or whole market segment. This is also known as volatility which is due to day
to day fluctuation of stock prices.
Q14
Q15
Q16
Q17
Q18
Q19
Q20
2
4
4
1
2
3
1
References
Berry,A. (1999), Financial Accounting An Introduction, Second Edition, London: Thompson
Black, G. (2009), Introduction to accounting and finance, Second edition, Essex: Pearson
Education
Gowthorpe,C. (2005), Financial Accounting for non-specialists, London :Thompson
Learning
Kotler, P., Armstrong, G., Saunders, J. and Wong, V. (1999), Principles of Marketing, 2nd
Edition, Cambridge: Prentice Hall
Linzer, R. S. and Linzer, 0.L. (2008), Cash Flow Strategies, San Francisco: John Wiley and
sons
ROSS S, WESTERFIELD RW, JORDAN BD & FIRER C. 2003. Fundamentals of corporate
finance. 2nd ed. Boston: McGraw Hill.
STEYN PG & MARITZ M. 2003. Financial Management of corporate projects and
programmes. Pretoria: Crane field.