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    Mashud Riad
    The document discusses various capital budgeting techniques including payback period, net present value, and internal rate of return. It provides examples to calculate each metric and outlines the relevant decision criteria. Specifically: - Payback period is the time to recover the initial investment from cash inflows. A project is accepted if payback period is less than the maximum payback period. - Net present value discounts future cash flows to calculate if a project's value exceeds its cost. A project is accepted if NPV is positive. - Internal rate of return is the discount rate that sets NPV equal to zero. A project is accepted if IRR exceeds the cost of capital. An example calculates each metric for

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    New Microsoft Word Document

    Uploaded by

    Mashud Riad
    296 views10 pages
    The document discusses various capital budgeting techniques including payback period, net present value, and internal rate of return. It provides examples to calculate each metric and outlines the relevant decision criteria. Specifically: - Payback period is the time to recover the initial investment from cash inflows. A project is accepted if payback period is less than the maximum payback period. - Net present value discounts future cash flows to calculate if a project's value exceeds its cost. A project is accepted if NPV is positive. - Internal rate of return is the discount rate that sets NPV equal to zero. A project is accepted if IRR exceeds the cost of capital. An example calculates each metric for

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    The document discusses various capital budgeting techniques including payback period, net present value, and internal rate of return. It provides examples to calculate each metric and outlines the relevant decision criteria. Specifically: - Payback period is the time to recover the initial investment from cash inflows. A project is accepted if payback period is less than the maximum payback period. - Net present value discounts future cash flows to calculate if a project's value exceeds its cost. A project is accepted if NPV is positive. - Internal rate of return is the discount rate that sets NPV equal to zero. A project is accepted if IRR exceeds the cost of capital. An example calculates each metric for

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    296 views10 pages

    New Microsoft Word Document

    Uploaded by

    Mashud Riad
    The document discusses various capital budgeting techniques including payback period, net present value, and internal rate of return. It provides examples to calculate each metric and outlines the relevant decision criteria. Specifically: - Payback period is the time to recover the initial investment from cash inflows. A project is accepted if payback period is less than the maximum payback period. - Net present value discounts future cash flows to calculate if a project's value exceeds its cost. A project is accepted if NPV is positive. - Internal rate of return is the discount rate that sets NPV equal to zero. A project is accepted if IRR exceeds the cost of capital. An example calculates each metric for

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    of 10

    Payback Period

    Definition of PBP
    According to L. J. Gitman, Payback period is the exact amount of the time required for the firm
    to recover its initial investment in a project as calculated from cash inflows.

    Decision Criteria:
    i. PBP > Project Life = Accepted.
    ii. PBP = Project Life = May be Accepted.
    iii. PBP < Project Life = Rejected.

    Calculation of PBP:
    1. When cash flows are even,
    PBP=

    A
    B

    Where,
    A=Net cash invested
    B= Net cash flow for each Period.

    Problem (a): Jordan Enterprises is considering a capital expenditure that requires an initial
    investment of $42000 and returns after-tax cash inflows of $7000 per year for 10 years. The firm
    has a maximum acceptable PBP of 8 years. What is the PBP of the project? Should the company
    accept the project or not?
    Answer:
    We know that,
    PBP = A/B

    Where,

    A = Net cash invested = $42000


    B = Net Cash Flow for Each Period = $7000

    So, PBP = 42000/7000


    = 7 Years

    As the actual PBP is less than maximum acceptable PBP, the company should accept the project.
    2. When cash flows are uneven / mixed,
    PBP=A +

    B
    C

    Where,
    A = Year in which the cumulative cash flow is near
    to the net cash invested.
    B = Cumulative cash flow of year A
    C = Cash flow of the following year of the year A

    Problem (b): Bill Williamson has the opportunity to invest in Project A that costs $9000 today
    and provides yearly payment of $2200, $2500, $2500, $2000, and $1800 over 5 years. Or Bill
    can invest in Project A that costs $9000 today and provides yearly payment of $1500, $1500,
    $1500, $3500 and $4000 over 5 years. Calculate PBP of both projects, which project he should
    invest using Payback Method?
    Schedule of Cash flow of Project A
    Year
    0
    1
    2
    3 (A)
    4
    5

    Cash flow ($)


    -9000
    2200
    2500
    2500
    2000 (C)
    1800

    So PBP for Project A,


    PBP=A +

    PBP=3+

    B
    C

    |1800|
    2000

    PBP=3+0.9
    PBP=3.9Years

    Cumulative Cash flow ($)


    -9000
    -6800
    -4300
    -1800 (B)
    200
    2000

    Schedule of Cash flow of Project B


    Year
    0
    1
    2
    3
    4 (A)
    5

    Cash flow ($)


    -9000
    1500
    1500
    1500
    3500
    4000 (C)

    Cumulative Cash flow ($)


    -9000
    -7500
    -6000
    -4500
    -1000 (B)
    3000

    So PBP for Project A,


    PBP=A +

    B
    C

    |1000|

    PBP=4 +

    4000

    PBP=4 +0.25
    PBP=4.25 Years
    Although Bill would get more Cash in Project B after 5 years. But as his choices are on the basis
    of Payback Method, he will choose Project A because it has lower PBP.

    Net Present Value (NPV)


    Definition of NPV:
    The Net Present Value equals the present value of the cash inflows minus the present value of
    cash out flows with the cost of capital used as a discount rate.
    So NPV = Total discounted cash inflows Initial investment

    Equation to Solve NPV:


    n

    NPV =
    i=1

    Or,
    NPV =

    CF n
    (1+i)n

    CF 1
    1

    (1+ i)

    CF 0

    CF 2
    2

    (1+i)

    CF 3
    (1+i)3

    +CF 0

    Here,
    CFn = Cash inflow of year n
    i = Interest rate / Discount Rate / Cost of Capital
    CF0 = Initial Investment

    Steps in Calculating NPV:


    When cash inflows are mixed,
    1. Calculate cash inflows after tax.
    2. Discount them with rate of interest.
    3. Calculate NPV using the equation.

    Decision Criteria:
    NPV>0 = Accepted
    NPV<0 = Rejected
    Higher NPV = Accepted
    Lower NPV = Rejected
    Problem (C): Neil Corporation has two projects under consideration. Initial investment is
    $40,000 for each of them. The cash flows for each project are shown in the following table.
    The firm has a 16% cost of capital. What are the Net Present Value of 3 Projects? Which
    Project should be choosen?
    4

    Year
    1
    2
    3
    4
    5

    Project A
    7000
    10000
    13000
    16000
    19000

    Project B
    19000
    16000
    13000
    10000
    7000

    Project C
    13000
    13000
    13000
    13000
    13000

    Answer:
    Schedule of Cash Inflow of Project A
    Year
    n
    1
    2
    3
    4
    5

    Cash Inflow
    Discount factor
    CFn
    (1+i)n
    7000
    (1+0.16)1 = 1.16
    10000
    (1+0.16)2 = 1.3456
    13000
    (1+0.16)3 = 1.5608
    16000
    (1+0.16)4 = 1.8106
    19000
    (1+0.16)5 = 2.1003
    Total Discounted Cash Inflow

    Discounted Cash Inflow


    CFn / (1+i)n
    6034.48
    7431.63
    8328.55
    8836.66
    9046.15
    39677.47

    So, NPVA = 39,677.47 40,000 = -322.53


    Schedule of Cash Inflow of Project B
    Year
    n
    1
    2
    3
    4
    5

    Cash Inflow
    Discount factor
    CFn
    (1+i)n
    19000
    (1+0.16)1 = 1.16
    16000
    (1+0.16)2 = 1.3456
    13000
    (1+0.16)3 = 1.5608
    10000
    (1+0.16)4 = 1.8106
    7000
    (1+0.16)5 = 2.1003
    Total Discounted Cash Inflow

    Discounted Cash Inflow


    CFn / (1+i)n
    16379.31
    11890.61
    8328.55
    5523.03
    3332.86
    45454.36

    So, NPVB = 45454.36 40,000 = 5454.36


    Schedule of Cash Inflow of Project B
    Year
    n
    1
    2
    3
    4
    5

    Cash Inflow
    Discount factor
    CFn
    (1+i)n
    13000
    (1+0.16)1 = 1.16
    13000
    (1+0.16)2 = 1.3456
    13000
    (1+0.16)3 = 1.5608
    13000
    (1+0.16)4 = 1.8106
    13000
    (1+0.16)5 = 2.1003
    Total Discounted Cash Inflow

    So, NPVC = 42565.81-40000 = 2565.81


    Project B Should be chosen as it has highest NPV.
    5

    Discounted Cash Inflow


    CFn / (1+i)n
    11206.89
    9661.12
    8328.55
    7179.78
    6189.47
    42565.81

    Internal Rate of Return (IRR)

    Definition of Internal Rate of Return (IRR):


    Internal rate of return is defined as the discount rate which equals the aggregate present value
    of the net cash inflows with the aggregate present value of cash outflows of the project.

    Decision Criteria:
    i. IRR>Cost of Capital =Accepted.
    ii. IRR< Cost of Capital = Rejected.

    Calculation of IRR:
    1. When cash flows are even,

    i. Calculate discount factor by using following equation


    Discount Factor=

    Investment Required
    Net Annual Cash Flow

    ii. Compute the discount factor with PVIF table and calculate IRR.

    Problem (D):
    Kingsway Airways Can buy an additional Air Jet for $40000 that will provide $ 13000 of Annual Net
    Cash Inflow for 5 years. Calculate the IRR. If cost of capital for Kingsway Airways is 13% , what
    would be the project acceptance decision?
    Answer:
    We know that,

    Discount Factor =

    So , DF =

    Investment Required
    Net Annual Cash Flow

    40000
    13000

    So , DF =3.076
    So , PVIFA IRR ,5 years =3.076
    6

    So , PVIFA 18 , 5 years=3.127
    So , PVIFA 19 , 5 years=3.058
    So , PVIFA 20 , 5 years=3.2 .991
    So, IRR = 19% [ 3.058

    is the closest to 3.076]

    Project will be accepted because IRR (19%) is greater than Cost of Capital (14%)

    2. When cash flows are uneven / mixed,


    i. At first calculate Net annual cash inflow or Average annual cash inflow.
    ii. Imagine an IRR in which NPV may become 0 or near 0.
    iii. Conduct trial.
    iv. If NPV<0, then calculate NPV with higher IRR imagined. If NPV>0, then calculate NPV with
    lower IRR imagined.
    v. Do this trial and error till we get discount rate for both positive and negative NPV
    vi. Calculate actual IRR by using this calculation,

    IRR= A+

    C
    (B A)
    CD
    Where,
    A=Lower discount rate.
    B=Higher discount rate
    C=NPV of A.
    D=NPV of B.

    Problem (E):
    Bell Manufacturing is attempting to choose the better of two mutually exclusive projects. Their
    cost of capital is 15% and the relevant cash inflows for the projects are following:

    Project X
    $500000

    Initial Investment
    Year (n)
    1
    2
    3
    4
    5

    Project Y
    $325000
    Cash Inflows (CFn)

    100000
    120000
    150000
    190000
    250000

    140000
    120000
    95000
    70000
    50000

    Answer:
    Since net cash flows are uneven, we need to imagine discount rate for the calculation of NPV = 0.
    When Discount Factor is 16% then NPV for Project X:
    Annual Cash flow
    (500000)
    100000
    120000
    150000
    190000
    250000

    Discount Factor
    1.00
    0.862
    0.743
    0.641
    0.552
    0.476

    Discounted Annual Cash Flow


    (500000)
    86200
    89160
    96150
    104880
    119000
    NPV
    4610
    Since net present value is positive figure, we need to decrease discount rate. When Discount Factor
    is 15% then NPV for Project X:
    Annual Cash flow
    (500000)
    100000
    120000
    150000
    190000
    250000

    Discount Factor
    1
    0.869
    0.756
    0.658
    0.572
    0.497

    NPV
    Since we have both positive and negative net present value,

    IRR= A+

    C
    (B A)
    CD

    IRR=15+

    9250
    (1615)
    92504610

    IRR=15+ 0.667
    IRR=15.667

    Discounted Annual Cash Flow


    (500000)
    86900
    90720
    98700
    108680
    124250
    (9250)

    Since the IRRx is greater than Cost of Capital it can be accepted.


    Since net cash flows are uneven, we need to imagine discount rate for the calculation of NPV = 0.
    When Discount Factor is 18% then NPV for Project Y:
    Annual Cash flow
    (325000)
    140000
    120000
    95000
    70000
    50000

    Discount Factor
    1.00
    0.847
    0.718
    0.609
    0.516
    0.437

    Discounted Annual Cash Flow


    (325000)
    118580
    86160
    57855
    36120
    21850
    NPV
    4435
    Since net present value is positive figure, we need to decrease discount rate. When Discount Factor is
    17% then NPV for Project Y:
    Annual Cash flow
    (325000)
    140000
    120000
    95000
    70000
    50000

    Discount Factor
    1.00
    0.855
    0.731
    0.624
    0.534
    0.456

    NPV
    Since we have both positive and negative net present value,

    IRR= A+

    Discounted Annual Cash Flow


    (325000)
    119700
    87720
    59280
    37380
    22800
    (1880)

    C
    (B A)
    CD

    IRR=1 7+

    1880
    (1 81 7)
    18804 435

    IRR=17 +0. 298


    IRR=17.298

    Since Project Y has higher IRR, so Project Y will be chosen.

    10

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