problem 1

The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000 and
$10,000 in four years. Using present value index method, appraise profitability of the proposed
investment assuming a 10% rate of discount.

Solution

Calculation of present value and profitability index

Year Cash Inflows Present Value Factor Present Value

$ @10% $

1 20,000 .909 18,180

2 15,000 .826 12,390

3 25,000 .751 18,775

4 10,000 .683 6,830

56,175

Total present value = $56,175

Less: intial Outlay = $50,000

Net present value= $6,175

Profitability Index (gross) = Present value of cash inflows / intial cash outflow

= 56,175 / 50,000

= 1.1235

As the P.I. is higher than 1, the proposal can be accepted.

Net Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = .1235

N.P.I. = 1.1235 – 1 = 0.1235

As the net profitability index is positive, the proposal can be accepted.

Problem 2

A company is considered the purchase of a machine. the machines A and B are available for $80,000
each. Earnings after taxation are as:

Year Machine A Machine B

$ $

1 24,000 8,000

2 32,000 24,000

3 40,000 32,000

4 24,000 48,000

5 16,000 32,000

Evaluate the two alternatives according to (a). Payback Method, (b). Rate of Return Method and (c).
Net Present Value Method (A discount rate of 10% is to be used).

Solution

(a). Payback Method

24,000 of 40,000 = 2 years and 7.2 month

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method Machine, A will be preferred.

(b). Rate of return on Investment Method

Particular Machine A Machine B

 Total Cash Flows 1,36,000 1,44,000

Average Annual Cash Flows 1,36,000 / 5 = $27,000 1,44,000 / 5 = $28,800

Annual Depreciation 80,000 / 5 = $16,000 80,000 / 5 = $16,000

Annual Net Savings 27,200 – 16,000 = $11,200 28,800 – 16,000 = $12,800

Average Investment 80,000 / 2 = $40,000 80,000 / 2 = $40,000

ROI = (Annual Net Savings / Average

(11,200 / 40,000) x 100 (12,800 / 40,000) x 100
Investments) x 100

= 28% = 32%

According to rate of return on investment method machine B will be preferred due to higher rate of
return on investment.

(c). Net Present Value Method

Calculation of Present Value of Cash Flows

Year Discount Factor Machine A Machine B

(at 10%) Cash Flows ($) P.V ($) Cash Flows ($) P.V

1 .909 24,000 21,816 8,000 7,2

2 .826 32,000 26,432 24,000 19,

3 .751 40,000 30,040 32,000 24,

4 .683 24,000 16,392 48,000 32,

5 .621 16,000 9,936 32,000 19,

 1,36,000 1,04,616 1,44,000 1,0

Net Present Valu = Present Value – Investment

Net Present Value of Machine A: $1,04,616 – $80,000 = $24,616

Net Present Value of Machine B: $1,03,784 – 80,000 = $23,784

Accroding to Net Present Value Method, Machine A will be preferred as its Net Present Value is higher
than that of Machine B.

Problem 3

A business enterprise can make either of two investments at the beginning of 2015. assuming
required rate of return in 10% p.a. evaluate the investment proposals under:

(a). Return on investment

(b). Payback Period

(c). Discounted payback period

(d). profitability index

The forecast particular are given below:

Proposal A Proposal B

Cost of Investment $20,000 28,000

Life 4 years 5 years

Scrap Value Nil Nil

Net Income (After depreciation and tax):

End of 2015 $500 Nil

End of 2016 $2,000 $3,400

End of 2017 $3,500 $3,400

 End of 2018 $2,500 $3,400

End of 2019 Nil $3,400

It is estimated that each of the alternative projects will require an additional working capital of $2,000
which will be received back in full after the expiry of each project life. Depreciation is provided under
the straight-line method. The present value of $1 to be received at the end of each year, at 10% p.a. is
given below:

Year 1 2 3 4 5

P.V. .91 .83 .75 .68 .62

Solution

Calculation of Profit after Tax

Year Proposal A $20,000 Proposal B $28,000

Net Income Dep. Cash Inflow Net Income Dep. Ca

$ $ $ $ $ $

2015 500 5,000 5,500 – 5,600 5,

2016 2,000 5,000 7,000 3,400 5,600 9,

2017 3,500 5,000 8,500 3,400 5,600 9,

2018 2,500 5,000 7,500 3,400 5,600 9,

2019 – – – 3,400 5,600 9,

 Total 8,500 20,000 28,500 13,600 28,000 41

(a). Return on Investment

Proposal A Proposal B

Investment 20,000 + 2,000 = 22,000 28,000 + 2,000 = 30,000

Life 4 years 5 years

Total Net income $8,500 $13,600

Average Return ($) 8,500 / 4 = 2,125 13,600 / 5 = 2,720

Average investment ($) (22,000 + 2,000) / 2 = 12,000 (30,000 + 2,000) / 2 = 16,000

Average return on Average (2,125 / 12,000) x 100 (2,720 / 16,000) x 100

Investment ($) = 17.7% = 17%

(b). Payback Period

Proposal A Cash Inflow ($)

2015 5,500

2016 7,000

2017 7,500 (7,500 / 8,500 = 0.9)

20,000

Payback Period = 2.9 years

Proposal B Cash inflow

 $

2015 5,600

2016 9,000

2017 9,000

2018 4,400 (4,400 / 9,000 = 0.5)

Payback period = 3.5 years

(c). Discounted Payback Period

Proposal A Proposal B

P.V. of cash inflow P.V. of cash inflow

Year $ Year $

2015 5,005 2015 5,096

2016 5,810 2016 7,470

2017 6,375 2017 6,750

2018 2,810 (2,810 / 5,100 = 0.5) 2018 6,120

2019 2,564 (2,564 / 5,580 = 0.4)

20,000 28,000

Discounted Payback Period = 3.5 years Discounted Payback Period = 4.4 years

(d). Profitability Index method

 Proposal A Proposal B

(22,290 / 20,000) x 100 (31,016 / 28,000) x 100

Gross Profitability Index
= 111.45% = 111.08%

(2,290 / 20,000) x 100 (3,016 / 28,000) x 100

Net Profitability Index
= 11.45% = 10.8%