Spring 2012 Semester

Financial Management (MGT201)

Assignment 1

Marks 20

CAPITAL BUDGETING
Case:Suppose, you have been appointed as a financial analyst at a company
named ABC Incorporation, which requires you to think over and analyze
two projects so that a wise investment decision can be made for future
expansion of the business. The details of both projects are as follows:
Project 1 requires an initial investment of Rs. 700,000. Expected cash inflows
of the project for next five years are Rs. 162,000, Rs. 173,600, Rs. 185,550, Rs.
189,850 and Rs. 192,980. Required rate of return for this investment is 8%.
Project 2 requires an initial investment of Rs. 830,000. Expected cash inflows
of the project for next five years are Rs. 163,000, Rs. 167,456, Rs 172,850, Rs.
177,940 and Rs. 181,550. Required rate of return for this project is 9%.
Required:
Analyze the feasibility of project 1 by using Net Present Value
method.
(Marks 7)

Analyze the feasibility of project 2 with the help of Profitability

Index.
(Marks 8)

Calculate Payback Period of each project and analyze which project

will recover the invested money in less time.
(Marks 5)

(Show complete calculations and provide all formulas as they carry marks)

Solution:

A).

NPV = -IO + CFt / (1+i) t

= -700, 000 + 162,000/ (1.08) 1 + 173,600/ (1.08) 2 + 185,550 / (1.08) 3 +
189,850 / (1.08) 4 +192,980/ (1.08) 5

= -700,000 + 162,000/ 1.08 + 173,600/ 1.1664 + 185,550 / 1.2597 +

189,850 / 1.3605 + 192,980/1.4693
= -700, 000 + 150,000+148,834+147,296+139,545+131,339
= 17,014 (Rupees)
Project is feasible because NPV is positive.

B).

Initial investment ICO

i
CF 1
CF 2
CF 3
CF 4
CF 5
(1+ k)

Rs. 830,000
0.09
Rs. 163,000
Rs. 167,456
Rs. 172,850
Rs. 177,940
Rs. 181,550
1.09

PI = {CF 1 / (1+i) 1 + CF 2 / (1+i) 2 + . + CF n / (1+i) n}/ ICO

= CF1/ (1+i) 1

= 163,000/ 1.09

= Rs. 149,541

= CF2/ (1+i) 2

= 167,456/ 1.1881

= Rs. 140,944

= CF3/ (1+i) 3

= 172,850/ 1.2950

= Rs. 133,472

= CF4/ (1+i) 4
= CF5/ (1+i) 5

= 177,940/ 1.4116
= 181,550/ 1.5386

= Rs. 126,057
= Rs. 117995

{CF 1 / (1+i) 1 + CF 2 / (1+i) 2 + . + CF n / (1+i) n}

= Rs. 668,010

{CF 1 / (1+i) 1 + CF 2 / (1+i) 2 + . + CF n / (1+i) n}/ ICO

0.80

Decision: If profitability index is equal to or greater than 1.00 the investment proposal is
acceptable. Here proposal is not acceptable as PI is less than 1.

C).

Payback period =
a + (b-c)/ d
Where,
a = number of years before full recovery of net investment
b = initial outlay
c = cumulative inflows that does not exceed the initial outlay
d = following years cash inflow

Project 1

Year
0
1
2
3
4
5

Cash flows
Cumulative inflows
(Rs.)
(Rs.)
-700,000
162,000
162,000
173,600
335,600
185,550
521,150
189,850
711,000
192,980
903,980

= 3 + (700,000 521,150) / 189,850

= 3.94 years
Project 2
Year
0
1
2
3
4
5

Cash flows
Cumulative inflows
(Rs.)
(Rs.)
-830,000
163,000
163,000
167,456
330,456
172,850
503,306
177,940
681,246
181,550
862,796

= 4 + (830,000 681,246) / 181,550

= 4.82 years
Project 1 will recover invested money in less time period.