ASSIGNMENT

On
Financial Management
Assignment No. 1

Submitted To:
Prof. Ayub Abbas
Submitted By:
Abdullah Ghauri
Registration No.
M1F17BBAM0061

Program: BBA (HONS)

Semester: 6th

University Of Central Punjab

 Capital Budgeting
Definition:

Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line
or other projects.
Capital budgeting is set of techniques used to decide which investments to make in projects.
There are a number of capital budgeting techniques available, which include the following:

Types:
• Payback Period measures the time in which the initial cash flow is returned by the project. Cash
flows are not discounted. Lower payback period is preferred.

• Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows.
Higher NPV is preferred and an investment is only viable if its NPV is positive.

• Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total
net income divided by initial or average investment. Net income is not discounted.

• Internal Rate of Return (IRR) is the discount rate at which net present value of the project
becomes zero. Higher IRR should be preferred.

• Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial
investment required for the project.

• Discounted payback . Determine the amount of time it will take for the discounted cash flows
from a proposal to earn back the initial investment. If the period is sufficiently short, then
accept the proposal.
 Types of Capital Budgeting
Accounting Rate of Return
Pros
• Accounting rate of return is simple and straightforward to compute.
• It focuses on accounting net operating income. Creditors and investors use accounting net operating
income to evaluate the performance of management.
• This method gives a clear picture of the profitability of a project.
• This method is useful to measure current performance of the firm.
• This method gives a clear picture of the profitability of a project

Cons
• Accounting rate of return method does not take into account the time value of money. Under this
method a dollar in hand and a dollar to be received in future are considered of equal value.
• Cash is very important for every business. If an investment quickly generates cash inflow, the
company can invest in other profitable projects. But accounting rate of return method focus on
accounting net operating income rather than cash flow.
• The accounting rate of return does not remain constant over useful life for many projects. A project
may, therefore, look desirable in one period but undesirable in another period.

Modified Internal Rate of Return

Pros
• Tells whether an investment increases the firm's value
• Considers all cash flows of the project
• Considers the time value of money
• Considers the riskiness of future cash flows (through the cost of capital in the decision rule)

Cons
• Requires an estimate of the cost of capital in order to make a decision
• May not give the value-maximizing decision when used to compare mutually exclusive projects
• May not give the value-maximizing decision
• when used to choose projects when there is capital rationing

Internal Rate of Return

Pros
• Tells whether an investment increases the firm's value
• Considers all cash flows of the project
 • Considers the time value of money
• Considers the risk of future cash flows (through the cost of capital)
• Useful in ranking and selecting projects when capital is rationed

Cons
• Requires an estimate of the cost of capital in order to calculate the profitability index
• May not give the correct decision when used to compare mutually exclusive projects.

Net Present Value

Pros
• Tells whether the investment will increase he firm's value
• Considers all the cash flows.
• Considers the time value of money
• Considers the risk of future cash flows (through the cost of capital)

Cons
• Requires an estimate of the cost of capital in order to calculate the net present value.
• Expressed in terms of dollars, not as a percentage.

Discounted Payback Period

Pros
• Considers the time value of money
• Considers the riskiness of the project's cash flows (through the cost of capital)

Cons

• No concrete decision criteria that indicate whether the investment increases the firm's value
• Requires an estimate of the cost of capital in order to calculate the payback
• Ignores cash flows beyond the discounted payback period
 Payback Period

Pros
• Simple to compute
• Provides some information on the risk of the investment
• Provides a crude measure of liquidity

Cons
• No concrete decision criteria to indicate whether an investment increases the firm's value
• Ignores cash flows beyond the payback period
• Ignores the time value of money
• Ignores the risk of future cash flows
•

Modified Internal Rate of Return

Pros
• Tells whether an investment increases the firm's value
• Considers all cash flows of the project
• Considers the time value of money
• Considers the riskiness of future cash flows (through the cost of capital in the decision rule)

Cons
• Requires an estimate of the cost of capital in order to make a decision
• May not give the value-maximizing decision when used to compare mutually exclusive projects
• May not give the value-maximizing decision
• when used to choose projects when there is capital rationing
Question No. 1
Fitch Industries is in the process of choosing the better of two equal-risk, mutually
exclusive capital expenditure projects—M and N. The relevant cash flows for each
project are shown in the following table. The firm’s cost of capital is 14%.

a. Calculate each project’s payback period.

b. Calculate the net present value (NPV) for each project.
c. Calculate the Profitability index
d. Calculate the internal rate of return (IRR) for each project.
e. Summarize the preferences dictated by each measure you calculated, and indicate
which project you would recommend. Explain why.

Solution
Part (a)
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 $28,500
Project M payback period = = = 2.85 years
𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 $10,000

Project N payback period

Years Cash flow Cumulative cash flow
1 $11,000 $11,000
2 10,000 21,000
3 9,000 30,000
4 8,000 38,000
 $27,000−$21,000
= 2+
$9,𝑜𝑜𝑜
6,𝑜𝑜𝑜
2+
9,𝑜𝑜𝑜

= 2.67 years

Part (b)
Project M net present value (NPV)
NPV= present value of cash flow - initial investment
= 10,000 (PVIFA 14% 4 years) – 28,500
[ (1−(1+0.14)−4 ]
= 10,000 − 28,500
0.14
= 10,000 (2.9137) – 25,500
= 29,137 ₋ 28,500
NPV = $637
Project N net present value (NPV)
Years Cash flows PVIF 14% (1+i)-n Present value
0 (27,000) 1 (27,000)
1 11,000 0.8771 9648.1
2 10,000 0.7694 7694
3 9,000 0.6749 6074.1
4 8,000 0.5920 4736

NPV= present value of cash flow - initial investment

28,152.2 – 27000
NPV = $1152.2
Part (c)
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
Project M profitability index =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
$29137
=
$28,500

Profitability index = 1.0223

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
Project N profitability index =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
$28152.2
=
$27,000

Profitability index = 1.0426

Part (d)
Project M internal rate of return (IRR)
Assume that the rate of interest is 15%
NPV = present value of cash flow – initial investment
=10,000 (PVIFA 15% 4 years) – 28,500
[ (1−(1+0.15)−4 ]
=10,000 − 28,500
0.15

=10,000 (2.8549) – 28,500

=28,549 – 28,500
NPV= 49

Assume that the rate of interest is 20%

NPV = present value of cash flow – initial investment
=10,000 (PVIFA 20% 4 years) – 28,500
[ (1−(1+0.20)−4 ]
=10,000 − 28,500
0.20
=10,000 (2.5887) – 28,500
=25,887 – 28,500
NPV= (2613)

❖ A 15% NPV = 49
❖ B 20% NPV = (2613)

NPVA
IRR =𝐴 + 𝐵−𝐴
𝑁𝑃𝑉𝐴−𝑁𝑃𝑉𝐵
49
=15 + (20 − 15)
49−(−2613)
49
=15 + (5)
2662

=15 + 0.0184 (5)

=15 + 0.092
IRR = 15.09%

Project N internal rate of return (IRR)

Assume that the rate of interest is 15%
Years Cash flows PVIF 15% (1+i) Present value
0 (27,000) 1 (27,000)
1 11,000 0.8695 9564.5
2 10,000 0.7561 7561
3 9,000 0.6575 5917.5
4 8,000 0.5717 4573.6

NPV = present value of cash flow – initial investment

= 27,616.6 – 27,000
NPV = 616.6
Assume that the rate of interest is 20%
Years Cash flows PVIF 20% (1+i) Present value
0 (27,000) 1 (27,000)
1 11,000 0.8333 9166.3
2 10,000 0.6944 6944
3 9,000 0.5787 5208.3
4 8,000 0.4822 3857.6

NPV = present value of cash flow – initial investment

= 25176.2 – 27,000
NPV = (1823.8)

❖ A 15% NPV = 616.6

❖ B 20% NPV = (1823.8)

NPVA
IRR =𝐴 + 𝐵−𝐴
𝑁𝑃𝑉𝐴−𝑁𝑃𝑉𝐵
616.6
=15 + (20 − 15)
616.6−(−1823.8)
616.6
=15 + (5)
2440.4

=15 + 0.2526 (5)

=15 + 1.263
IRR = 16.26%

d) Summarize the preferences dictated by each measure you calculated, and indicate
which project you would recommend. Explain why.

M N
Payback Period 2.85 yrs. 2.67 yrs.
NPV $637 $1,152
IRR 15.09% 16.26%
Project N would be recommended due to the following factors:
(1) higher NPV
(2) shorter payback period
(3) higher IRR.