Solving Problem Cases

1. An investment has an initial cost of P684,680. The cash flows over the 4-year life of
the investment are projected to be P263,279; P294,060; P227,604 and P174,356. If
the discount rate is infinite, what is the NPV? At what discount rate is the NPV just
equal to zero?
Answer:

NPV = -684,680 + 263,279 + 294,060 + 227,604 + 174,356

NPV = ₱274,619.00

If the required return is infinite, future cash flows have no value. Even if the cash flow in 1 year
is 1 trillion, at an infinite rate of interest, the value of this cash flow today is zero. So, if the
future cash flows have no value today, the NPV of the project is simply the cash flow today, so
at an infinite interest rate:

NPV = -₱684,680.00

2. Why is NPV method considered a superior method of evaluating the cash flows from
a project? What does the amount of NPV represent with respect to the firm's
shareholders?
Answer:
NPV is considered a superior method of evaluating the cash flows from a project
because it is able to rank projects of different sizes over varying periods of time to
determine the most profitable course of action. It is the discount rate that is used to
calculate a zero NPV for a series of cash flows. The Net Present Value Method Cash flow
from future years is discounted back to the present to find their worth. The NPV method
produces a dollar amount that indicates how much value the project will create for the
company. Stockholders can see clearly how much a project will contribute to their value.

3. An investment project has an annual cash inflows of P42,000; 53,000; 61,000 and
74,000, and a discount rate of 14%. What is the discounted payback period for these
cash flows if the initial cost is P70,000; P100,000; and P130,000.
Answer:
Value today of the project cash flows for the first 4 years:

Year number Solution Total

₱42,000.00
₱36,842.11
1 1.14
₱53,000.00
₱40,781.78
2 1.14^2
 ₱61,000.00
₱41,173.26
3 1.14^3
₱42,000.00
₱43,813.94
4 1.14^4

Discounted payback = 1 + (70,000. - 36,842.11) / 40,781.78

Discounted payback = 1.81 years

The discounted payback for an initial cost of 100,000.

2 + (100.000. - 36,842.11 -
  Discounted payback= 40,781.78)/41,173.26
  Discounted payback = 2.54 years

If the initial cost is 130,000., the discounted payback is:

3 + (130,000. - 36,842.11 - 40,781.78 - 41,173.26) /
Discounted payback = 43,813.94
Discounted payback = 3.26 years

4. A project that provides annual cash flows of P28,500 for 9 years costs P138,000
today. Is this a good project if the required return is 8%? What if it is 20%? At
what discount rate would you be indifferent between accepting the project and
rejecting it?
Answer:

NPV of this project at

8%
NPV = -138,000. + 28,500 (PVIFA 8%,9)
NPV = ₱40,036.31

NPV of this project at

20%  
NPV = -138,000. + 28,500. (PVIFA20%,9)
NPV = -₱23,117.45

To sum up, for the 8% we would accept the project because the NPV is
positive while in 20% we would reject the project because the NPV is
negative.
0 = -138,000 + 28,500 (PVIFA IRR,9)
IRR = 14.59%

5. What is the profitability index for the following set of cash flows if the relevant
discount rate is 10%? What if the discount rate is 15% or 22%?
 Year Cash Flows
0 (14,000)
1 7,300
2 6,900
3 5,700
Answer:
Profitability index at a required return of 10%
 
PI= [7,300 / 1.1 + 6,900. / 1.1^2 + 5,700. / 1.1^3] / 14,000.
PI= ₱1.19

Profitability index at a required return of 15%

 
PI= [7,300 / 1.15 + 6,900. / 1.15^2 + 5,700. / 1.15^3] / 14,000.
PI= ₱1.09

Profitability index at a required return of 22%

 
PI= [7,300 / 1.22 + 6,900. / 1.22^2 + 5,700. / 1.22^3] / 14,000.
PI= ₱0.98