QUESTION 3: NET PRESENT VALUE

Solution,

Formula Of Net Present Value (NPV)

NPV =Present Value of Cash Inflows(PVCI )−Present Value of CashOutflows (PV C O)where ,
Present Value of Cash Inflow=Equal Annual Cash inflow × Present Value Interest factor of Annuity (PVIFA)
Present Value of CashOut flows=Cash outflow × Present Value Interest facto r
Here, PVCO = Initial Investment

Calculation of Net Present Value

Calculation of PVCI
Particulars Project a Project b Project c
Equal Annual Cash inflo w 2,000 3,000 5,000
PVIFA(14%,20years) 6.6231 6.6231 6.6231
PVCI 13,246.2 19,869.3 33,115.5
Calculation of PVCO
Here, The only cash outflow is Initial Investment. So, PVCO=Initial Investment
PVCO 10,000 25,000 30,000
Calculation of NPV
N PV 3,246.2 (5,130.7) 3,115.5

Decision Criteria : Select the Projects having positive NPV. If the Projects are mutually exclusive, Select
the Project having highest positive NPV.

Decision : Project A and Project C can be accepted. If the Projects are mutually exclusive, Only Project A
is selected. However, Project B cannot be accepted.
QUESTION 4: PAYBACK AND NPV
a) Calculation of Payback Period

Formula/concept used:

Payback Period: It is the time period within which the initial investment in the project is returned back to
the investors. In order to calculate the payback period, the cumulative cash inflow is compared with the
initial investment. The period in which the cumulative cash inflow becomes at least equal to the initial
investment is the payback period.

a) Calculation of Payback Period

Project A Project B Project C
Initial Investment 40,000 40,000 40,000
Year Cash Cumulative Cash Cumulative Cash Cumulative
inflow Cash inflow Cash inflow Cash
inflow inflow inflow
1. 13,000 13,000 7,000 7,000 19,000 19,000
2. 13,000 26,000 10,000 17,000 16,000 35,000
3. 13,000 39,000 13,000 30,000 13,000 48,000
4. 13,000 52,000 16,000 46,000 10,000 58,000
5. 13,000 65,000 19,000 65,000 7,000 65,000
Payback year 4
th
4
th
3
rd

Decision Criteria: Select the project having the least payback period.

Decision: Project C is preferred according to this method.

b) Calculation of Net Present Value :

Formula/concept used:

NPV =Present Value of Cash Inflows(PVCI )−Present Value of CashOutflows (PVCO)where ,

Present Value of Cash Inflow=∑ (Annual cash Flow × Present Value Interest Factor ( PVIF ) )

PV = Present Value = Annual cash Flow × Present Value Interest Factor ( PVIF )

Present Value of CashOut flows=Cash outflow × Present Value Interest facto r

Here , PVCO=Initial Investment
 Calculation of PVCI
Particulars Project A Project B Project C
Years Cash flow PVIF@16% PV Cash flow PVIF@16% PV Cash flow PVIF@16% PV
1. 13,000 0.8621 11,207.3 7,000 0.8621 6,034.7 19,000 0.8621 16,379.9
2. 13,000 0.7432 9,661.6 10,000 0.7432 7,432 16,000 0.7432 11,891.2
3. 13,000 0.6407 8,329.1 13,000 0.6407 8,329.1 13,000 0.6407 8,329.1
4. 13,000 0.5523 7179.9 16,000 0.5523 8836.8 10,000 0.5523 5,523
5. 13,000 0.4761 6189.3 19,000 0.4761 9045.9 7,000 0.4761 3,332.7
PVCI 42,567.2 39,678.5 45,455.9
Calculation of PVCO
PVCO 40,000 40,000 40,000
Calculation of NPV
NPV 2,567.2 (321.5) 5,455.9

Decision Criteria : Select the Projects having positive NPV. If the Projects are mutually exclusive, Select
the Project having highest positive NPV.

Decision : Project C is selected according to this method.

c) Comment on the findings on part a and part b :

As per part a, Project C has the least payback period and as per part b, Project C has the highest NPV.
Project B has Negative NPV. So, It can’t be selected. Thus, I recommend the Project C.

QUESTION 5: INTERNAL RATE OF RETURN – TRIAL & ERROR

 a) Calculation of the present value interest factor(PVIF) for each amount, in
each year for both the 12% and 14% scenarios.

Year PVIF@12% PVIF@14%

1. 0.8929 0.8772
2. 0.7972 0.7695
3. 0.7118 0.6750
4. 0.6355 0.5921

b) Calculation of the present value for each amount in each year

for both the 12% and 14% interest rate scenarios.

Year Cash Inflow PVIF@12% PV PVIF@14% PV

1. 5,400 0.8929 4,821.66 0.8772 4,736.88
2. 8,000 0.7972 6,377.6 0.7695 6,156
3. 10,000 0.7118 7,118 0.6750 6,750
4. 12,000 0.6355 7,626 0.5921 7,105.2

c) Calculation of the sum of the present values and the NPV for
both the 12% and 14% scenarios.

Particulars for 12% scenarios for 14% scenarios

sum of the present values 25,943.26 24,748.08
Less Initial Investment 25,000 25,000
NPV 943.26 (251.92)

d) Calculation of the internal rate of return using the trial and error method
 The NPV @ 12% is positive whereas the NPV @ 14% is negative, Thus, the Internal Rate Of
Return lies Between 12% and 14%.
Calculating NPV @ 13%

Particulars Cash Flows PVIF@13% PV

Year 1 5,400 0.8850 4,779
Year 2 8,000 0.7831 6,264.8
Year 3 10,000 0.6931 6,931
Year 4 12,000 0.6133 7,359.6
sum of the present values 25,334.4
Less Initial Investment 25,000
NPV 334.4

Thus, IRR lies between 13% and 14 %.

Now, using Interpolation technique in order to calculate IRR
14 %−13 %
IRR=13 %+ × ( 334.4−0 ) IRR=13 %+0.57 %IRR=13.57 %
334.4−(−251.92 )

QUESTION 6: INTERNAL RATE OF RETURN – TRIAL & ERROR

Solution,

Formula/Concept used:
IRR is the discounting rate at which NPV of the project is equal to zero.

Calculation of IRR for Project A

Particulars For 12% For 10%
Annual cash inflow 1627.45 1627.45
life 10 years 10 years
PVIFA 5.6502 6.1446
PV 9,192.88 10,000
Less Initial Investment 10,000 10,000
NPV (807.12) 0

At 10% discounting rate, NPV of Project A is zero. Therefore, The Internal rate of Return is 10%.

Calculation of IRR for Project B

 Particulars For 20% FOR 24%
Annual cash inflow 13,425,000 13,425,000
Life of project 6 years 6 years
PVIFA 3.3255 3.0205
PV 44,644,837.5 40,550,212.5
Less Initial Investment 40,550,000 40,550,000
NPV 14,645,545 212.5

Considering the 212.5 as a round off error, We consider the IRR for the Project B to be 24%.

Decision Criteria:

Select the project having highest IRR provided that the IRR of the selected project is more the cost of
capital.

Decision:

The IRR of Project A is less than the cost of capital. The cost of capital is 12%. However the IRR of Project
B is more than the cost of capital. So, Select the project B.

QUESTION 7: COMPARING PAYBACK PERIOD, NPV AND IRR

Here is an explanation of the advantages and disadvantages between the following capital budgeting
methods: payback period, net present value (NPV) and internal rate of return (IRR)

Advantages of Payback Period:

 It is easy to calculate and simple to understand.

Disadvantages of Payback Period:

 It ignores time value of money.

 It ignores all cash Inflows after payback period.

Advantages of Net Present Value (NPV):

 It recognizes time value of money.

 It is the best method for selection of mutually exclusive projects.
  It takes into account all the years cash flows arising out of the project over its useful life.

Disadvantages of Net Present Value (NPV):

 It is difficult to calculate and understand.

 This method requires estimation of cash flows which is very difficult due to uncertainities
existing in the business world.
 It needs discounting rate for calculation of present values.

Advantages of Internal Rate of Return:

 It considers the time value of money.

 It also takes into account the total cash flows generated by any project over the life of the
project.

Disadvantages of Internal Rate of Return:

 It involves lengthy and complicated computational method.

 It assumes that all Intermediate cashflows are reinvested at Internal Rate of Return.