You are a Financial Analyst for Amazon Electronics Company. The director of capital budgeting has asked you to analyze two proposed capital investment projects P and Q. Each project has a cost of Rs. 10,000, and the cost of capital for each project is 12 percent. The projects’ expected net cash flows are as follows:
Expected Net Cash Flows
Year Project P Project Q
0 (Rs.10,000) (Rs. 10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s payback period, net present value (NPV), and internal rate of return (IRR).
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. How might a change in the cost of capital, produce a conflict between the NPV and IRR rankings of these two projects? Would this conflict exist if k were 5 percent?
e. Why does the conflict exist?
Solution. (a)
CALCULATION OF PAYBACK PERIOD
Project P
Rs. 10000 is covered in 3rd year, therefore, payback period is:
= 2 years + (12 months/3000) x 500
= 2 year and 2 months
Project Q
Rs. 10000 is covered in 3rd year, therefore, payback period is:
= 2 years + (12 months x 3500) x 3000
= 2 year and 10.28 months
or 2 years, 10 months and (.28 x 30 days)*
or 2 years, 10 months and 8 days
*.28 month can be converted into days by multiplying .28 month with days in month. Therefore .28 is multiplied with 30 (days in month) to convert it in days.
CALCULATION OF NET PRESENT VALUE
Year | Amount | Discounting Factor | Present Value | ||
Project P | Project Q | Project P | Project Q | ||
0 | (10000) | (10000) | 1 | (10000) | (10000) |
1 | 6500 | 3500 | .893 | 5804.5 | 3125.5 |
2 | 3000 | 3500 | .797 | 2391 | 2789.5 |
3 | 3000 | 3500 | .712 | 2136 | 2492 |
4 | 1000 | 3500 | .636 | 636 | 2226 |
Net Present Value | 967.5 | 633 | |||
CALCULATION OF INTERNAL RATE OF RETURN
CALCULATION OF NET PRESENT VALUE
(AT DISCOUNTING FACTOR 8 %)
Year | Amount | Discounting Factor | Present Value | ||
Project P | Project Q | Project P | Project Q | ||
0 | (10000) | (10000) | 1 | -10000 | -10000 |
1 | 6500 | 3500 | .926 | 6019 | 3241 |
2 | 3000 | 3500 | .857 | 2571 | 2999.5 |
3 | 3000 | 3500 | .794 | 2382 | 2779 |
4 | 1000 | 3500 | .735 | 735 | 2572.5 |
Net Present Value | 1707 | 1592 | |||
CALCULATION OF NET PRESENT VALUE
(AT DISCOUNTING FACTOR 14%)
Year | Amount | Discounting Factor | Present Value | ||
Project P | Project Q | Project P | Project Q | ||
0 | (10000) | (10000) | 1 | -10000 | -10000 |
1 | 6500 | 3500 | 0.877 | 5700.5 | 3069.5 |
2 | 3000 | 3500 | 0.769 | 2307 | 2691.5 |
3 | 3000 | 3500 | 0.675 | 2025 | 2362.5 |
4 | 1000 | 3500 | 0.592 | 592 | 2072 |
Net Present Value | 624.5 | 195.5 | |||
Internal Rate of Return
Project P
8% + 6% x (1707 / 1082.5)
= 8% + 9.46%
= 17.46%
Project Q
8% + 6% x (1592 / 1396.5)
= 8% + 6.84%
= 14.84%
b) If projects are independent then company can accept both the projects because both the projects have positive NPV.
c) If projects are mutual exclusive then company should accept Project P because it has more NPV.
d) Calculation of NPV when cost of capital is 5%
| Year | Amount | Discounting Factor | Present Value | ||
| | Project P | Project Q | Project P | Project Q | |
| 0 | -10000 | -10000 | 1 | -10000 | -10000 |
| 1 | 6500 | 3500 | 0.952 | 6188 | 3332 |
| 2 | 3000 | 3500 | 0.907 | 2721 | 3174.5 |
| 3 | 3000 | 3500 | 0.864 | 2592 | 3024 |
| 4 | 1000 | 3500 | 0.823 | 823 | 2880.5 |
| Net Present Value | | | 2324 | 2411 | |
Conclusion: When cost of capital is taken 5% then the NPV of both the projects is positive but project P has lower NPV then the project Q, which shows that if both projects are mutual exclusive then project Q should be accepted.
But, if decision is taken by considering the IRR then project P should be accepted because project P has higher IRR (calculated in part A).
e) The conflict arises due to reinvestment rate. The basic presumption behind the two is different.
1. In case of NPV, it is assumed that intermediate cash inflows are reinvested at cut off rate.
2. In case of IRR, it is assumed that intermediate cash inflow is reinvested at IRR rate.
That is why NPV is more reliable. Because it is possible to reinvest at cut off rate not at IRR rate, which is very high at different times.
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