Blog: Acc501 Assignment No. 2 solution

Virtual University Of Pakistan

ACC501 Spring Semester 2011

“Business Finance (ACC501)”

Assignment No. 2 Total Marks: 15

Question

A Volvo enterprise is considering two mutually exclusive projects “Project A” and “Project B” with an initial investment Rs. 205,000. Board of directors of Volvo has set 4 years as pay back period and required return is set at 7%. The cash inflows associated with two projects are as follows:

Keep in to consideration given information. You are required to calculate the following:

1. Calculate Payback period for each project.

2. Calculate NPV for each project.

3. Calculate PI for each project.

4. Rank the projects by each of the used techniques. Also give justification for this ranking.

NOTE:

It is necessary to show formula and complete working. Marks will be deducted if instruction will not be followed.

Assignment Schedule

Opening Date and Time

9th June, 2011 At 12:01 A.M. (Mid-Night)

Due Date and Time

15th June, 2011 At 11:59 P.M. (Mid-Night)


Solution:


In the project “A” the initial investment is Rs. 205,000 and the cash flows are Rs. 80,000, 50,000, 45,000, 450000 & 45,000 in five years.
The cash flows over 5 years are Rs. 240,000, so the project pays back sometime in the fifth year.

Year Paid back Remaining
1 60,000 145,000
2 50,000 95,000
3 40,000 55,000
4 50,000 5,000 for 5th year
5 40,000

Note that this Rs. 5,000 is 5,000/40,000 = 5/40 of the fifth year’s cash flows.
Spreading this ratio over 365 days:
5/40 x 365 = 45 days (approx)
Which means, that the payback period is just over 4 year and 1.5 months

In the project “B” the initial investment is Rs. 205,000 and the cash flows are Rs. 60,000, 50,000, 40,000, 50,000 & 40,000 in all five years.
The cash flows over 5 years are Rs. 265,000, so the project pays back sometime in the fourth year.

Year Paid back Remaining
1 80,000 125,000
2 50,000 75,000
3 45,000 30,000 to be paid in 4th year
4 45,000
5 45,000

This Rs. 30,000 is 30,000/45,000 = 2/3 of the fourth year’s cash flows.
Spreading this ratio over 12 months:
2/3 x 12 = 8 months
Which means, that the payback period is just over 3 year and 8 months


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Consider the following investments:
Year Long Short
0 -$250 -$250
1 100 100
2 100 200
3 100 0
4 100 0
•The payback on long is
2 + $50/100 = 2.5 years
•The payback on short is
1 + $150/200 = 1.75 years
•With a cutoff of two years, short is accepted and long is not
•Is payback period rule giving us the right decisions?
•Suppose, we require a 15% return on this kind of investment; NPV for the two investments is:
NPV (Short) =
-$250 +100/1.15 + 200/1.152 = -$11.81
NPV (Long) =
-$250 + 100 x (1 – 1/1.154)/.15 = $35.5
•We can see that the NPV of shorter term investment is negative, which would diminish the value of shareholders’ equity.
•Longer term investment increases share value
•Whenever we have mutually exclusive investments, we shouldn't rank them based on their returns
•In other words, IRR can be misleading in determining the best investment
•Instead we should look at their relative NPVs to avoid possibility of choosing incorrectly


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Assignemt#2
Question: 1

PBP A B

1 60000 205000 1 80,000 205000
2 50000 145000 2 50,000 125000
3 4000 95000 3 45000 75000
4 5000 55000 4
45000 30,000
5 40,000 5000

4.125%
3.66 years


(2) Calculate NPV for each project

205000 221590
- 199060 - 205000
5940 16590

A B
0.935 56100 74800
0.873 43650 43650
0.816 32640 36720
0.763 38150 34335
0.713 28520 32085
Total 199060 221590



(3) Calculate PI for each project

A B
199060 = 221590
205000 205,000

0.97102 1.08093


(4) Rank the project by each of the used techniques. Also give justification for this ranking.


B project is acceptable in all techniques.

Pay

A It has shorter payback period.
B It has positive NPV
C It has men then 1. Projects them