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COURSE: LEVEL: 300 FINANCIAL 2010 MANAGEMENT 23rd October (UFIN100) 2010
CAPITAL BUDGETING TECHNIQUES QUESTION 1: The information below relates to an investment project with a project cost of GH 10,050.
YEAR CASH FLOW 0 (now) - 10,050 1 5,000 2 4,000 3 3,000 4 2,000 5 1,000
A) What is the payback period for this investment project? B) If the discount or required rate of return is 13%, what is the net present value (NPV)? C) What is the profitability index (PI) of this investment project? SOLUTION (a): The payback period formula is: Payback
project _ cos t total _ cash _ flows _ before _ payback cash _ flow _ in _ year _ of _ payback
period
year
before
payback
Year before payback is the year before total cash flows (excluding project cost) exceeds project cost Total cash flow in year of payback = . Note that the project cost is GH 10,050. However, to find the year before payback, add all the cash flows from year 1 till it exceeds the project cost, GH 10,050. This means that add GH 5,000 + GH 4,000 + GH 3,000 = GH 12,000. Therefore, the year of payback is between the second and third year. In the second year, total cash flows are GH 5,000 + GH 4,000 = GH 9,000. This is less than the project cost of GH 10,050. In the third year the total cash flows are GH 12,000 (=GH 5,000 + GH 4,000 + GH 3,000). The cash flow in the year of payback is the cash flow in the third year of GH 3,000. Therefore, the payback period using the formula is: Payback period = year before payback +
project _ cos t total _ cash _ flows _ before _ payback cash _ flow _ in _ year _ of _ payback
(1 + i)
CFt
WHEN USING THE NET PRESENT VALUE FORMULA, PLEASE NOTE THAT PROJECT COST ALWAYS HAS A NEGATIVE SIGN IN FRONT OF IT.
CF3 CFt CF1 CF2 1 2 3 t The NPV formula may be: project cost + (1 + i ) + (1 + i ) + (1 + i ) + + (1 + i )
Therefore, the NPV of this project is:
5,000 4,000 3,000 2,000 1,000 1 2 3 4 5 -10,050 + (1 + 0.13) + (1 + 0.13) + (1 + 0.13) + (1 + 0.13) + (1 + 0.13) =
-10,050 + 4,424.78 + 3,132.59 + 2,079.15 + 1,226.64 + 542.76 = 1,355.91. The NPV of this investment project is GH 1,355.91. According to the NPV method criteria, this NPV is positive so accept the project. SOLUTION (c): Question c wants to know the profitability index (PI). The formula for the PI is:
(1 + i)
CFt
5,000 4,000 3,000 2,000 1,000 1 2 3 4 (1 + 0.13) + (1 + 0.13) + (1 + 0.13) + (1 + 0.13) + (1 + 0.13) 5 = 11,405.91
Using the PI formula, the PI is:
According to the PI method criteria, this project should be accepted because it has a PI greater than 1.