Fin622 GDB No. 1 solution

Semester "Fall 2010"

"Corporate Finance (Fin622)"

This is to inform that Graded Discussion Board (GDB) will be opened according to the following schedule

Schedule

Opening Date and Time

November 22 , 2010 At 12:01 A.M. (Mid-Night)

Closing Date and Time

November 24 , 2010 At 11:59 P.M. (Mid-Night)

Topic/Area for Discussion

“Capital budgeting"

Note: The discussion question will be from the area/topic mentioned above. So start learning about the topic now.

Discussion Question

XYZ Company is one of the biggest manufacturing concerns of the country. Being the finance manager of XYZ Company, you have been assigned a task to evaluate three projects. The future cash flows from the three projects are summarized in given table.

Project A
Project B
Project C

Initial investment
45,000
70,000
50,000

Cash inflows

Year 1
20,000
20,000
30,000

Year 2
20,000
26,000
28,000

Year 3
20,000
30,000
35,000

Consider the discount factor to be 14% and that the company has sufficient funds to take projects.

Required:

I. On the basis of NPV approach, which project(s) you would select if the projects are independent and why?

II. On the basis of NPV approach, which project(s) you would select if the projects are mutually exclusive and why?

.........

FIN622 GDB No. 1 Solution

Project A

Initial Investment = 45000

Years 1 2 3

Cash Flows 20000 20000 20000

Calculation:-

NPV = -Io + CF1/(1+r)t + CF2/(1+r)t + CF3/(1+r)t

NPV = - 45000 + 20000/(1+0.14)1 + 20000/(1+0.14)2 + 20000/(1+0.14)3

NPV = -45000 + 17543.859 + 15389.350 + 13499.430

NPV = - 45000 + 46432.639

NPV = 1432.639

Project B

Initial Investment = 70000

Years 1 2 3

Cash Flows 20000 26000 30000

Calculation:-

NPV = -Io + CF1/(1+r)t + CF2/(1+r)t + CF3/(1+r)t

NPV = - 70000 + 20000/(1+0.14)1 + 26000/(1+0.14)2 + 30000/(1+0.14)3

NPV = - 70000 + 17543.859 + 20006.155 + 20249.145

NPV = - 70000 + 57800

NPV = - 12200

Project C

Initial Investment = 50000

Years 1 2 3

Cash Flows 30000 28000 35000

Calculation:-

NPV = -Io + CF1/(1+r)t + CF2/(1+r)t + CF3/(1+r)t

NPV = - 50000 + 30000/(1+0.14)1 + 28000/(1+0.14)2 + 35000/(1+0.14)3

NPV = - 50000 + 26316 + 21545 + 23624

NPV = - 50000 + 71485

NPV = 21485

1) On the basis of NPV approach, which project(s) you would select if the projects are independent and why?

Reference:

MGT201 (Page 47)

Independent: implies that the cash flows of the two investments are not linked to each other

Solution:-

If the projects are independent then I will select Project C 1st and after that I will select Project A on 2nd because both have Positive NPV.

2) On the basis of NPV approach, which project(s) you would select if the projects are mutually exclusive and why?

Reference:

MGT201 (page 47)

Mutually Exclusive: means that you can invest in ONE of the investment choices and having chosen one you cannot choose another.

Solution:-

I will Select Project C because it has positive NPV and also have greater amount Rs. 21485.