Solution to Assignment 1

Given Data:

Survey cost = Rs. 10,000,000/-

License cost = Rs. 850,000/-
Corporate tax = 30% = 0.30
Depreciation = Straight line method = Initial investment salvage value / no. of years
Capital budget = Rs. 12,00,000/-
Project A:
Drilling rig cost = Rs. 400,000/-
Installation cost = 50% of drilling rig cost = Rs. 200,000/-
Oil well cost = Rs. 100,000/-
Working capital = Rs. 30,000/-
Life of project = 4 years
Discounted cash flows = Rs. 50,000/-, Rs. 170,000/-, Rs. 290,000/- and Rs. 307,600/- for each
year respectively.
Project B:
Drilling rig cost = Rs. 60,000/-
Installation cost = Rs. 20,000/-
Well cost = Rs. 40,000/-
Working capital = Rs. 30,000/- and Rs. 40,000/- for year 2 and 3 respectively.
Life of project = 5 years
Discounted cash flows = Rs. 15,000/-, Rs. 25,000/-, Rs. 29,200/-, Rs. 30,000/- and Rs. 40,000/-
for each year respectively.
Project C:
Drilling rig cost = Rs. 540,000/-
Installation cost = Rs. 80,000/-
Salvage Value = Rs. 70,000/-
Life of project = 4 years
Discounted cash flows = Rs. 144,000/-, Rs. 153,000/-, Rs. 150,000/- and Rs. 235,000/- for each
year respectively.
Project D:
Drilling rig cost = Rs. 750,000/-
Consultant cost = Rs. 200,000/-
Cancellation cost for consultant = Rs. 100,000/-
Installation cost = 20% of 750,000 = Rs. 150,000/-
Working capital = Rs. 200,000/- in year 2.
Life of project = 6 years
Discounted cash flows = Rs. 140,000/-, Rs. 180,000/-, Rs. 110,000/-, Rs. 220,000/-, Rs.
230,000/- and Rs. 200,000/- for each year respectively.
Points considered during solution:

Survey cost and license cost are sunk costs, so they are irrelevant costs.
Initial investments of the projects will be calculated by adding the relevant costs only.
Total initial investment of in each project will be taken as negative.
As discounted cash flows are given so tax and depreciation are already considered in
discounted cash flows.
In Project B, working capital of year 2 and year 3 are irrelevant because given discounted
cash flows have already considered working capitals.
In Project C salvage value is not relevant as it is considered for calculation of depreciable
cost only. So it should not be subtracted from initial investment.
In Project consultant cost and cancellation cost are sunk costs and are irrelevant.

Solution to requirement 1:
Calculation of Net Present Value (NPV) and Profitability Index (PI) of each project:

Net Present Value (NPV) of Project A:

Total initial investment = Drilling rig cost + installation cost + oil well cost + working capital
= 400,000 + 200,000 + 100,000 + 30,000 = Rs. 730,000/-
Total discounted cash flows of 4 years = 50,000 + 170,000 + 290,000 + 307,600 = Rs. 817,600/-

Net Present Value (NPV) = -Total initial investment + Total discounted cash flows
= -730,000 + 817,600 = Rs. 87,600/-

Profitability Index (PI) of Project A:

Profitability Index (PI) = Net Present Value + Total initial investment / Total initial investment
= 87,600 + 730,000 / 730,000 = 817,600 / 730,000 = 1.12

Net Present Value (NPV) of Project B:

Total initial investment = Drilling rig cost + installation cost + well cost
= 60,000 + 20,000 + 40,000 = Rs. 120,000/-
Total discounted cash flows of 5 years = 15,000 + 25,000 + 29,200 + 30,000 + 40,000
= Rs. 139,200/-

Net Present Value (NPV) = -Total initial investment + Total discounted cash flows
= -120,000 + 139,000 = Rs. 19,000/-
Profitability Index (PI) of Project B:

Profitability Index (PI) = Net Present Value + Total initial investment / Total initial investment
= 19,000 + 120,000 / 120,000 = 139,000 / 120,000 = 1.16

Net Present Value (NPV) of Project C:

Total initial investment = Drilling rig cost + installation cost

= 540,000 + 80,000 = Rs. 620,000/-
Total discounted cash flows of 4 years = 144,000 + 153,000 + 150,000 + 235,000
= Rs. 682,000/-

Net Present Value (NPV) = -Total initial investment + Total discounted cash flows
= -620,000 + 682,000 = Rs. 62,000/-

Profitability Index (PI) of Project C:

Profitability Index (PI) = Net Present Value + Total initial investment / Total initial investment
= 62,000 + 620,000 / 620,000 = 682,000 / 620,000 = 1.10

Net Present Value (NPV) of Project D:

Total initial investment = Drilling rig cost + installation cost

= 750,000 + 150,000 = Rs. 900,000/-
Total discounted cash flows of 6 years = 140,000 + 180,000 + 110,000 + 220,000 + 230,000 +
200,000 = Rs. 1,080,000/-

Net Present Value (NPV) = -Total initial investment + Total discounted cash flows
= -900,000 + 1,080,000 = Rs. 180,000/-

Profitability Index (PI) of Project D:

Profitability Index (PI) = Net Present Value + Total initial investment / Total initial investment
= 180,000 + 900,000 / 1,000,000 = 1,080,000 / 900,000 = 1.20

Solution to requirement 2:
Ranking of the projects on the basis of Profitability Index (PI), budget based upon this ranking
and calculate NPV of selected portfolio of projects:

Ranking is calculated as under:

 PROJECT INITIAL DISCOUNTED RANKING
PI
S INVESTMENT CASH FLOWS PI

A (730,000) 817,600 1.12 3

B (120,000) 139,200 1.16 2
C (620,000) 682,000 1.10 4
D (900,000) 1,080,000 1.20 1

As budget is limited to Rs. 12,00,000 so project selection on basis of PI is as under:

PROJECT INITIAL RANKING

NPV PI
S INVESTMENT PI

D (900,000) 180,000 1
B (120,000) 19,000 2
A *(180,000) **201,620.16 ***0.28 3
Total (1,200,000) 400,620.16

* 12,00,000 900,000 120,000 = 180,000 [180,000 / 730,000 x 100 = 24.66%]

** 817,600 x 24.66 /100 = 201,620.16
*** 1.12 x 24.66 /100 = 0.28

So, on the basis of PI, 100% of Project D, 100% of Project B and 24.66% of Project A should be
taken. Budget allocation is Rs. 900,000 for Project D, Rs. 120,000 for Project B and Rs. 180,000
for Project A. NPV of this selected portfolio of projects is Rs. 400,620.16.

Solution to requirement 3:
Ranking of the projects on the basis of NPV, budget based upon this ranking and calculate NPV
of selected portfolio of projects:

Ranking is as under:

DISCOUNTE
PROJECT INITIAL
D CASH NPV RANKING
S INVESTMENT
FLOWS NPV
A (730,000) 817,600 87,600 2
B (120,000) 139,200 19,000 4
C (620,000) 682,000 62,000 3
D (900,000) 1,080,000 180,000 1

As budget is limited to Rs. 12,00,000 so project selection on basis of NPV is as under:

 PROJECT INITIAL RANKING
NPV PI
S INVESTMENT NPV

D (900,000) 180,000 1
A *(300,000) **336,033.60 ***0.46 2
Total (1,200,000) 516,033.60

* 12,00,000 900,000 = 300,000 [300,000 / 730,000 x 100 = 41.10%]

** 817,600 x 41.10 /100 = 336,033.60
*** 1.12 x 41.10 /100 = 0.46

So, on the basis of PI, 100% of Project D, and 41.10% of Project A should be taken. Budget
allocation is Rs. 900,000 for Project D, and Rs. 300,000 for Project A. NPV of this selected
portfolio of projects is Rs. 516,033.60.

Solution to requirement 4:
Selected portfolio and reason for its selection:

Project D and Project A are feasible as they are appearing in both portfolios. Portfolio based on
NPV ranking should be selected by the company as its NPV is more than the NPV of portfolio
based on PI.