PRACTICE QUESTIONS ON NPV

1. Quadrant is a highly geared company that wishes to expand its operations. Six
possible capital investments have been identified, but the company only has
access to a total of $620,000. The projects may not be postponed until a future
period. After the projects end, it is unlikely that similar investment opportunities
will occur.
Expected net cash flows (including residual values) are:

Projects A and E are mutually exclusive. All projects are believed to be of similar risk
to the company's existing capital investments.
Any surplus funds may be invested in the money market to earn are turn of 9% per
year. The money market may be assumed to be an efficient market.
Quadrant's cost of capital is 12% per year.
Required:
(a)Calculate the expected Net Present Value for each project, and rank the projects.
(b)Assuming the projects are divisible, calculate the profitability index for each
project, and rank the projects to determine how the money would be best invested.
Explain briefly why the rankings differ from that in (a) above.
 1. A company is considering which of two mutually exclusive projects it should
undertake. The finance director thinks that the project with the higher NPV
should be chosen, whereas the managing director thinks that the one with the
higher IRR should be undertaken, especially as both projects have the same
initial outlay and length of life. The company anticipates a cost of capital of
10%, and the net after tax cash flows of the projects are as follows:

Required:
(a)Calculate the NPV of each project.
(b)Recommend, with reasons, which project you would undertake (if either).
(c)Briefly explain the inconsistency in ranking of the two projects in view of the
remarks of the directors.
 Amortization
Amortization is an accounting technique used to periodically lower the book value of
a loan or intangible asset over a set period of time. In relation to a loan, amortization
focuses on spreading out loan payments over time. When applied to an asset,
amortization is similar to depreciation.
 Amortization typically refers to the process of writing down the value of either
a loan or an intangible asset.
 Amortization schedules are used by lenders, such as financial institutions, to
present a loan repayment schedule based on a specific maturity date.
 Intangibles amortized (expensed) over time help tie the cost of the asset to the
revenues generated by the asset in accordance with the matching principle of
generally accepted accounting principles (GAAP).
The term "amortization" refers to two situations. First, amortization is used in the
process of paying off debt through regular principal and interest payments over time.
An amortization schedule is used to reduce the current balance on a loan, for example,
a mortgage or car loan, through installment payments.
Amortization can refer to the process of paying off debt over time in regular
installments of interest and principal sufficient to repay the loan in full by its maturity
date. With mortgage and auto loan payments, a higher percentage of the flat monthly
payment goes toward interest early in the loan. With each subsequent payment, a
greater percentage of the payment goes toward the loan's principal
Typically, the total monthly payment is specified when you take out a loan. However,
if you are attempting to estimate or compare monthly payments based on a given set
of factors, such as loan amount and interest rate, you may need to calculate the monthly
payment as well. If you need to calculate the total monthly payment for any reason, the
formula is as follows:
Example of Amortization
For example, let's look at a four-year, $30,000 auto loan at 3% interest. The monthly
payment is going to be $664.03 using:

 r = 3%/12 = 0.0025
n = 4years*12 = 48

 30.000* 0.0025(1+0.0025)^48
(1+0.0025)^48-1

= 30.000* (0.00281832/0.127328021)
= 3.000(0.022134326)
= 664.03
In the first month, $75.00 ($30,000 outstanding loan balance * 3% interest rate / 12
months) of the $664.03 monthly payment goes to interest while the remaining $589.03
($664.03 total monthly payment - $75.00 interest payment) goes toward principal.
INTEREST = 30.000(0.0025) = 75 month 1
= 29,410.97(0.0025) = 73.53 month 2 and so on for the other months.
Each month, the total payment stays the same, while the portion going to principal
increases and the portion going to interest decreases. In the final month, only $1.66 is
paid in interest because the outstanding loan balance at that point is very minimal
compared to the starting loan balance.
Loan Amortization Schedule
Total Payment Computed Interest Principal Principal
Period Due Due Due Balance
$30,000.00
1 $664.03 $75.00 $589.03 $29,410.97
2 $664.03 $73.53 $590.50 $28,820.47
3 $664.03 $72.05 $591.98 $28,228.49
4 $664.03 $70.57 $593.46 $27,635.03
5 $664.03 $69.09 $594.94 $27,040.09
6 $664.03 $67.60 $596.43 $26,443.66
7 $664.03 $66.11 $597.92 25,845.74
8 $664.03 $64.61 $599.42 $25,246.32
9 $664.03 $63.12 $600.91 $24,645.41
10 $664.03 $61.61 $602.42 $24,042.99
11 $664.03 $60.11 $603.92 $23,439.07
12 $664.03 $58.60 $605.43 $22,833.64
13 $664.03 $57.08 $606.95 $22,226.69
14 $664.03 $55.57 $608.46 $21,618.23
15 $664.03 $54.05 $609.98 $21,008.24
16 $664.03 $52.52 $611.51 $20,396.73
17 $664.03 $50.99 $613.04 $19,783.69
18 $664.03 $49.46 $614.57 $19,169.12
19 $664.03 $47.92 $616.11 $18,553.02
20 $664.03 $46.38 $617.65 $17,935.37
21 $664.03 $44.84 $619.19 $17,316.18
22 $664.03 $43.29 $620.74 $16,695.44
23 $664.03 $41.74 $622.29 16,073.15
24 $664.03 $40.18 $623.85 $15,449.30
25 $664.03 $38.62 $625.41 $14,823.89
26 $664.03 $37.06 $626.97 $14,196.92
27 $664.03 $35.49 $628.54 $13,568.38
28 $664.03 $33.92 $630.11 $12,938.28
29 $664.03 $32.35 $631.68 $12,306.59
30 $664.03 $30.77 $633.26 $11,673.33
31 $664.03 $29.18 $634.85 $11,038.48
32 $664.03 $27.60 $636.43 $10,402.05
Loan Amortization Schedule
Total Payment Computed Interest Principal Principal
Period Due Due Due Balance
33 $664.03 $26.01 $638.02 $9,764.02
34 $664.03 $24.41 $639.62 $9,124.40
35 $664.03 $22.81 $641.22 $8,483.18
36 $664.03 $21.21 $642.82 $7,840.36
37 $664.03 $19.60 $644.43 $7,195.93
38 $664.03 $17.99 $646.04 $6,549.89
39 $664.03 $16.37 $647.66 $5,902.24
40 $664.03 $14.76 $649.27 $5,252.96
41 $664.03 $13.13 $650.90 $4,602.06
42 $664.03 $11.51 $652.52 $3,949.54
43 $664.03 $9.87 $654.16 $3,295.38
44 $664.03 $8.24 $655.79 $2,639.59
45 $664.03 $6.60 $657.43 $1,982.16
46 $664.03 $4.96 $659.07 $1,323.09
47 $664.03 $3.31 $660.72 $662.36
48 $664.03 $1.66 $662.36 $0.00

Why is amortization important?

Amortization is important because it helps businesses and investors understand and
forecast their costs over time. In the context of loan repayment, amortization schedules
provide clarity into what portion of a loan payment consists of interest versus principal.
This can be useful for purposes such as deducting interest payments for tax purposes.
Amortizing intangible assets is also important because it can reduce a business’s
taxable income and therefore its tax liability, while giving investors a better
understanding of the company’s true earnings.
What is the difference between amortization and depreciation?
Amortization and depreciation are similar concepts, in that both attempt to capture the
cost of holding an asset over time. The main difference between them, however, is
that amortization refers to intangible assets whereas depreciation refers to tangible
assets. Examples of intangible assets include trademarks and patents; whereas tangible
assets include equipment, buildings, vehicles, and other assets subject to physical wear
and tear.
Sample Amortization Table

Sometimes it’s helpful to see the numbers instead of reading about the process. The
table below is known as an amortization table (or amortization schedule). It
demonstrates how each payment affects the loan, how much you pay in interest, and
how much you owe on the loan at any given time. This amortization schedule is for the
beginning and end of an auto loan. This is a $20,000 five-year loan charging 5%
interest (with monthly payments).

NB: when the interest factor is rounded up you have interest for the 1 st month as 84
meanwhile when all the values are considered it becomes 83.33+ (so don’t get confused
about you being wrong)

For month 1 we have;

Interest = 20,000(0.00416667) =83.33

Payment is constant

Principal due =377.42 - 83.33=294.09

Balance at the end = 20,000 - 294.09(principal) =19,705.91

Automatically 19,705.91 becomes the beginning balance for month 2 as shown

Now we compute for month 2 as thus;

Interest = 19,705.91 (0.00416667) =82.11

Payment is still constant

Principal due =377.42 - 82.11=295.31(2)

Balance at the end = 19,705.91 - 295.31 (principal) = 19,410.6

ETC.

Values after the decimal play little or no effect on the principal result so be wise in
your computation.
Month Balance (Start) Payment Principal Interest Balance (End)
1 $ 20,000.00 $ 377.42 $ 294.09 $ 83.33 $ 19,705.91
2 $ 19,705.91 $ 377.42 $ 295.32 $ 82.11 $ 19,410.59
3 $ 19,410.59 $ 377.42 $ 296.55 $ 80.88 $ 19,114.04
4 $ 19,114.04 $ 377.42 $ 297.78 $ 79.64 $ 18,816.26
.... .... .... .... .... ....
57 $ 1,494.10 $ 377.42 $ 371.20 $ 6.23 $ 1,122.90
58 $ 1,122.90 $ 377.42 $ 372.75 $ 4.68 $ 750.16
59 $ 750.16 $ 377.42 $ 374.30 $ 3.13 $ 375.86
60 $ 375.86 $ 377.42 $ 374.29 $ 1.57 $0

Amortization Schedule Example

Even if you understand what amortization is, it can be complicated to think about in
terms of dollars and cents. Let’s work through an example to illustrate the amortization
process.
Let’s say you take out a 30-year mortgage with a $200,000 principal and a fixed
4% interest rate. Your lender tells you that your monthly payment is $954.83 before
taxes and homeowners insurance, but where does that money actually go? In the first
month, your payment goes almost entirely toward interest: $665.71 goes toward
interest and only $288.16 goes toward principal.
Every month, this process repeats itself and you pay less and less toward interest. By
the time you pay off the loan, you will have paid your original $200,000 loan as well
as $143,738.99 in interest.
Let’s say that you take out the same 30-year fixed rate loan worth $200,000 with 4%
interest annually. Your monthly payment is still $954.83, but let’s say you pay an extra
$100 per month toward principal. At the end of your loan, you will have saved
$26,854.95 in interest. That’s 59 months of payments saved – almost 4 years!

Amortization Loan Table Example

The amortization table is built around a $15,000 auto loan with a 6% interest rate and
amortized over a period of two years. Based on this amortization schedule, the borrower
would be responsible for paying $664.81 each month, and the monthly interest payment
would start at $75 in the first month and decrease over the life of the loan. Absent any
additional payments, the borrower will pay a total of $955.42 in interest over the life of the
loan. (Fixed payment has been given use to calculate the principal due, do not ignore It.
you can put on your schedule so you are clear on your computation)

Auto Loan Amortization Table

Beginning Ending
Month balance Interest Principal balance

1 $15,000.00 $75.00 $589.81 $14,410.19

2 $14,410.19 $72.05 $592.76 $13,817.43

3 $13,817.43 $69.09 $595.72 $13,221.71

4 $13,221.71 $66.11 $598.70 $12,623.01

5 $12,623.01 $63.12 $601.69 $12,021.32

6 $12,021.32 $60.11 $604.70 $11,416.61

7 $11,416.61 $57.08 $607.73 $10,808.89

8 $10,808.89 $54.04 $610.76 $10,198.12

9 $10,198.12 $50.99 $613.82 $9,584.30

10 $9,584.30 $47.92 $616.89 $8,967.42

11 $8,967.42 $44.84 $619.97 $8,347.44

12 $8,347.44 $41.74 $623.07 $7,724.37

24 $661.50 $3.31 $661.50 $0.00