BBMF2093 CORPORATE FINANCE

TUTORIAL 2 INVESTMENT APPRAISAL

1. Differentiate between independent project and mutually exclusive project.

Independent project: if the cash flows of one is unaffected by the acceptance of the other.
(choose as many projects as you want as long as you have the fund and fulfill capital
budgeting criteria)

For example, McDonald may have two capital budgeting projects to consider. The first is a new
deep frying system. The second is a new order placement system for the drive-thru. McDonald
could choose to take the new deep fryer or the new order placement, or both. Since taking one
project does not influence the other, so they are independent. When we have independent
projects, the decision rule does not need to rank which project is the best, but merely identify the
project is good or bad.

Mutually exclusive project: if the cash flows of one can be adversely impacted by the
acceptance of the other. (can only choose 1 project and normally the best one). The decision
to choose which project shall be accepted depends on different factors like initial investment,
time period required for completion, strategic importance of the project, etc. Generally, the
project which adds more value to the business in the long run will be selected.

For example, ABC company is considering upgrading the printing system and has the choice of
two alternatives. The first is a low-cost model that will need replaced in 2 years and the second is
a more expensive model that will need replaced in 5 years. ABC can only choose one of these
options, so they are mutually exclusive. When we have mutually exclusive projects, the decision
rule needs to not only decide if a project is good or bad, but needs to be able to rank which project
is the best.

2. Binaan Teguh Berhad (BTB) has two potential projects, Project A and Project B. The
forecasted cash flows and relevant information of the two projects are given below.

The internal rate of return (IRR) of Project A and Project B are 12 percent per year and 15
percent per year respectively. Both projects require initial capital in year 0 and having
cost of capital of 5 percent per year.

(a) Determine the initial capital of both projects.

Project A
 Year Cash flow PVIF 12% Discounted Cash
(RM’million) Flow M
0 ? 1.0000 ? -a
1 50 0.8929 44.65
2 80 0.7972 63.78
3 80 0.7118 56.94
4 90 0.6355 57.20
NPV 0.00 M
(-a+44.65+63.78+56.94+57.20=0)
Initial capital of Project A = 44.64+63.78+56.94+57.2= RM 222.57 million

Project B
Year Cash flow PVIF Discounted Cash
(RM’million) IRR=15% Flow M
0 ? 1.0000 ? -b
1 60 0.8696 52.18
2 40 0.7561 30.24
3 40 0.6575 26.30
4 20 0.5718 11.44
NPV 0.00 M
(-b+52.18+30.24+26.30+11.44=0)
Initial capital of Project B = 52.18+30.24+26.30+11.44= RM 120.16 million

(b) Assuming both projects are mutually exclusive, suggest a capital budgeting decision
using Net Present Value (NPV) criteria. Show workings.
Project A NPV
Year Cash flow (RM’ PVIF 5% Discounted Cash
million) Flow M
0 -222.57 1.0000 -222.57
1 50 0.9524 47.62
2 80 0.9070 72.56
3 80 0.8638 69.10
4 90 0.8227 74.04
NPV 40.75 M

NPV = (47.62 + 72.56 + 69.10 + 74.04) - 222.57

NPV = 263.32 – 222.57 = RM40.75M

Project B NPV
Year Cash flow PVIF 5% (cost of Discounted Cash
(RM’million) Capital- loan interest) Flow M
0 -120.16 1.0000 -120.16
1 60 0.9524 57.14
2 40 0.9070 36.28
3 40 0.8638 34.55
4 20 0.8227 16.45
NPV 24.26 M

NPV = (57.14 + 36.28 + 34.55 + 16.45) - 120.16

 NPV= 144.42 – 120.156 = RM24.26M

Therefore, BTB should chose Project A due to higher NPV, compared to project B

(c) Calculate the following capital budgeting criteria of both projects.

(i) Payback period

(ii) Discount Payback Period

(a) Is your capital budgeting decision in (b) consistent with decision using IRR? Provide
reasons.

(b) Determine the Modified Internal Rate of Return (MIRR) for PROJECT A ONLY.

3. Why manager prefers the use of Modified Internal Rate of Return (MIRR) over IRR?

4. The management of NuRobotic Sdn. Bhd. is considering to purchase a new equipment.

Its choice is between Equipment A and Equipment B. Both equipments have five-year
useful life and they are mutually exclusive.

The initial cost (cash outlay) for Equipment A is RM160,000 and for Equipment B is
RM220,000 and their respective scrap values at the end of year 5 are given as follows:
Equipment A Equipment B
Initial Investment RM160,000 RM220,000
Scrap Value RM10,000 RM25,000
The cash inflows generated are as follows:
Year Equipment A (RM) Equipment B (RM)
1 30,000 70,000
 2 40,000 70,000
3 80,000 60,000
4 60,000 60,000
5 60,000 50,000
Required
(a) NuRobotic’s current investment policy is to accept only investment that are
recoverable within 4.5 years. Calculate the discounted payback period for equipment
A and equipment B if the cost of capital is 12%. Advise the company which new
equipment to purchase if they are mutually exclusive.

(b) Calculate the Net Present Value (NPV) for equipment A and equipment B given the
cost of capital is 12%.

(c) Advise the management on which equipment to purchase based on NPV calculation if
equipment A and equipment B are mutually exclusive. Explain your recommendation.

(d) The simple payback method of investment appraisal is the most popular method used
in practice. However, it has several theoretical limitations. Discuss the FOUR (4)
limitations of this capital budgeting technique.