TUTORIAL 3

COURSE: LEVEL: 300 FINANCIAL 2010 MANAGEMENT 23rd October (UFIN100) 2010

DATE: 18th October LECTURER: Kofi B. Afful

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

10,050 9,000 1,050 3,000 =2+ = 2 + 3,000 = 2 + 0.35 = 2.35.

SOLUTION (b): The net present value formula is: project cost +

(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:

present _ value _ of _ cash _ flows project _ cos t

Note that the present value of the cash flows is different from the NPV!!! It is:

(1 + i)

CFt

CF3 CFt CF1 CF2 1 2 3 t = (1 + i ) + (1 + i ) + (1 + i ) + + (1 + i )

Therefore, the present value of the projects cash flows are:

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:

present _ value _ of _ cash _ flows 11,405.91 project _ cos t = 10,050 = 1.14

According to the PI method criteria, this project should be accepted because it has a PI greater than 1.