Illustration

A company with a cost of capital 14% is trying

to determine the optimal replacement cycle for
the laptop computers used by its sales team. The
following information is relevant to the
decision.
The cost of each laptop is Rs.24000.
Maintenance cost are payable at the and of full
each year of ownership, but not in the year of
replacement e.g. if the laptop owned for 2 years,
then maintenance cost is payable at the end of
year 1.
Interval between Trade in value Maintenance Cost
Replacement ( years ) Rs. Rs.
1 12000 Zero

2 8000 750 (payable at end of Y1 )

3 3000 1500 (payable at end of Y2)

Required:
1) Ignoring taxation, calculate equivalent annual
cost of the three replacement cycles and
recommend which should be adopted?
2) What other factors should the company take into
account when determining the optimal cycle .
Solution
Replace in 1 year Replace in 2 years Replace in 3 years
Year Cash Flow NPV Cash Flow NPV Cash Flow NPV PVIF 14%
0 -24000 -24000 -24000 -24000 -24000 -24000 1
1 12000 10524 -750 -658 -750 -658 0.877
2 8000 6152 -1500 -1154 0.769
3 5000 3375 0.675

-13476 -18506 -22437

PVIFA at 14% 0.877 1.647 2.322
AEV -15366 -11236.2 -9663

The computer should be replaced after every three years.

 Illustration
 Roshan Pakistan Pharmaceuticals has just developed a new
drug at a cost of Rs. 250,000 and is now considering
whether to put it into production.
 The production of drug will require the purchase of new
specialized machinery at a cost of Rs. 2.4 million payable
immediately.
 The machinery has an expected useful life of four (4) years
and at the end of which it will have scrap value of Rs.
400,000.
 Additional working capital of Rs. 300,000 will be required
immediately and will be released at the end of 4th year.
4
 Illustration

 The following information relating to

this investment proposal has been
prepared:

Current selling price Rs. 16 per unit

Expected selling price inflation 7.5% per annum

Current variable operating cost Rs. 5 per unit

Current fixed operating overhead Rs. 165,000 per annum

Expected variable and fixed cost inflation 6% per annum
5
 Illustration

 The production and sale forecast for the

new drugs have been made by
marketing department are as follows:

Year 1 2 3 4

Demand(in units) 115,000 99,000 88,000 58,000

6
 Illustration
 It is expected that all units of drug produced will
be sold and in line with company policy of keeping
no inventory of finished goods.
 For investment appraisal purposes, company uses
a nominal rate of 10% for discounting annual cash
flows and a target return on capital employed of
20% per year.
 Company pays tax @ 35% per annum in the year
in which taxable profit occurs. The company
charges depreciation on straight-line basis. 7
 Illustration
 Required:
 Calculate the following values for the investment proposal:
 Net present value (NPV)

 Internal rate of return (IRR)

 Return on capital employed (accounting rate of return)

based on average investment

 Discounted payback period

 Discuss your findings in each sections of (a) above and

advise whether the investment proposal is financially
acceptable or not.
8
 Solution
Calculation of Net Present
i) Value

Year 0 1 2 3 4

Investment -2400000 - - - -

Operating cash flow (W-1) - 950,840 882,678 843,302 607,267

Working capital -300000 - - - 300,000

Machinery Residual (0.4 * 0.65) - - - - 260,000

Net Cash Flow -2700000 950,840 882,678 843,302 1,167,267

Discounting at 10% 1.000 0.909 0.826 0.751 0.683

Present values -2700000 864,314 729,092 633,320 797,244

Net Present Value 323,969

9
 Solution
Workings for net cash flows (W-1)
Initial selling price 17.20 18.49 19.88 21.37
Demand 115,000 99,000 88,000 58,000
Sales Revenue 1,978,000 1,830,510 1,749,154 1,239,315
Variable cost/unit 5.3 5.62 5.96 6.31
Variable cost 609,500 556,380 524,480 365,980
Fixed overhead 174,900 185,394 196,518 208,309
Operating Cost 784,400 741,774 720,998 574,289
Depreciation 500,000 500,000 500,000 500,000
Total Cost 1,284,400 1,241,774 1,220,998 1,074,289
Net Profit before tax 693,600 588,736 528,156 165,027
Tax @ 35% 242,760 206,058 184,855 57,759
Net Profit after tax 450,840 382,678 343,302 107,267
Operating Cash flow 950,840 882,678 843,302 607,267
(Including Depreciation Rs. 500m) Ignore product development cost of Rs. 250,000 as sunk cost. 10
 Solution
ii) Calculation of Internal Rate of Return

Year 0 1 2 3 4

Net cash flow -2700000 950,840 882,678 843,302 1,167,267

Discount at 20% 1.000 0.833 0.694 0.579 0.482

Present values -2700000 792,050 612,579 488,272 562,623

Net Present value - 244,477

Internal Rate of return = 10 + ((20-10) * 323,969)/(323,969 + 244,477)

= 10 + 5.69 = 15.69% 11
 Solution

iii) Calculation of Return on capital employed based on average investment:

Total net profit after tax 450,840 + 382,678 + 343,302+107,267 1,284,087

Average annual net profit after tax 321,022

Average Investment 2,700,000/2 1,350,000

Return on capital employed 321,022/1,350,000 23.78%

12
 Solution

iv) Calculation of discounted payback period:

Year 0 1 2 3 4

Present values - 2,700,000 864,314 729,092 633,320 797,244

Cumulative PV - 2,700,000 - 1,835,686 - 1,106,594 - 473,275 323,969

Discounted Payback 3 + (473,274/797,244) 3.6 years

13
 Solution
 Solution 14(b):
 Findings in each sections of (a) above and advise whether the investment
proposal is financially acceptable.
 The investment proposal has a positive net present value of Rs. 323,969 and
is therefore financially acceptable. The results of other investment appraisal
methods don’t alter this decision, as the NPV appraisal method always offers the
right advice.
 The internal rate of return is 15.69% is higher than the expected return of
10% required by the company, therefore the investment proposal is
acceptable.
 Return on capital employed of 23.78% is also higher than the company
target return of 20%, therefore the investment proposal is acceptable.
 Discounted payback period of 3.6 year is significant portion of the
foreseeable life of the investment proposal of four years. The sensitivity of the
investment proposal to changes in demand and life cycle period should be
analyzed, since an onset of technological obsolescence may have a significant
impact on its financial acceptability. 14
 Illustration

 Panther plc. Has a cost of capital of 18%

per annum. It is the Board policy of
expansion from internal resources only and
will not have recourse to the market.
 The retention of profits generated an
investment fund of Rs. 2,500,000 and the
following projects are under consideration:

15
 Illustration
(Rs. in thousands)

Projects A B C D E F G H
Life (In years) 5 4 4 3 5 3 5 6
Required
Investment (Rs.) 900 500 1200 2000 800 1000 750 1250
Annual Cash
Flow(Rs.) 341 208 481 949 262 452 224 304
IRR 26% 24% 22% 20% 19% 17% 15% 12%

Required: How should the available fund be invested?

16
 Solution
Calculation of Net Present Value:
PV
Project Life Annual Cash Factor PV of Initial NPV
Cash
Inflow at 18% Inflow Outflow

A 5 341 3.127 1066.31 900 166.31

B 4 208 2.690 559.52 500 59.52
C 4 481 2.690 1293.89 1200 93.89
D 3 949 2.174 2063.13 2000 63.13
E 5 262 3.127 819.27 800 19.27
F 3 452 2.174 982.65 1000 -17.35
G 5 224 3.127 700.45 750 -49.55
H 6 304 3.498 1063.39 1250 -186.61

Projects F,G and H show a negative NPV and can therefore be rejected
straight away as not being worthwhile. 17
 Solution
Project NPV Initial PI Ranking
Outlay

A 166.31 ÷ 900 = 18.48% I

B 59.52 ÷ 500 = 11.90% II
C 93.89 ÷ 1200 = 7.82% III
D 63.13 ÷ 2000 = 3.16% IV
E 19.27 ÷ 800 = 2.41% V

Projects Initial Cost NPV

A 900 166.31
C 1200 93.89
2100 260.20
Unused Fund 400
18
2500
 Solution

 Available fund should be invested in projects

A and C to maximize NPV Rs. 260.20
thousand.
 However, because the problem of
indivisibility of fund amounting to Rs.
400,000 remain unused and invested at
18%.

19
MULTIPLE IRRS
 A single IRR will result only when the
cash flow follow the normal pattern of
an initial out-flow followed by a series
of inflows over the years.
 Where the cash flow signs change
between positive and negative a
number of times over the years, it is
likely that a number of real solutions
may exist.
IRRS
 YEAR PVIF 6% CASH FLOW PV
 0 1 -3910 -3910
1 .943 -10,000 -9434
 2 .890 40,000 35600
 3 .840 -26510 -22258
 NPV -2

21
IRRS
 YEAR PVFI 30% CASH FLOW PV
 0 1 -3910 -3910
 1 0.769 -10,000 -7692
 2 0.592 40,000 23668
 3 0.455 -26,510 -12067
 NPV -1
 The discount rates 5-30 % NPV is
positive and so if the cost of capital in
this range, the project should be
accepted.
22
MIRR
Assumptions
 All interim inflows are invested out
side.
 At the IRR of the project.

 Another criticism of IRR is that it cannot

cope with variations in the cost of
capital over the life the project.
 To overcome the shortcomings of IRR

the MIRR is calculated. 23

 MIRR
 Year cflo pvif 10% reinvestment
 1 1280 1.331 1704
 2 1280 1.210 1549
 3 40 1.100 44
 4 40 1.000 40
 Terminal value 3337
 Year 0 outflow =2000
 Year 4 inflow=3337=0.599
 In the table for year 4
0.599=13.5%
24