e following business concepts have been developed by your colleagues, and they h
ID: 2575634 • Letter: E
Question
e following business concepts have been developed by your colleagues, and they have asked you to provide feedback on each as a potential investment. Using the data provided, calculate the payback period and NPV of each. Rate of Net Cash Net Cash Net Cash Net Cash Net Cash Seed Return Flow Flow Flow Flow Flow Other Net Payback $1,000| 5% | s200 2 | Year 3 | Year 4 | Year 5 | Cash Flow: Period |NPV $300 Project | Capital | (%) | Year 1 | Year $400 SO SO $250,000 8% | $2.000 $25,000 $25,000 S1,000,000: S148,000| S200.000 896 per year for 5 years SO S1,000,000 $5,000,000 $6,000,000 $8,000,000 | 1796 50,000 | 25% $120million! 6% SO SO for 3 years S0 $1,000 $29,000 $35,0000 $70,000 SO SO l $20 million | S80 million | S40 million | S20 million in Year 6 $5 million in Year 7 soExplanation / Answer
Project A
Calculation of payback period : Payback period means the period in which we can recover the initial capital
Year Net Cash flows: Cum. cash flows
1 $200 $200
2 300 500
3 400 900
4 500 1,400
5 0 1,400
Payback period = In 3 years, we can recover $900 and the balance can be recovered in the fraction of 4th year that is to be calculated as follows;
payback period = 3 years + (balance $100/500 in 4th year)= 3 years + (100/500) = 3.20 years or 3 years 2 months
Project B
Year Net Cash flows: Cum. cash flows
1 $2,000 $2,000
2 25,000 27,000
3 25,000 52,000
4 1,000,000 1,052,000
5 148,000 1,200,000
6 to 10 200,000 p.a 2,200,000
Payback period : to recover Seed capital $250,000, how many years it takes
Look at Cumumuatve cash flows, to recover $52,000 it takes 3 years, and recover, the balance amount i.e $198,000, how many years it takes when we get 1,000,000 in 4th year, then
Payback peridod = 3 years + (198,000/1,000,000) = 3.19 years i.e 3 years 2 months approxiamtely
Project C :
Year Net Cash flows: Cum. cash flows
1 $0 $0
2 0 0
3 0 0
4 1,000,000 1,000,000
5 5,000,000 6,000,000
6 to 8 6,000,000 p.a 18,000,000
Payback period : to recover initial seed capital $8,000,000, it takes 5 years to recover $6,000,000 and balance $2,000,000 will be recovered in the fraction of 5th year i.e as follows:
Payback period = 5 years + (balance 2,000,000)/6,000,000 in 6th year) = 5.33 years i.e 5 years 4 months approximately
Project D
Year Net Cash flows: Cum. cash flows
1 $0 $0
2 1,000 1,000
3 29,000 30,000
4 35,000 65,000
5 70,000 135,000
Payback period : To recover initial seed capital $50,000, it takes 3 years to recover $30,000 and to recover the balance $20,000 it takes fraction of 4th year, hence
Payback period = 3 years + (balance 20,000/35,000 in 4th year) = 3. 57 years i.e 3 years 6 months
Project E
Year Net Cash flows: Cum. cash flows
1 $0 $0
2 0 0
3 20 million 20 million
4 80 million 100 million
5 40 million 140 million
6 20 million 160 million
7 5 million 165 million
Payback period : To recover initial $120 million, it takes 4 year to recover $100 million and the balance $20 million will be recoverd in the fraction of 5th year i.e as follows
Payback period = 4 years + (Balance $20 million/$40 million in 5th year) = 4. 5 years i.e 4 year 6 months
Payback periods of all the Projects :
Project Payback period
A 3.20 years
B 3.19 years
C 5.33 years
D 3.57 years
E 4.50 years
Hence, the Project Bis preferable as its payback period is the least ie. 3.19 years, however, the payback period of the project will be compared with the company's payback period. If the project peirod is less than that of comapny payback period, such project or projects will be accepted.
NPV CALCULATION FOR PROJECT A
Year PVF @ 5% Cash Flows PV of cash flows
1 0.9524 $200 $190.48
2 0.9070 300 272.10
3 0.8638 400 345.52
4 0.8227 500 411.35
5 0.7835 0 0
Total Present Value 1,219.45
Less: Initital Seed capital 1,000.00
NPV 219.45
NPV = Difference between Present value of cash inflows and Present value of cash outlows i.e initial capital
NPV of project B:
Year PVF @ 8% Cash Flows PV of cash flows
1 0.9259 $2,000 1.851.18
2 0.8573 25,000 21,432.50
3 0.7938 25,000 19,845.00
4 0.7350 100,000 73,500.00
5 0.6806 148,000 100,728.80
6 0.6302 200,000 126,040.00
7 0.5835 200,000 116,700.00
8 0.5403 200,000 108,060.00
9 0.5002 200,000 100,040.00
10 0.4632 200,000 92,640.00
Total Present Value 760,837.48
Less: Initital Seed capital 250,000.00
NPV 510,837.48
Note; For PVF (present value factor,refer present value tables) or apply the following formula
For 1st year = 1/(1+r) = 1/(1+0.08) = 0.9259
For 2nd year = 1/(1+r)2 = 1/(1+0.08)2 = 1/1.1664 = 0.8573 etc.
For 3rd year = 1/(1+r)3 where r = rate of return
NPV for Project C
Year PVF @ 17% Cash Flows PV of cash flows
1 0.8547 $0 $0
2 0.7305 0 0
3 0.6244 0 0
4 0.5337 1,000,000 533,700
5 0.4561 5,000,000 2,280,500 0
6 0.3898 6,000,000 2,338,800
7 0.3332 6,000,000 1,999,200
8 0.2848 6,000,000 1.708,800
Total Present Value 8,861,000
Less: Initital Seed capital 8,000,000
NPV 861,000
In the same way, you can do for Project D and E and finally, we should accept the Project whose Positive NPV is more ( we can reject the project whose NPV is negative i.e Initial investment is more than the present vlaue of cash inflows)
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