Make a comparison of two mutually exclusive investments, expected cash flows are

Question

Make a comparison of two mutually exclusive investments, expected cash flows are presented in Table 1 to 1

Cost of equity of the company in which the investment would be realized is 11%.

Discuss the results of all methods used.

(Recommended methods: net cash income, average annual return, payback method,

Try to apply the EVA method.

Investment XAX ABY CF1 CF2 CF3 CF4 CFS 100 100 110 120 100 100 80 80 Net cash income Investment CF1 CF2 CF3 CF4 CF5 100 100 110 120 350 ABY 100 100 320 Average annual return InvestmentCF XAX ABY CF per year Average annual return Average payback time 450 90 420 84% 1,19047619 Payback method Investment I CF1 CF2 CF3 CF5 100 100 100 100 120 350 100 110 XAX cum ABY ABY cum 120 230 100 0 160 240 320 DEVA Simplifying assumptions: depreciations - straiht live method tax 20 % Investment CF1 CF2 CF3 CF4 CFS XAX 100 100 110 120 depreciation capital WACC NOPAT EVA DEVA 100 60 1196 1196 1196 1196 1196 39,2 ABY 100 100 80 80 depreciation capital WACC NOPAT EVA 100 60 1196 1196 1196 1196 1196 39,2 41,4 43,6 45,8

Explanation / Answer

There are two mutually exclusive investments are available, XAX and ABY. Both investments include an equal amount of 100 for initial Cash outflow. The cash inflow from both the investments are for 5 years. The net cash income of XAX (350) is more than net cash income of ABY (320) by 30. The average annual return of XAX (90%) is also more than the average annual return of ABY (84%) But average payback time of ABY is earlier than average payback time of XAX.

Calculation of EVA for both investments

The EVA of XAX is increasing in all the five years but the EVA of ABY is decreased from first year to second year and starts increasing after that. But the EVA of XAX for the last three years remains more than the EVA of ABY. Therefore on the basis of EVA method, the investment XAX is better.

Thus on overall basis, the investment XAX should be selected.

Investment IC CF1 CF2 CF3 CF4 CF5 XAX (i) -100 40 80 100 110 120 Depreciation (100/5) (ii) 20 20 20 20 20 NOPAT (iii) = [(i)-(ii)]*(1-0.20) 16 48 64 72 80 Capital (iv) 100 80 60 40 20 WACC (v) 11% 11% 11% 11% 11% Cost of capital (vi) = (iv)*(v) 11 8.8 6.6 4.4 2.2 EVA [(iii)-(vi)] 5 39.2 57.4 67.6 77.8

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