Investment Appraisal - Tutorial 2
Question 1.
- What is the payback period for the following set of cash flows?
- What is the discounted payback period if we use 10 per cent discount rate?
- What is the main disadvantage of the discounted payback period as a method of investment appraisal?
- What
advantages does the discounted payback have over the ordinary
payback?
What is the payback period for the following set of cash flows?
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Answer 1
. The Sum of the Out Flow and the Cash Flow becomes positive during the Third Year. At the beginning of the 3rd year there was a deficite of £600 with an expected Fash Flow of £1400. Assuming this is linear, then it's £1400 / 12 = £116.67r Cash flow per month.. The deficite divided by the flow is £800 / 116.67r = 6.86 months 0.86 x (365/12) = 26 days Therefrore Payback is in 3 years 6 months and 26 days.
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What
is the discounted payback period
if we use 10 per cent discount rate? . The Sum of the Out Flow and the discounted Cash Flow becomes positive during the Fith Year. At the beginning of the 5th year there was a deficite of £191 with an expected Fash Flow of £1000. Assuming this is linear, then it's £1000 / 12 = £83.3r Cash flow per month.. The deficite divided by the flow is £191 / 83.3r = 2.292 months 0.292 x (365/12) = 9 days Therefrore Payback is in 5 years 2 months and 10 days.
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What is the discounted payback period if we use 10 per cent discount rate?
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What is the main disadvantage of the discounted payback period as a method of investment appraisal?
Answer 3The
discounted payback method does not consider the timings or size of the
inflows
or for inflows after the payback period.
What advantages
does the discounted
payback have over the ordinary payback?
Answer 4
The discounted payback method does consider the time value of money.
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What
is the project payback period if the
initial cost is £2,400? . The Sum of the Out Flow and the discounted Cash Flow becomes positive during the Fith Year. At the beginning of the 4th year there was a deficite of £205 with an expected Fash Flow of £765. Assuming this is linear, then it's £765 / 12 = £63.75 Cash flow per month.. The deficite divided by the flow is £205 / 63.75 = 3.226 months 0.226 x (365/12) = 7 days Therefrore Payback is in 3 years 3 months and 7 days. |
What
is the project payback period if the
initial cost is £2,400?
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Answer 2
. The Sum of the Out Flow and the discounted Cash Flow becomes positive during the Fith Year. At the beginning of the 4th year there was a deficite of £205 with an expected Fash Flow of £765. Assuming this is linear, then it's £765 / 12 = £63.75 Cash flow per month.. The deficite divided by the flow is £205 / 63.75 = 3.226 months 0.226 x (365/12) = 7 days Therefrore Payback is in 3 years 3 months and 7 days. What if the initial cost is £3,600? At the beginning of the 5th year there was a deficite of £540£540 / 63.75 = 8.472 months 0.472 x (365/12) = 14 days Therefrore Payback is in 4 years 3 months and 7 days |
What
if it is £6,500? . The Sum of the Out Flow and the discounted Cash Flow throuout tremains Negative throughout the period if the cash flows continue after and EXTENDED period at £63.75 per month.. Then:- £390 / 63.75 = 5.96 months 0.96 x (365/12) = 29 days Therefrore Payback is in 8 years 5 months and 29 days. But this is not a valid calculation as it ignorant of the factors that imposed the 8 year period set down. |
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Question
3
. The
finance manager of ABC plc is evaluating two
mutually exclusive projects with the following cash flows.
ABS’s cost of capital is 10% and both investment projects have zero scrap value. The company’s current return on capital employed is 12% (average investment basis) and the company uses straight line depreciation over the life of projects. |
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i. The net
present value method (NPV) of investment
appraisal is used:
ii. The internal
rate of return method of investment
is used;
iii. The return on
capital employed method of
investment appraisal is used.
b.
Discuss the problems that arise for the net present value method of
investment
appraisal when capital is limited and explain how such problems may be
resolved
in practice.
Advise
the company which project should be undertaken in the
following circumstances if the net present value method (NPV) of
investment
appraisal is used:
Answer a,i
Answer a,ii
Both Projects have a positive NPV when
considering the companies cost of Capital but neither have a positive
NPV when
considering the companies average return on capital employed.
I
would advise the company that if they where
to choose either project, then to opt for project A for 5 reasons.
- It has the higher NPV.
- The payback on investment occurs
after 3.5 yrs
(whereas Project B takes closer to 5 years).
- The losses on
Project B (when
considering the Companies
ROCE) is 7 times higher than Project A.
- Project A would
still have a positive
NPV
after 4 years should the project finish earlier.
- Project B also relies heavily on cash flow in year 4 should the Projects run into trouble after 3 years then Project B would cause a loss of almost 45% (£77,000) of the investment. As opposed to less than 8% (£10,000) for Project A.
ii.
The internal rate of return method of investment is used;
Answer a,ii
Again
both project show a return
greater than the cost of Capital; However, the IRR does not show the
problems
Identified in items 2, 4 and 5 in answer (i)
iii. The return on capital employed method of investment appraisal is used.
Answer a iii
Again
Project A shows a 2% advantage over Project
B so Project A would be the better choice; however, neither show any
inherent
dangers and both appear superb investments.
b.
Discuss the
problems that arise for the net present value method of investment
appraisal
when capital is limited and explain how such problems may be resolved
in
practice.
NPV assumes that future cash flows are
known and that the companies cost of capital is fixed, this is unlikely
to be
true as both are forecasted; however when capital is limited then a
profitability index is needed to evaluate the selection of projects and
the
projects with the higher Profitability Index should be taken.
Profitability
Index = NPV of cashflows/Initial Capital invested
This does in no way guarantee success
but reduces the possible risks in undertaking a venture.
Question 4.
Explain
what is meant by the term “capital rationing” and
differentiate between hard and soft rationing
Capital
rationing is the process of limiting the capital expenditure. This could be due to “Hard
Rationing” when an
outside body limits the amount of capital it is prepared to loan (Gearing)
or
“Soft Rationing” when the company itself imposes the limits on
expenditure.
(Budgeting). All companies are faced
with such limitations and managers have to therefore decide which
investment
opportunities to accept and which, although profitable, they have to
reject.