Corporate Finance – FIN 622 Assignment # 02 Semester Fall 2007

Question 01

The management of LTD Construction Company is evaluating a proposed capital project of acquiring a new earth mover. The Mover’s basic price is Rs.5,000,000, and it would cost another Rs.1,000,000 to modify it for special use. Assume that the mover’s depreciation expense for first year is Rs.1,980,000, for second year is Rs.2,700,000 and for third year is Rs.900,000. After three years the mover would be sold for Rs.200,000. The mover will also require an increase in networking capital of Rs.200,000. The earth mover would have no effect on revenues, but it is expected to save the firm Rs.2,000,000 per year in before tax operating costs, mainly labor. The tax rate of the firm is 40%.

Required:

1. Calculate the initial cash out flow of the proposed project.
2. What are the operating cash flows of the project in first, second and third year.
3. What are the additional (Non operating) cash flows in the third year?
4. If the project’s cost of capital is 10%, should the earth mover be purchased?

Question 02

Suppose you are working as a financial analyst in a public Limited company. Your company is involved in the exploration, extraction and marketing of Oil. The capital budgeting division of your company has propped two new projects X and Y. The director of capital budgeting has asked you to analyze the two proposed projects and present a report on the financial viability of the projects.

Some key facts about the projects are as follow;

Each project has a cost of Rs.10 million, and the cost of capital for each project is 15%. The projects’ expected net cash flows are as follows:

Net Cash flows

Year Project X Project Y

1 Rs.2,000,000 Rs.1,500,000

2 2,500,000 2,000,000

3 3,500,000 2,500,000

4 2,500,000 2,000,000

5 2,000,000 3,000,000

6 3,500,000 4,000,000

7 2,500,000 2,500,000

8 1,500,000 1,000,000

Total cash flows Rs.20, 000,000 Rs.18, 500,000

Required:

1. Calculate each project’s Simple pay back period and Discounted payback period.
2. Calculate each project’s Net Present Value (NPV) and Internal Rate of Return (IRR).
3. Which project should be selected if both the projects are mutually exclusive? Why.

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Solution

Question No.01

Given Data is

Mover’s Price = Rs.5,000,000

Cost of modification = Rs.1,000,000

Change in working capital = Rs.200,000

Depreciation expenses

1^st year = Rs.1,980,000

2^nd year = Rs.2,700,000

3^rd year = Rs.900,000

Sales price after 3^rd year = Rs.2,000,000

Cost savings per year = Rs.2,000,000

Tax rate = 40%

1. Initial Cash out flow of the proposed project:

Basic price = Rs.5,000,000

+ Modification Cost = Rs.1,000,000

+Change in working capital = Rs.200,000

Initial Cash Out flow = 6,200,000

2. Operating Cash Flows of the project in first , second and third year:

a) Depreciation Tax savings:

1^st year = Rs.1,980,000 40% = Rs.792,000

2^nd year = Rs.2,700,000 40% = Rs.1,080,000

3^rd year = Rs.900,000 40% = Rs.360,000

b) After tax cost savings = Rs. 2,000,000 ( 1- 40%) per year.

= 2,000,000 60%

= 1,200,000 per year

Operating Cash flows year 01 year 02 year 03

(1)After tax cost savings 1,200,000 1,200,000 1,200,000

(2)Depreciation tax savings 792,000 1,080,000 360,000

Total (1+ 2) Rs.1,992,000 Rs.2,280,000 Rs.1,560,000

3. Terminal Cash Flow in the third year:

a) Book value of the mover after three years:

Depreciable cost of the mover – Accumulated depreciation

= 6,000,000 – (1,980,000 + 2,700,000 + 900,000)

= 6,000,000 – 5,580,000

= Rs.420,000 (book value of the mover after third year)

b) Profit/ (Loss) on disposal of the mover:

= Sales price – Book value

= Rs.200,000 – Rs.420,000

= (Rs.220,000)

Since we have loss on disposal of the mover, therefore we would have tax savings due to this loss, because loss on disposal of asset is tax deductible.

c) Tax savings due loss on disposal of the mover:

= Loss on disposal of assets tax rate

= Rs.220,000 40%

= Rs.88,000

d) Terminal Cash Flows/Non operating Cash flows

Sales price of the mover after third year = Rs.200,000

Add: Tax savings due loss on disposal of

The mover = Rs.88,000

Add: Networking Capital recovery = Rs.200,000

Total = Rs. 488,000

4. Decision

We use NPV criterion to decide whether to purchase or not to purchase the mover.

Periods year 01 year 02 year 03

(1)Operating Cash Flows Rs.1,992,000 Rs.2,280,000 Rs.1,560,000

(2)Non operating Cash Flows - - Rs.488,000

Net Cash Flows (1+2) Rs.1,992,000 Rs.2,280,000 Rs.2,048,000

NPV = - Initial Cash Out flow + Sum of Present values of future Net Cash Flows

NPV = - 6,200,000 + + +

NPV = - 6,200,000 + + +

NPV = - 6,200,000 + 1,810,909.091 + 1,884,297.521 + 1,538,692.712

NPV = - 6,200,000 + 5,233,899.324

NPV = - Rs.966,100.676

Since NPV of the mover is negative, therefore the proposed project should be rejected.

Question No.02

1. Simple and Discounted payback periods of Project X and Project Y.

Project X
Years	Cash Inflows	Cum Cash Inflows	Discount Factor At 15%	Discounted Cash Flows	Cum Discounted Cash Flows
1	2,000,000	2,000,000	0.870	1,740,000	1,740,000
2	2,500,000	4,500,000	0.756	1,890,000	3,363,000
3	3,500,000	8,000,000	0.658	2,303,000	5,933,000
4	2,500,000	10,500,000	0.572	1,430,000	7,363,000
5	2,000,000	12,500,000	0.497	994,000	8,357,000
6	3,500,000	16,000,000	0.432	1,512,000	9,869,000
7	2,500,000	18,500,000	0.376	940,000	10,809,000
8	1,500,000	20,000,000	0.327	490,500	11,299,500
Total				11,299,500

Project Y
Years	Cash Inflows	Cum Cash Inflows	Discount Factor At 15%	Discounted Cash Flows	Cum Discounted Cash Flows
1	1,500,000	1,500,000	0.870	1,305,000	1,305,000
2	2,000,000	3,500,000	0.756	1,512,000	2,817,000
3	2,500,000	6,000,000	0.658	1,645,000	4,462,000
4	2,000,000	8,000,000	0.572	1,144,000	5,606,000
5	3,000,000	11,000,000	0.497	1,491,000	7,097,000
6	4,000,000	15,000,000	0.432	1,728,000	8,825,000
7	2,500,000	17,500,000	0.376	940,000	9,765,000
8	1,000,000	18,500,000	0.327	327,000	10,092,000
Total				10,092,000

1. Simple payback period of Project X = 3 +

= 3 + 0.8 = 3.8 years

2. Discounted payback period of Project X = 6 + = 6 + 0.14 = 6.14 Years

3. Simple payback period of Project Y = 4 +

= 4+ 0.67 = 4.67 Years

4. Discounted Payback period = 7 +

= 7+ 0.72 = 7.72 Years

2. Net Present Values (NPV) and Internal Rate of Return ( IRR) of Project X and Project Y:

1. NPV of Project X = - Initial Cash Out Flow + Sum of Discounted Cash Flows

= - Rs.10,000,000 + Rs.11,299,500 = Rs.1,299,500

2. NPV of Project Y = - Initial Cash Out Flow + Sum of Discounted Cash Flows

= -10,000,000 + 10,092,000 = Rs.92,000

3. IRR of Project X

To calculate IRR of the project we try to find out such two discounting rate where at one rate the NPV of the project is positive and at the other the NPV is negative. Then we use interpolation method to find the exact value of IRR between these two rates.

At 15% NPV of the project = Rs.1,299,500 (as calculated above)

Therefore we try some high discounting rates..

Years	Cash Inflows	At 18%		At 20%
		Discount Factors	Discounted Cash Flows	Discount Factors	Discounted Cash Flows
1	2,000,000	0.847	1,694,000	0.833	1,666,000
2	2,500,000	0.718	1,795,000	0.694	1,735,000
3	3,500,000	0.609	2,131,500	0.579	2,026,500
4	2,500,000	0.516	1,290,000	0.482	1,205,000
5	2,000,000	0.437	874,000	0.402	804,000
6	3,500,000	0.370	1,295,000	0.335	1,172,000
7	2,500,000	0.314	785,000	0.279	697,500
8	1,500,000	0.266	399,000	0.233	349,500
Total			Rs.10,263,500		Rs.9,656,000

NPV at 18%

= - Initial Cash Out Flow + Sum of Discounted Cash Flow at 18%

= - 10,000,000 + 10,236,500 = 263,500

NPV at 20%

= - Initial Cash Out Flow + Sum of Discounted Cash Flow at 18%

= - 10,000,000 + 9,656,500 = - 344,000

So our IRR is between 18% and 20%.

Using Interpolation formula

IRR

= Lower Discount rate + Difference between two Discount rates ()

= 18% + 2% ()

= 18% + 0.87%

= 18.87 %

4. IRR of Project Y:

NPV at 15% = Rs.92,000 ( As calculated above)

We choose a high discounting rat let 17%

Years	Cash Inflows (in Rs)	Discount Factor at 17%	Discounted Cash Flows(Rs)
1	1,500,000	0.855	1,282,500
2	2,000,000	0.731	1,462,000
3	2,500,000	0.624	1,560,000
4	2,000,000	0.534	1,068,000
5	3,000,000	0.456	1,368,000
6	4,000,000	0.390	1,560,000
7	2,500,000	0.333	832,000
8	1,000,000	0.285	285,000
Total			9,418,000

NPV at 17% = - Rs.10,000,000 – Rs.9,418,000 = - Rs.582,000

So our IRR is between 15% and 17%.

Using interpolation formula

IRR = Lower Discount rate + Difference between two Discount rates ()

= 15% + 2% ()

= 15% + 0.02 ( 0.137)

= 15% + 0.00274

= 15.274%

3. Decision

Project	Simple payback Period	Discounted Payback Period	NPV	IRR
Project X	3.8 Years	6.14 Years	Rs.1,299,500	18.87%
Project Y	4.67	7.72	92,000	15.274

The above table summarizes the payback periods, NPV and IRR of Project X and Project Y. As the table shows that Project X has better Simple Payback Periods, Discounted Payback periods, NPV and IRR as compare to Project Y. Therefore Project X is recommended for selection.