DEPARTMENT SCHOOL OF MANAGEMENT SCIENCE

PROGRAM - MASTERS OF BUSINESS ADDMINISTRATION /MBA/

EXTENSION 2013

COURSE NAME- ADVANCED FINANCIAL MANAGEMENT

STUDENT NAME - HABTAMU GETA DAGNAW

STUDENT ID NO-ZPGCE/030/13

PHONE NO-0919051949/0913239279

SUBMITED TO DR .HAIMANOT/PHD/

SUBMISSION DATE FEB 23/2014 E.C

1. A company has an investment opportunity costing $40,000 with the following expected net cash
flow after taxes and before depreciation.

Year Net Cash flow

1 $7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000

Using 10% as the cost of capital, determine the following

a. Payback period
b. Net present value at 10% discount factor
c. Profitability index at 10% discount factor
d. Internal rate of return with the help of 10% and 15% discount factor.
SOLUTIONS
(A). Payback Period = 5.625 years
(B).Net Present Value= Rs. 8,961
(C).pofitability index=0.224
(D). Internal rate of Return = 14.7%
Explanation:

(A). Payback Period:

Discounted Payback Period = Year Before the Discounted Payback

Period Occurs + (Cumulative Cash Flow in Year Before Recovery /

Discounted Cash Flow in Year After Recovery)

Initial Outlay = Rs. 40,000

Cashflow for 5 years = Rs. 70,000 + Rs. 70,000 + Rs. 70,000 + Rs. 70,000 + Rs. 70,000

= Rs. 35,000
Balance Outlay = Rs. 40,000 - Rs. 35,000

= Rs. 5,000

Cash Flow for 6 years = Rs. 8000

∴ Payback Period = 5years + 5,000/8,000

5year+0.625

Payback period = 5.625 years

(B). Net Present Value

present
value under
10% = Rs. 48,961
present value under 15% = Rs. 39,420

NET PRESENT VALUE=48,961-40,000

NPV=8,961

PV is less than Rs. 40,000. Hence, Internal Rate of Return is less than 15% but more than 10%.
(C).profitability index(gross)=total pv inflows/initial out lay
P.i (gross)=48,961/40,000
P.i(gross)=1.224
p.i is greater than one we can aceept the project.
P.i net=npv/initial outlay
P.i=8961/40,000
p.i=0.224
Or
P.i gross pi-1
net p.i=1.224-1=0.224 which is positive we can accept the project

(D). Internal rate of Return:

Internal Rate return= 10 + (48961 - 40,000)/(48,961 - 39,420)×5

IRR = 10 + 4.7%

IRR = 14.7%
 2. The Alpha Company Ltd is considering the purchase of new machine. Two alternative machines
(A and B) have been suggested each costing $400,000. Earning after taxation are expected to be
as follows:

Year machine-A Machine-B

1 $40,000 $120,000
2 120,000 160,000
3 160,000 200,000
4 240,000 120,000
5 160,000 80,000

The company has a target of return on capital of 10% and on this basis, you are required to
compare the profitability of the machines and state which alternative you consider financially
preferable.
Note:- the present value of $1
1year=0.91,2nd year=0.83,3rdyear=0.75,4th year=0.68,5ht year=0.62.

SOLUTION

Year machine-A pvf pv Machine-B pvf pv

1 $40,0000.91 36,400 $120,000 0.91 109,200

2 120,0000.83 99,600 160,000 0.83 132,800

3 160,0000.75 120,000 200,000 0.75 150,000

4 240,0000.68 163,200 120,000 0.68 81,600

5 160,0000.62 99,200 80,000 0.62 49,600

TOTAL CASH INFLOWS=720,000 680,000

Total present value 518,400 523,200

Less intial outlay 400,000 400,000

Net present value 118,400 123,200

Gross p.i=total present value/initial outlay

Gross p.i of Poject A=518,400/400,000

=1.296
NET PROFITABILITY INDEX=NET PRESENT VALUE /INITIAL OUTLAY

P.I of project A=118,400/400,000

P.I of project A =0.296

or gross p.i-1

1.296-1

P.i =0.296

Gross p.i of project B=total present value/initial outlay

Gross p.i of Poject B=523,200/400,000

=1.308

NET PROFITABILITY INDEX=NET PRESENT VALUE /INITIAL OUTLAY

P.I of project A=122,400/400,000

P.I of project B =0.308

or gross p.i-1

1.308-1

P.i=0.308

Decision criteria

The two projects are profitable since their gross profitability index is greater than one

Or both projects have a positive profitability index

But from the two projects the higher profitability index is preferiable for investment

P.i of B 0.308> p.i if A 0.296

project B is more profitable than project A

So project B is more profitable than project A

3. X.Ltd is producing articles mostly by manual labor and is considering to replace it by anew
machine. There are two alternative models M and N of the new machine. Prepare a statement of
probability showing the pay-back period from the following information:
Particulars Machine-M machine-N
Estimated life of machine 4years 5years
Cost of machine $90,000 $180,000
 Estimated savings in scrap 5,000 8,000
Estimated savings in direct wages 60,000 80,000
Additional cost of maintenance 8,000 10,000
Additional cost of supervision 12,000 18,000

SOLUTIONS profitability statement

Particulars Machine-M machine-N

Particulars Machine M Machine N

Estimated saving in scrap 5,000 8,000

Estimated saving in direct wages 60,000 80,000

Total saving 65,000 88,000

Additional cost of maintenence 8,000 10,000

Additional cost of supervision 12,000 18,000

Total additional cost 20,000 28,000

Net cash inflows(saving-cost) 45,000 60,000

Payback period=orginal 90,000/45,000=2year 180,000/60,000=3year

investment/annual cash inflows

Machine ''M''is prefered for because it has a shorter pay back

investment than machine ''N'' period than machine ''N''

MACHINE ''M'' PAY BACK BEFRORE MACHINE ''N''

So its more preferable than Machine N
4. Calculate the average rate of return for project A and B from the following:
Particulars project-A project-B
Investments $20,000 $30,000
Expected life (no salvage value) 4years 5years
Projected net income(after interest ,depreciation and taxes)
Years project-A project-B
1 $2,000 $3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 Nil 1,000
 Total 6,000 10,000

If the required rate of return is 12% which project should be undertaken?

Solution for project A
Total profits = 2000+ 1500+ 1500 + 1000=$6,000
= $6,000 / 4 = $1500
Net investment ($20,000 – 0) = $20,000
Average rate of return project A = (Average annual profit / Net investment) x 100
ARR of project A= (1500 / 20,000) x 100
ARR of project A= 7.5%

Solution for project B

Total profits = 3,000+ 2,000+ 2,000 + 1,000+1,000=$10,000

= $10,000 / 5 = $2,000

Net investment ($30,000 – 0) = $30,000

Average rate of return project B = (Average annual profit / Net investment) x 100

ARR of project B= (2,000 / 30,000) x 100

ARR of project B= 6.6666..%

ARR OF PROJECT B=6.67%

OR
ARR of project A is 15%/2=7.5% and ARR of project P=13.33%/2=6.67%

(ii) If the required rate of return is 12% which project should be undertaken?

ARR=AAP/AI×100%

AAP of project A at a given ARR 12% will be

12%=(AAP/20,000)×100%

0.12=(AAP/20,000)×1

0.12=AAP/20,000

AAP of project A=0.12×20,000

AAP of project A=2,400

AAP of project B at a given ARR 12% will be

12%=(AAP/30,000)×100%

0.12=(AAP/30,000)×1

0.12=AAP/30,000

AAP of project A=0.12×30,000

AAP of project A=3,600

My General decision is the two projects will be undertaken since they have positive AAP

Both projects are profitable

But from the two the one which have higher AAp will be preferable in this case project ''B is profitable
than project A'' by their AAP

AAPb>AAPa=3,600>2,400

This project has also a conflict if it is not independent or if the projects are mutually exclusive because

according to their ARR project ''A is preferable where as

According to their AAP at the same ARR(12%) Project ''B is preferable so their is aconflict between the
two projects.
5. From the following information calculate the net present value of the two projects and suggest
which of the two projects should be accepted assuming a discount rate of 10%.

Particulars project-X project-Y

Initial investment $20,000 30,000
Estimated life 5years 5years
Scrap value $ 1,000 $2,000

The profits before depreciation and after taxes (cash flows) are as follows:
Particulars year-1 year-2 year-3 year-4 year-5
Project-X 5,000 10,000 10,000 3,000 2,000
Project-Y 20,000 10,000 5,000 3,000 2,000

Solutions
 The two projects are accepted because their NPV >0
the project with higher NPV is selected
Project Y is more preferable than project X
6.

Initial investment $60,000

Life of the asset 4years

Estimated net annual cash flows:
1st year $15,000
2ndyear 20,000
3rd year 30,000
4 year
th
20,000
Calculate internal rate of return.

When cash flow is nit uniform(TRIAL AND ERROR METHOD

 At IRR ,total PV of cash inflows is equal to initial investment.
Initial Investment is Rs. 60,000. Hence, IRR must be in between 14% and 15% (i.e between s
60,595 ans Rs 59,285).
The exact IRR is calculate as follows:
At 14% Total Present value =60,595
At 15% total present value = 59,285
1,310
The difference of 1310 in rate =1%
Fo a difference of 565, the difference in rate (60595-60,000)
=1/1310X595= 0.45%
IRR= 14+0.45=14.45%
7. The initial cash outlay of a project is $50,000 and it generates cash inflows of
$20,000,$15,000,$25,000,and $10,000 in 4 years. Using present value index method. Appraise
profitability of the proposed investment assuming 10% rate of discount.
Solution
The first step is to calculate the present value and profitability index.
Year Cash Inflows Present Value Factor Present Value
$ @10% $
1 20,000 0.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
=56,175
Total present value = $56,175
Less: intial outlay = $50,000
Net present value = $6,175
Profitability Index (gross) = Present value of cash inflows / Intial cash outflow
= 56,175 / 50,000
= 1.1235
Given that the profitability index (PI) is greater than 1.0, we can accept the proposal.
Net Profitability = NPV / Initial cash outlay
= 6,175 / 50,000
= 0.1235
Or
N.P.I. = 1.1235 – 1
N.P.I = 0.1235
Given that the net profitability index (NPI) is positive, we can accept the proposal.
8. A firm whose cost of capital is 10% is considering two mutually exclusive project-A and B , the
cash flows of which are as below:
Year project-A project-B
0 -50,000 -80,000
1 62,500 96,170
Suggest which project should be taken up using (i) NPV method (ii) the internal rate of return
method.
 SOLUTION
i. Using NPV method

Project A Project B

Year Cash flow Pvf@10 Pv Cash flow Pvf10% Pv

0 -50,000 - - -80,000 - -

1 62,500 0.909 56812.5 96,170 0.909 87418.53

NPV less(50,000) less(80,000)

=6812.5 =7418.53

NPV of project A NPV of project B

=6812.5 =7418.53
The two projects are mutually exclusive so my decision between the two project is aproject with
a higher net present value which is project ''B''
NPVb>NPVa
Since 7418.53>6812.5
I prefer to invest on project B according to their npv of the two projects

(ii)using internal rate of return method

IRR is the rate of return at which total present value
of future cash flows is equal to initial investment.
This method is used when the amount of investment
and cash inflows are known but rate of return is not
known.
The rate of return is generally found by trial and
error method.
IRR is the rate at which the NPV becomes zero.

The project with higher IRR is usually selected.

 IRR FOR PROJECT A
0$=[(62,500/1+IRR)`1-50,000]×100%
$0=(62,500/-50,000IRR-50,000)×100%
50,000IRR+50,000=62,500
50,000IRR=62,500-50,000
50,000IRR=12,500
50,000IRR/50,000=12,500/50,000
IRR =0.25×100%
IRR of project A=25%
IRR FOR PROJECT B
0$=[(96,170/1+IRR)`1-80,,000]×100%
$0=(96,170/-80,000IRR-80,000)×100%
80,000IRR+80,000=96,1700
80,000IRR=961700-80,000
80,000IRR=16170
80,000IRR/80,000=16170/80,000
IRR =0.202×100%
IRR of project B=20.2%
the projects are mutually exclusive projects

The IRR of project A is greater than The IRR of project B

The two projects should be taken since their IRR is greater than discounting factor(10%)

From the two i decide to prefer the one whose IRR is higher

By using thier IRR project A is mire preferable than project B

Since

IRR of A>IRR of B

25%>20.2%

Generally the projects are not independent rather they are mutually exclusive

As i try to investigate by using the two methods

1,using NPV project both projects will undertaken but the project with higher NPV is preferable

Which is project B has greater BPV and it is preferable by using this method.

Where as

By using IRR method

The two projects will undertaken because their IRRis greater than the discounting rate (i=10%)

From the two the one which have higher IRR will be selected in this case project A is selected.

Their will a conflict between the two projects