Finance Introduction Diploma level

Question

a) Assume the following two mutually exclusive projects each with 4 years of economic life and will generate the following cash flows in Shs ‘000’

Years 1 2 3 4

Project U.K  120 160 160 180

Project M.K 150 130 170 120

The initial capital outlay for each project is Kshs 400 million. (Assuming a discount rate of 10% )

Required:

i) Compute the payback period for each project.                                      (4 Marks)

ii) Compute the Net present value for each project     (8 marks)

Advise the management on which project to undertake using the two capital budgeting techniques

Answer 1

i)

Payback Period represents the number of years to recover the original cash investment.

Project U.K: At the end of Year 3, the project will have received 120+160+160 = 440. This implies the payback period is somewhere between the beginning and end of Year 3. The required amount needed in Year 3 = 400 - (120+160) or 120. Therefore, 75% (120) of the total cash flow from Year 3 (160) is required so the total payback period is 2 + 0.75 or 2.75 years.

Project M.K: At the end of Year 3, the project will have received 150+130+170=450. This implies the payback period is somewhere between the beginning and end of Year 3. The required amount needed in Year 3= 400 - (150+130) or 120. Therefore, 70.5% (120) of the total cash flow from Year 3 (170) is required so the total payback period is 2 + 0.705 or 2.705 years.

ii)

Net present value is the discounted values of all cash inflows netted against the discounted values of cash outflows incremental to the project(s). Usually, the cash outflows are one time initial payments at t=0 although that is not required to be the case.

Project U.K:

Initial Outlay Year 1 CF Year 2 CF Year 3 CF Year 4 CF

-400 + (120/(1+.10)^1) + (160/ (1+0.10)^2) + (160/(1+.10)^3) + (180/(1+0.10)^4)

-400 + 109.09 + 132.23 + 120.21 + 122.94 = 484.48 - 400 or 84.48

Project M.K:

Similar math as above except that cash flows are slightly altered

-400 + 136.36 + 107.44 + 127.72 + 81.96 = 453.49 - 400 or 53.49

Project U.K has the quicker payback period and higher NPV so it should be chosen based on these two capital budgeting tools.