Annapurna Trading Ltd. is evaluating two mutually exclusive projects: Project A and Project B. The company will require Rs 100,000 for Project A and Rs 140,000 for Project B. The net cash flows of these projects are as follows: Ans: a. (Rs 3,027,947); (Rs 2,168,414); b. cannot be calculated Year Cash Flows A B Rs 100,000 -Rs 140,000 Profit after taxes 1 Rs 10,000 Rs 25,000 2 15,000 25,000 3 20,000 25,000 4 25,000 25,000 5 35,000 25,000 Both projects will be depreciated on straight line over a five-year life and cost of capital of the company is 12 percent. a. Calculate the PBP of each project. If firm has set a maximum payback period of three years, suggest as to which project is preferred. b. Evaluate the projects on the basis of their NPV. c. What are the profitability indexes of both projects?
Question
Annapurna Trading Ltd. is evaluating two mutually exclusive projects: Project A and Project B. The company will require Rs 100,000 for Project A and Rs 140,000 for Project B. The net cash flows of these projects are as follows: Ans: a. (Rs 3,027,947); (Rs 2,168,414); b. cannot be calculated Year Cash Flows A B Rs 100,000 -Rs 140,000 Profit after taxes 1 Rs 10,000 Rs 25,000 2 15,000 25,000 3 20,000 25,000 4 25,000 25,000 5 35,000 25,000
Both projects will be depreciated on straight line over a five-year life and cost of capital of the company is 12 percent. a. Calculate the PBP of each project. If firm has set a maximum payback period of three years, suggest as to which project is preferred. b. Evaluate the projects on the basis of their NPV. c. What are the profitability indexes of both projects?
Solution
a. Payback Period (PBP) Calculation:
The Payback Period (PBP) is the time it takes for a project to generate enough cash flows to recover the initial investment.
For Project A: Year 1: Rs 10,000 Year 2: Rs 15,000 Year 3: Rs 20,000 Total by end of Year 3: Rs 45,000
The initial investment of Rs 100,000 is not recovered by the end of Year 3.
For Project B: Year 1: Rs 25,000 Year 2: Rs 25,000 Year 3: Rs 25,000 Total by end of Year 3: Rs 75,000
The initial investment of Rs 140,000 is not recovered by the end of Year 3.
Therefore, neither project meets the firm's maximum payback period of three years.
b. Net Present Value (NPV) Calculation:
The Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
For Project A: NPV = (10,000/1.12) + (15,000/1.12^2) + (20,000/1.12^3) + (25,000/1.12^4) + (35,000/1.12^5) - 100,000
For Project B: NPV = (25,000/1.12) + (25,000/1.12^2) + (25,000/1.12^3) + (25,000/1.12^4) + (25,000/1.12^5) - 140,000
The project with the higher NPV should be selected.
c. Profitability Index Calculation:
The Profitability Index (PI) is the ratio of the present value of future cash flows to the initial investment.
For Project A: PI = NPV of Project A / Initial Investment of Project A
For Project B: PI = NPV of Project B / Initial Investment of Project B
The project with the higher PI should be selected.
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