Unit 2 Investment Decision Examples PDF

BBA / BCOM (Hons.) Sem. 5 Unit 2 Investment Decision 5A02FIM UNIT 2: INVESTMENT DECISION Examples based on Capital Budgeting Example 1: ABC Co. Ltd. is evaluating a project whose expected cashflows are as f...

BBA / BCOM (Hons.) Sem. 5 Unit 2 Investment Decision 5A02FIM UNIT 2: INVESTMENT DECISION Examples based on Capital Budgeting Example 1: ABC Co. Ltd. is evaluating a project whose expected cashflows are as follows: Year 0 1st 2nd 3rd 4th 5th Cash flows (in Rs.) (10,00,000) 1,00,000 2,00,000 3,00,000 6,00,000 3,00,000 a) Compute net present value (NPV) of the project if discount rate is 12%. b) If discount rate is 12% for 1st year and then rises every year by 1%, what is net present value (NPV) of the project? Example 2: From the following cash flows information, compute internal rate of return (IRR): Year 0 1st 2nd 3rd 4th Cash flows (in Rs.) (11,000) 6,000 2,000 1,000 5,000 Example 3: From the following information, find out benefit cost ratio & net benefit cost ratio and also comment on the selection of the project with reason. The cost of capital for the company is 12%. Year 0 1st 2nd 3rd 4th Cash flows (in Rs.) (100000) 25000 40000 40000 50000 Example 4: Calculate payback period (PBP) for project A & B and also comment on the selection of the project. Year 1st 2nd 3rd 4th 5th Project A 14000 16000 18000 20000 25000 Annual CFAT Project B 22000 20000 18000 16000 17000 Initial investment (CF0 or I0) is Rs. 56,000 for both the project. CFAT in the fifth year includes Rs. 3,000 salvage value also. Example 5: From the following information of Machine A, compute its average rate of return (ARR): Year 1st 2nd 3rd 4th 5th Total Annual estimated income / profit 3375 5375 7375 9375 11375 36875 after depreciation & tax ✓ Cost of machine (CF0 or I0) = Rs. 56125 ✓ Estimated life = 5 years ✓ Estimated salvage value = Rs. 3000 ✓ Depreciation has been charged on straight line basis Example 6: Saundarya Co. Ltd. is considering an investment proposal to install new milling controls. ✓ The facility has a life expectancy of 5 years and no salvage. Prepared By: Dr. Kiran J. Patel, Faculty of Management Studies, Ganpat University Page 1 BBA / BCOM (Hons.) Sem. 5 Unit 2 Investment Decision 5A02FIM ✓ The company’s tax rate – 55% and no investment tax credits is allowed. ✓ The firm uses straight line method of depreciation. Year I0 1st 2nd 3rd 4th 5th Estimated profit before (50,000) 10,000 11,000 14,000 15,000 25,000 depreciation and tax Calculate the following: 1) Payback period (PBP) 2) Average rate of return (ARR) 3) Net present value (NPV) [10% discount rate] 4) Profitability index (PI) [10% discount rate] 5) Internal rate of return (IRR) Example 7: Krishna Co. Ltd. is considering two mutually exclusive projects X and Y. Project X costs Rs. 30,000 and Project Y costs Rs. 36,000. You have been given below net present value (NPV) and probability distribution for each project: Project X Project Y NPV (Rs.) Probability NPV (Rs.) Probability 3,000 0.10 3,000 0.20 6,000 0.40 6,000 0.30 12,000 0.40 12,000 0.30 15,000 0.10 15,000 0.20 1) Compute the expected net present value (NPV) of Projects X and Y. 2) Compute the risk attached to each project (i.e. standard deviation & coefficient of variation of each probability distribution). 3) Which project do you consider more riskier and why? Example 8: XYZ Co. Ltd. is considering an investment in one of the two mutually exclusive proposals. Certainty- equivalent approach is employed in evaluating risky investments. The current yield on treasury bills is 5% and the company uses this as the riskless rate. Expected values of net cashflows with their respective certainty-equivalent Project A Project B Year Certainty- Certainty- Cashflows Cashflows equivalent equivalent 0 (1,70,000) (1,50,000) 1 90,000 0.8 90,000 0.9 2 1,00,000 0.7 90,000 0.8 3 1,10,000 0.5 1,00,000 0.6 a) Which project should be acceptable to the company? b) Which project is riskier? How do you know? Prepared By: Dr. Kiran J. Patel, Faculty of Management Studies, Ganpat University Page 2 BBA / BCOM (Hons.) Sem. 5 Unit 2 Investment Decision 5A02FIM Example 9: Silver Automobile Co. Ltd. is considering investment in one of three mutually exclusive projects: A, B and C. The company’s cost of capital is 15% and risk-free rate of return is 10%. Income tax rate for the company is 40%. The company has gathered the following basic cash flows and risk index data for each project: Project A Project B Project C Initial Investment (I0) 15,00,000 11,00,000 19,00,000 Cash Inflows Year 1 6,00,000 6,00,000 4,00,000 Year 2 6,00,000 4,00,000 6,00,000 Year 3 6,00,000 5,00,000 8,00,000 Year 4 6,00,000 2,00,000 12,00,000 Risk Index (Ri) 1.80 1.00 0.60 Using the risk adjusted discount rate, which project should be accepted by the company? Example 10: ABC Co. Ltd. has an investment proposal, requiring an initial outlay of Rs. 40,000. The investment proposal is expected to have 2 years economic life with no salvage value. In year 1, there is a 0.4 probability that cash inflow after tax will be Rs. 25,000 and 0.6 probability that cash inflow after tax will be Rs. 30,000. The probabilities assigned to cash inflows after tax for year 2 are as follows: Year 1 Year 2 CFAT Probability CFAT Probability Rs. 12,000 0.20 Rs. 25,000 0.40 Rs. 16,000 0.30 Rs. 22,000 0.50 Rs. 20,000 0.40 Rs. 30,000 0.60 Rs. 25,000 0.50 Rs. 30,000 0.10 The firm uses 10% discount rate for this type of investment. Required: 1) Construct a decision tree for the proposed investment project. 2) What net present value (NPV) will the project yield if worst outcome is realized? What is the probability of occurrence of this NPV? 3) What will be the best outcome and the probability of that occurrence? 4) Will the project be accepted? Prepared By: Dr. Kiran J. Patel, Faculty of Management Studies, Ganpat University Page 3