Question 1

1. The amount of the annual repayment is:

It is given in the question that loan is repaid equally at the end of every year.

Loan = $ 2400000

Interest rate = 8.6%

 2.NPV = PV of CI – Initial outlay

3. IRR = PV of CI = PV of CO

IRR = 31%

Refer to the excel sheet

4. PBP

PBP = 2 + 341262.57/1319368.72 = 2.26 years

5. ARR = Average net income/initial outlay

ARR = 901368.72/2400000

ARR = 38%

6. PI = PV of CI/ initial outlay

PI = 3268666.19/2400000

PI = 1.36

7. Yes, the project should be acceptable.

• NPV method is most used method for the investment decisions. It is used to analyse the projected earnings from projected investment. It is calculated by subtracting the PV of the estimated cost of the projected investment from the PV of the estimated earnings from that investment. Further this method accounts for time value of money concept by using discounted cash flows. Thus, it is to be noted that if the NPV is more than zero then accept the project otherwise rejected. In addition to this, in case of competing projects accept the project with higher NPV (Shapiro, 2005).

As per NPV method, the answer is: project should be acceptable.

• Some firms also use IRR method for the investment proposals. In this method, discount rate makes the NPV zero that means Present value of all cash flows both positive and negative is equal. This metric is used to evaluate the earnings through projected capital investments. Thus, the project should be acceptable only if IRR is greater than required rate of return. Also, when there are competing projects then with higher IRR making it seem to be an outstanding investment than the lower IRR (Shapiro, 2005).

As per IRR method, the answer is: project should be acceptable.

• Payback period states about the length of time required in order to recoup the monies spent in the investment. This method for the investment decision is simplest and it is widely used by the small business firms because it gives the rough scheduled time to the company get back the initial investment amount. Thus taken the PBP for the investment appraisal, accept the project only if pay-back period is less than the target period. Further, the project with higher PBP should be selected in case of competing projects (Kaplan and Garrick, 1981).

As per PBP method, the answer is: project should be acceptable.

• ARR states about the estimated profit earned from the projected investment. It is calculated by dividing the average net income to the initial cash outlay. It is expressed in percentage form. Further it is advisable to accept the project only if the project ARR is greater than project’s required rate of return. Higher ARR is accepted in case of mutually exclusive projects.

As per IRR method, the answer is: project should be acceptable.

• PI index is a relative degree of the NPV method. It is computed by dividing PV of CI to the Initial investment. PI is calculated in ratio form. Thus, company should move towards the project only if PI is greater than 1 otherwise rejected. Thus, for mutually exclusive projects, project with higher PI should be selected (Bierman and Smidt, 2012).  

As per PI method, the answer is: project should be acceptable.

Treatment of Loan repayment: It is given in the question that loan repayment is made at the end of every year. So the amount of interest is deducted in the operating cash flows.

Treatment of salvage amount: Salvage means the amount which is expected to receive at the end of the life of the asset. In capital budgeting, the salvage value is sum up with terminal year operating cash flow of the project.

 2.

NPV represents the earnings from the projected investment. Yes, Multitakks limited should accept the project because NPV is positive.

3. Managerial options:

Availability of managerial options increases the investment’s value. The value can be seen as its NPV composed with the options value if any.

Project’s value = NPV + value of options.

With higher uncertainty, the chances of options value are also greater (Dayananda, D., 2002).

Varieties of Managerial options are:

Option to Expand: In manufacturing business, the management seeks to make the investment and initially investment outlay represents the negative NPV and so the management finds the option to expand till the offset of the negative NPV. Thus, the project should be accepted.

Option to abandon: In this option, the project should be restraint if their economic use is not justified. In this option, the resources should be either diverted to another department or to sell the resources. Thus, when the option to abandon the project is available then, the value of investment is increased.

Option to postpone: In this option, the option to wait is available in some cases. In other words, project is not undertaken now. This is very advantageous for the company because company can gather information from external sources about prices, cost etc. and thus can take firmly decisions. Thus, it can be said that higher risks mean the higher value of option to postpone.

In fact, financial options are more easy to value than managerial options.

References

Bierman Jr, H. and Smidt, S.,2012, the capital budgeting decision: economic analysis of investment projects, Routledge.

Dayananda, D., Harrison, S., Irons, R., Herbohn, J. and Rowland, P., 2002, Capital budgeting: Financial appraisal of investment projects, Cambridge University Press: UK.

Kaplan, S. and Garrick, B.J., 1981, On the quantitative definition of risk, Risk analysis. Vol.1, no.1, pp. 11-27.

Shapiro, A.C., 2005, Capital budgeting and investment analysis, Prentice hall.

Weingartner, H.M.,1969, ‘some new views on the payback period and capital budgeting decisions,’ management science, vol.15, no.12, pp. B-594.