Business Finance Assignment #2 Solution

Business Finance -ACC501

ASSIGNMENT NO. 2

BK Brothers (Pvt.) Limited is a sports goods manufacturing company of Sialkot. The company

manufactures different sports goods including cricket bats, footballs and tennis rackets. Now, the

company has planned to manufacture baseball bats and gloves. In order to manufacture these

products, the company needs to install a new manufacturing plant for which it has received two

proposals. To analyze these two alternatives, financial analyst of the company Mr. Usman Ali has

prepared following estimates of the initial investment and cash inflows associated with the

acquisition of new plants:

Plant A Plant B

Initial Investment ( 700,000 ) ( 420,000 )

Years (t) Cash Inflows (CFs)

1 130,000 90,000

2 185,000 125,000

3 170,000 100,000

4 172,000 92,000

5 450,000 220,000

Mr. Usman Ali has analyzed both projects for a period of 5 years. According to his analysis, the plants

would be sold after 5 years resulting large fifth-year cash inflows. He feels that although the two

plants have similar risk but plant A has a much higher initial investment. He has applied the firm’s

cost of capital (required rate of return) of 12% while analyzing the options. BK Brothers (Pvt.) Limited

requires all projects to have a maximum payback period of 4 years.

REQUIRED:

a. Use the following capital budgeting techniques to evaluate the feasibility of each plant:

(1) Payback Period ( 3 + 3 = 06 Marks)

(2) Net Present Value (NPV) ( 5 + 5 = 10 Marks)

(3) Internal Rate of Return (IRR) ( 6 + 6 = 12 Marks)

b. On the basis above findings, summarize your results according to the following format and

interpret which plant the company should acquire and why? ( 1 + 1 = 02 Marks)

Capital Budgeting

Technique

Plant A Plant B

Which Plant is

Better?

Payback Period (Years)

Net Present Value (Rs.)

Internal Rate of Return (%)

Decisive Interpretation: (Which Plant should be acquired and why?)

SOLUTION:

(a) CAPITAL BUDGETING TECHNIQUES:

(i) Payback Period:

Plant A:

Years 1 2 3 4 5

Cash Flow (Rs.) 130,000 185,000 170,000 172,000 450,000

Cum. CF (Rs.) 130,000 315,000 485,000 657,000 110,7000

Payback Period = 4 + (43000 / 450,000) = 4 + 0.096

Payback Period = 4.10 years

Plant B:

Years 1 2 3 4 5

Cash Flow (Rs.) 90,000 125,000 100,000 92,000 220,000

Cum. CF (Rs.) 90,000 215,000 315,000 407,000 627,000

Payback Period = 4 + (13,000 / 220,000) = 4 + 0.059

Payback Period = 4.06 years

(ii) Net Present Value (NPV):

Plant A:

NPV = – I.Inv. + {CF1/(1+r)} + {CF2/(1+r)2} + {CF3/(1+r)3} + {CF4/(1+r)4} + {CF5/(1+r)5}

NPV = – 700,000 + {130,000/(1+0.12)} + {185,000/(1+0.12)2} + {170,000/(1+0.12)3}

+ {172,000/(1+0.12)4} + {450,000/(1+0.12)5}

NPV = – 700,000 + (130,000/1.12) + (185,000/1.2544) + (170,000/1.4049)

+ (172,000/1.5735) + (450,000/1.7623)

NPV = – 700,000 + 116,071 + 147,481 + 121,003 + 109,309 + 255,342

NPV = – 700,000 + 749,206

NPV = Rs. 49,206

Plant B:

NPV = – I.Inv. + {CF1/(1+r)} + {CF2/(1+r)2} + {CF3/(1+r)3} + {CF4/(1+r)4} + {CF5/(1+r)5}

NPV = – 420,000 + {90,000/(1+0.12)} + {125,000/(1+0.12)2} + {100,000/(1+0.12)3}

+ {92,000/ (1+0.12)4} + {220,000/ (1+0.12)5}

NPV = – 420,000 + (90,000/1.12) + (125,000/1.2544) + (100,000/1.4049)

+ (92,000/1.5735) + (220,000/1.7623)

NPV = – 420,000 + 80,375 + 99,649 + 71,178 + 58,468 + 124,834

NPV = – 420,000 + 434,486

NPV = Rs. 14,486

(iii) Internal Rate of Return (IRR): (By using Trial & Error Method)

Plant A:

NPV @ 12 %: (as calculated above in NPV section)

NPV = Rs. 49,206

NPV @ 15%:

NPV = – I.Inv. + {CF1/(1+r)} + {CF2/(1+r)2} + {CF3/(1+r)3} + {CF4/(1+r)4} + {CF5/(1+r)5}

NPV = – 700,000 + {130,000/(1+0.15)} + {185,000/(1+0.15)2} + {170,000/(1+0.15)3}

+ {172,000/(1+0.15)4} + {450,000/(1+0.15)5}

NPV = – 700,000 + (130,000/1.15) + (185,000/1.3225) + (170,000/1.5208)

+ (172,000/1.7490) + (450,000/2.0114)

NPV = – 700,000 + 113,043 + 139,887 + 111,778 + 98,342 + 223,730

NPV = – 700,000 + 686,779

NPV = Rs. - 13,221

By using 12% rate we have a positive figure that is greater than zero whereas by using 15%

rate we have a negative figure that is lesser than zero. Thus, NPV appears to be zero

between 12% and 15% so IRR is somewhere in that range. By using INTERPOLATION

Formula, we can find the approximate value of IRR.

IRR = Lower discount Rate + Difference between the two discount rates x (NPV at

lower discounted rate / absolute difference between the NPVs of the two

discount rates)

= 12 + (15 – 12) x (49,206 / (49,206 – (–13,221))

= 12 + 3 x (49,206 / 62427)

= 12 + 3 x 0.7882166

= 12 + 2.3646498

IRR = 14.36 %

Plant B:

NPV @ 12 %: (as calculated above in NPV section)

NPV = Rs. 14,486

NPV @ 15 %:

NPV = – I.Inv. + {CF1/(1+r)} + {CF2/(1+r)2} + {CF3/(1+r)3} + {CF4/(1+r)4} + {CF5/(1+r)5}

NPV = – 420,000 + {90,000/(1+0.15)} + {125,000/(1+0.15)2} + {100,000/(1+0.15)3}

+ {92,000/ (1+0.15)4} + {220,000/ (1+0.15)5}

NPV = – 420,000 + (90,000/1.15) + (125,000/1.3225) + (100,000/1.5208)

+ (92,000/1.7490) + (220,000/2.0114)

NPV = – 420,000 + 78,261 + 94,518 + 65,752 + 52,601 + 109,379

NPV = – 420,000 + 400,511

NPV = Rs. - 19,489

By using 12% rate we have a positive figure that is greater than zero whereas by using 15%

rate we have a negative figure that is lesser than zero. Thus, NPV appears to be zero

between 12% and 15%, so IRR is somewhere in that range. By using INTERPOLATION

Formula, we can find the approximate value of IRR.

IRR = Lower discount Rate + Difference between the two discount rates x (NPV at

lower discounted rate / absolute difference between the NPVs of the two discount

rates)

= 12 + (15 – 12) x (14,486 / (14,486 – (–19,489))

= 12 + 3 x (14,486 / 33,975)

= 12 + 3 x 0.426372

= 12 + 1.279125

IRR = 13.28 %

(b) CONCLUSION:

Capital Budgeting

Technique

Plant A Plant B

Which Plant is

Better?

Payback Period (Years) 4.10 years 4.06 years Plant B

Net Present Value (Rs.) Rs. 49,206 Rs. 14,486 Plant A

Internal Rate of Return (%) 14.36% 13.28 % Plant A

Decisive Interpretation: (Which Plant should be acquired and why?)

It can be concluded on the basis of above analysis that Plant A is more feasible

as it is having a higher NPV along with a higher IRR. Payback period is almost

same for both plants however it is bit lower for Plant B but NPV and IRR are

considered stronger criteria as compared to payback period.

Therefore, Plant A should be acquired.

---

Show your LOVE Please Like us on facebook | Follow on twitter