Mr. Ali wants to start “Rent-A-Car” business. He wants to start this business with at least 20 cars. He estimates that the required investment for the business is Rs. 30 Million. He projects that revenue (before tax and depreciation) from the business will be Rs. 6 Million for the first year and it will keep on growing at a rate of 5% annually till the 10th year.
Some other information regarding the project is as follows:
Annual depreciation will be Rs. 3 Million under the straight line method.
Cost of capital is 10% while the rate of tax is 35%.
Suppose you are running a financial consultancy firm, Mr. Ali wants to get his project evaluated by your firm. You have to suggest Mr. Ali about the feasibility of the project after applying different capital budgeting techniques.
Keeping your task into consideration, provide answers to the following:
1. Calculate net cash flows for 10 years. (10 Marks)
2. Evaluate the project by using the following capital budgeting techniques:
a. Payback Period (The desired payback period is 5 years) (04 Marks)
b. Net Present Value (10 Marks)
c. Profitability Index (03 Marks)
3. Is there any contradiction among the results of above used techniques? What would be your final recommendation regarding the acceptance/rejection of the project? Support your recommendation with financial rationale. (03 Marks)
We will know this by applying the NPV rule,
Calculating the future cash flows:
PV = 10,000 x (1-1/1.15^8 ) / 0.15 + 2000 / 1.15^8
PV = 10,000 x 4.4873 + 2000 / 3.0590
PV = 45,527
Comparing this value with the estimated costs, NPV is;
NPV = -40,000 + 45,527
NPV = 5,527
Therefore, this is a good investment, as it would increase the total worth.
Requirement: What is the Payback period of the project?
Project costs = 40,000
After the first year cash revenue is 30,000
Remaining 10,000 will be paid during 2nd year so the Payback period of project is
10,000 / 30,000 = 0.3
1 + 0.3 = 1.3 Years
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