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FIN622 Corporate Finance Assignment 1 Solution Fall 2012

Tyres Manufacturing Incorporation (TMI) – a fast growing tyre manufacturing company in Pakistan has been serving nationally and internationally for the last 40 years. The company is a standard manufacturer of rubber tyres and tubes for all types of light vehicles running on the country’s roads. TMI is reliable name known for its quality products. Major customers of the company include people owing and driving vehicles manufactured by famous vehicle manufacturers in Pakistan. To meet the rising demand for its products, TMI is thinking to expand manufacturing capacity for which two mutually exclusive investment opportunities named as project Alpha and Project Beta are under consideration.
The management has gathered necessary data which will be helpful in evaluation of the projects. Evaluation will be done through capital budgeting techniques. The company has to choose between these two equally risky and mutually exclusive projects. The expected cash flows of two projects are as follows:
Year
End
Project Alpha
Rs.(000)
Project Beta
Rs. (000)
0 (200,000) (200,000)
1 60,000 55,000
2 80,000 65,000
3 75,000 70,000
4 60,000 80,000
TMI has estimated its required rate of return for each project at 12.3%. It has also estimated internal rate of return (IRR) for project Alpha at 14% and for project Beta at 12%.
Required
You as financial analyst need to recommend one of the two projects that TMI may add to its assets.
Your decision is subject to the following: 1. Calculate Net Present Value (NPV) and profitability Index (PI) for each project. (16 marks)
2. If you apply NPV criterion, which project should be selected and why? (1 mark)
3. If you apply Profitability Index criterion, which project should be selected and why? (1mark)
4. If you apply IRR criterion, which project should be selected and why? (2 marks)
Show formulas and complete calculations as they carry marks.

Solution:

Net Present Value (NPV)
NPV = -Io + CF1 / (1+i)^1 + CF2 / (1+i)^2 + CF3 / (1+i)^3 + CF4 / (1+i)^4 +…….+ ∞
For Alpha:
Io= 20,000
i = initial investment for alpha = 14%
For Beta:
Io= 20,000
i = initial investment for Beta = 12%

 

Profitability Index (PI):
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

 

Year Project Alpha
Years End Rs.(000) FVIF
12.3%=1/(1.123)^t
PV PI
0 -200,000 1.000 -200000

-0.85

1 60,000 1.123 67380

2.83

2 80,000 1.261 100890.32

2.12

3 75,000 1.416 106218.59

2.27

4 60,000 1.590 95426.78128

2.83

Total

75,000

  169915.6913  
Project Beta  
Years End Rs.(000) FVIF
12.3%=1/(1.123)^t
PV PI
0 -200,000 1.000 -200000

-0.851

1 55,000 1.123 61765

3.093

2 65,000 1.261 81973.385

2.617

3 70,000 1.416 99137.35069

2.430

4 80,000 1.590 127235.7084

2.126

Total NPV 170111.4441  

 

 

PV of Future Cash Flows of project ALPHA = 53428+ 63435 + 52956+ 37725
= 207547

PI= 207547/200000

 

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