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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