MGT201 Financial Management Assignment No 1 Solution Fall 2012

Case:
Fiber Limited (FL) is involved in processing of cotton and sale of fiber to the country’s textile sector. On the basis of a recent market research, Fiber has found two mutually exclusive projects – Theta and Gamma. The cash flows associated with these projects are:
Cash Flows (Rs. ‘000)
Project
FY- 0 FY-1 FY-2 FY-3 FY-4 FY-5 FY-6
Theta (40,000) 8,000 14,000 13,000 5,000 11,000 10,000
Gamma (18,000) 9,000 15,100 12,000 — — —
Discount rate for both projects is 8.4%. The management of FL wants to undertake only one project.
Required
1. Determine the viability of both projects by applying Common life approach and Equivalent Annuity Approach method (EAA). (11 + 6)
2. Which project would be feasible for Fiber Limited and why? (3)
Hint: Formula for calculating EAA is PV ÷ [{1-(1+i)-n} ÷ i]

Solution :

1. Simple NPV = −Initial Investment + Sum of Net Cash Flows from Each Future Year.

Simple NPV = − Io +PV (CF1) + PV (CF2) + PV (CF3) + PV (CF4) + …+ ∞

PV(CFx) = CFx/ (1+ i)^x

Where x is the year for which you are calculating

Calculate present value (PV) for each year for both projects independently like:

 Theta Gamma 1st yr =  8,000/(1.084)^1 = 7380.07 2nd yr =11914.32 3rd yr = 10205.99 4th yr =3621.20 5th yr = 7349.30 6th yr =  6163.45 1st yr =  9,000/(1.084)^1 = 4612.54 2nd yr =12765.34 3rd yr = 9420.92

Then calculate the simple NPV for each project. For that you will need to add all the PV’s you calculated for each project.

Simple NPV for Theta = 6634.32

Simple NPV for Gamma = 8798.8

Now

Common Life Approach:

The NPV formula remains the same:

Simple NPV = − Io +PV (CF1) + PV (CF2) + PV (CF3) + PV (CF4) + …+ ∞

Least common multiple: 6 (Since theta lasts for 6 years, and gamma lasts for 3, the least common multiple will be 6)

Now Common Life NPV for Theta will be the same as Simple NPV = 6634.32

But the Common Life NPV for Gamma will be different:

Since we need to assume that Gamma lasts as long as Theta, we assume that gamma has the same outflow over the next three years as it had the first three years:

Project

 Cash Flows (Rs. ‘000)

 FY- 0

 FY- 1

 FY- 2

 FY- 3

 FY- 4

 FY- 5

 FY- 6

Gamma

(18,000)

9,000

15,000

12,000

9000

15000

12000

Now we calculate PV’s for the 4th, 5th and 6th year.

PV for 4th = 6518.16

PV for 5th = 10021.77

PV for 6th = 7396.14

Hence the Common Life NPV for Gamma will be = 32734.87

EAA Approach:

In order to find the EAA value, first calculate the EAA factor:

EAA FACTOR = (1+ i) ^n / [(1+i)^ n  – 1] where n = life of project & i=discount rate

EAA Value For Theta = 2.62

EAA Value For Gamma = 4.72

EAA for each project: Simple NPV * EAA Factor

Theta: 17381.91

Gamma: 46250.33

1. I think Gamma is better

Advantages of asset with short life

The advantage of a short life asset is that the investor, by making reinvestment in the asset of a

superior quality, lowers down the costs and updates the project to the new technological requirements.

Plus more cash inflow