Assignment No.
02
Submitted To : Mam Fatima
Submitted by : Sumera Momin
(M.com 4th semester)
Roll No: M1F18MCOM0002
Subject: Project appraisal
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Question No.1
Write an essay discussing the meaning and importance of each of
these principles as they apply to capital budgeting. Evaluate the
importance of each principle and discuss the consequences of
ignoring any of these principles.
All general managers face capital-budgeting decisions in the course of their
careers. The most common of these is the simple “yes” versus “no” choice about a
capital investment. Regardless of the type of project, however, certain principles of
capital budgeting should always be considered. The most important of these
principles are:
1. Focus on Cash flows , not profits :
Mainly because we need a way to rigorously (or as rigorously as possible) account
for the time value of money and the risk of the investment -- i.e. we need to
perform discounting, and discount rates are for cash flows, not profits. Cash flow is
also generally easier to forecast than profits, which involve applying a bunch of
accounting rules.
Importance:
cash flow is more important because it keeps the business running while still
maintaining a profit. Alternately, a business may see increased revenue and cash
flow, but there is a substantial amount of debt, so the business does not make a
profit. We focus on cash flows rather than accounting profits in making our capital
budgeting decisions because earnings include non-cash transactions like
depreciation and credit sales.
Consequences of ignoring this factor:
We can’t ignore this factor because by ignoring this factor , we can't estimate the
real Inflows and outflows.
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2. Focus on incremental cash flows:
First things first, these are not just cash flows but incremental cash flows after tax
i.e. additional cash flows after tax which emanate from the new project undertaken.
We use cash flows because they determine whether the new project would be able
to generate enough cash so that it at least covers or pays off the capital that was
employed to bring it to life. Is it producing the bare minimum cash so that it leaves
us in no profit- no loss situation for this particular project 9assuming no other
cost). The profits are then determined in Income Statement to determine whether it
was actually profitable to undertake this project after deducting other expenses
related in the business.
Importance:
We focus on cash flows rather than accounting profits in making our capital
budgeting decisions because earnings include non-cash transactions like
depreciation and credit sales.
Consequences of ignoring this factor:
Incremental cash flow is about predicting the future cash flow of a business if it
takes on a new project. It helps management determine if a project is worth doing
or not. If the cash flow will increase, it is a positive incremental cash flow. So,
ignoring this factor will decrease the cash flows
3. Focus on Account for time:
The receipt of money is preferred sooner rather than later. That is the basic reason
of focusing on account for time. Because the earlier the money is received, the
greater the potential for increasing wealth. Thus, to forego the use of money, you
must get some compensation.
Importance:
Professional services firms also want their people to maximize the amount of time
they devote to generating revenue, while minimizing the amount of time spent on
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administrative duties. By tracking time, they record how productive each person is
by measuring the proportion of each day.
Consequences of ignoring this factor:
Time factor in cash flow while using capital budgeting cannot be ignored .Cash
flows received during the early years of a project get a higher weight than cash
flows received in later year. To properly manage your cash flow, you must know
the negative cash flow affects caused by the time it takes your customers to pay on
their accounts. Credit terms.
4. Focus on Account for risk:
The risk of the capital sum not being repaid. This uncertainty requires a premium
as a hedge against the risk, hence the return must be commensurate with the risk
being undertaken.
Importance:
Risk is inevitable to these investments. The various risks include cash flows not
being paid in time as agreed, the risk of the investee company collapsing and also
the management sinking the invested funds in risky projects. By incorporating risk
in capital budgeting, investors can minimize losses.
Consequences of ignoring this factor:
Risk is the potential that a chosen action or activity (including the choice of
inaction) will lead to a loss (an undesirable outcome).Risk aversion is the
reluctance of a person to accept a bargain with an uncertain payoff rather than
another bargain with a more certain, but possibly lower, expected payoff.
Question No.02
REQUIREMENT No.01
Prepare a table showing the estimated net cash flows for each year of the
project. Explain all steps involved in your calculation of the Year 1 estimated
net cash flow.
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Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 330000 330000 350000 360000 400000
Driver cost 33000 35000 36000 38000 40000
R.M 8000 13000 15000 16000 18000
Other cost 130000 135000 140000 136000 142000
Dep 120000 120000 120000 120000 120000
EBIT 39000 27000 39000 70000 80000
(_) Interest _ _ _ _ _
EBT 39000 27000 39000 70000 80000
Tax (10%) 3900 2700 3900 7000 8000
EAT 35100 24300 35100 63000 72000
Operating cash flows:
Year 1 Year 2 Year 3 Year 4 Year 5
EBIT 39000 27000 39000 70000 80000
Dep 120000 120000 120000 120000 120000
(_) Tax (3900) (2700) (3900) (7000) (8000)
OCF 155100 144300 155100 183000 192000
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Year C.F P.V Commutative P.V
1 155100 140361.991 140361.991
2 144300 118179.399 258541.39
3 155100 114954.232 373495.622
4 183000 122744.482 496240.104
5 192000 116543.978 612784.082
Net cash flows:
Year 1 155100
Year 2 144300
Year 3 155100
Year 4 183000
Year 5 192000
The first table shows the calculation of earnings after Tax (EAT)..In this all the
expenses are less from the revenue which also includes depreciation .By downing
this , I get earnings before interest and taxes. No interest is given.so I get earnings
after tax. Tax of 10% is dedicated and I get earning after tax. Then I calculate
operating cash flows. By means of which I calculate the present values and then
cumulative present values. Then finally I get net cash flows.
REQUIREMENT No.2
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Calculate the project’s Payback Period. Explain in your own words, all steps
involved in the calculation process.
Pay Back period:
Cash flows:
155100
144300
155100
183000
192000
PBP of un_ even cash flows:
= Years before full recovery + (unrecovered cost at end year / Cash flow
during the year )
= 3 + (145500/183000)
= 3.795
The second requirement is to calculate the payback period . For this , cash flows
are given. I call the payback period for uneven cash flows by using the above
formula.
REQUIREMENT No.3
Calculate the project’s Internal Rate of Return (IRR). Explain in your own
words, all steps involved in the calculation process.
ARR. = Avg income / Avg investment.
Average income = (155100+144300+155100+183000+192000). / 5
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= 165900
Average investment = 600000/ 5
= 120000
ARR. = 165900/1200
ARR. = 1.38
The third requirement is to calculate the accounting Rate of return. It is simply
calculated by the above formula which includes the average income and average
investment . Average income is calculated by adding all the cash flows by dividing
the number of years.
REQUIREMENT No.4
Calculate the project’s Net Present Value (NPV). Explain in your own words,
all steps involved in the calculation process.
Net cash Inflows:
= 330000+330000+350000+330000+40000
= 1790000
Net cash outflows :
Year 1 Year 2 Year 3 Year 4 Year 5
Printer cost 33000 35000 36000 38000 40000
R.M 8000 13000 15000 16000 18000
Other cost 130000 135000 140000 136000 142000
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Tax 3900 2700 3900 7000 8000
Net cash 174900 185700 194900 197000 20800
outflow
Net present value = PV of cash flows _ Initial investment
= 612784.082. _ 600000
NPV =. 12784.082
This requirement requires the calculation of net present values. As I know that
cash flows are equal to Inflows less outflow to calculate the cash flows then less
initial investment from it , to calculate the net present value.
REQUIREMENT No.5
Finally, which is the three evaluation techniques that you computed (i.e.,
payback period, ARR and NPV), should the firm use to make its decision of
whether or not to accept this project? Why? Is one of these techniques better
than the others and if so, why.
The techniques which I used ,the best is the net present value because this is one
of the widely used methods for evaluating capital investment proposals and this
project will be accepted .
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In this technique the cash inflow that is expected at different periods of time is
discounted at a particular rate. The present values of the cash inflow are compared
to the original investment.
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