# The opportunity cost of capital for b is 10 percent a

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The opportunity cost of capital for A is 14 percent. The opportunity cost of capital for B is 10 percent. a. Calculate the NPV for each project. b. Calculate the IRR for each project. c. Which project(s) should be accepted in each of the following situations? (1) The projects are mutually exclusive and there is no capital constraint. (2) The projects are independent and there is no capital constraint. (3) The projects are independent and there is a total of Rs.100,000 of financing for capital outlays in the coming period. d. Explain why the cost of capital for A might be higher than for B. Answers: a. NPV A = Rs.8,274, NPV B = Rs.11,065; b. IRR A = 21.86%, IRR B = 16.08% 8. Replacement project: Existing machine was purchased 2 years ago at a cost of Rs.3,200. It is being depreciated straight line over its 8 year life. It can be sold now for Rs.3,000 or used for 6 more years at which time it will be sold for an estimated Rs.500. It provides revenue of Rs.5,000 annually and cash operating costs of Rs.2,000 annually. A replacement machine can be purchased now for Rs.7,800. It would be used for 6 years, and depreciated straight line. It will result in additional sales revenue of Rs.1,500 annually, but because of its increased efficiency it would reduce cash operating costs by Rs.600 per year. The new machine would require additional inventories of Rs.700, and accounts receivable would increase by Rs.300. Its expected salvage value in 6 years is Rs.2,000. The tax rate is 40% and the required rate of return is 13%. Should the old machine be replaced?

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245 a. Calculate the incremental cash flow at time 0. b. Calculate the incremental annual operating cash flows that result from the new machine. c. Calculate the incremental terminal cash flow. d. Show the incremental CFs in the table below. Year Cash Flow 0 ________ 1 ________ 2 ________ 3 ________ 4 ________ e. Calculate the NPV for this project. Answers: a. Rs.6,040; b. Rs.1,620; c. 1,900; e. 1,349 Pay back period (A) When Cash inflows are uniform Initial investment Rs.2,00,000 Annual cash inflow Rs.50,000 Pay back period = Original Investment Annual cash inflow = 2,00,000 50,000 = 4 Years (B) When cash inflows are not uniform It investment in a project Rs.8,00,000 and net cash inflows after tax but before depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000, Rs,20,000, Rs.30,000, Rs.35,000 and Rs.15,000 Respectively, pay back period is calculated as follows. Solution Year Cash Inflow Cumulative cash inflows 1 Rs.20,000 Rs.20,000 2 Rs.25,000 Rs.45,000 3 Rs.20,000 Rs.65,000 4. Rs.30,000 Rs.95,000 At end of 4 th year the cumulative cash inflow exceeds the investment of Rs.80,000 Pay back period = 3 Years + 15000 30000 = 3 Years + ½ year = 3.5 Year
246 ARR on original investment method Annual average net earnings ARR = x 100 Original investment scrap value ARR on average investment method Annual average net earnings ARR = x 100 Average investment Average investment = Original investment 2 Average investment = Original investment Scrap value of asset 2 Original invest scarp value Average investment = + Additional working 2 + scrap capital value Discount Factor 1 where (1+r) n r Discount rate n No of years For example Discounting factor at 10% rate for a period of 5 year P.V. Factor for 1 st year = 1 = 1 = 0.909 (1 + 1) 1 1. 1 P.V. Factor for 2 nd year = 1 = 1 = 0.826 (1 + 1) 2 1. 21

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247 P.V. Factor for 3 rd
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• Spring '12
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