BBMF2093 CORPORATE FINANCE

TUTORIAL 2 INVESTMENT APPRAISAL

1. Binaan Teguh Berhad (BTB) has two potential projects, Project A and Project B. The
forecasted cash flows and relevant information of the two projects are given below.

The internal rate of return (IRR) of Project A and Project B are 12 percent per year and 15
percent per year respectively. Both projects require initial capital in year 0 and having cost of
capital of 5 percent per year.

(a) Determine the initial capital of both projects.

x = initial capital

Project A Project B

IRR = 12% IRR = 15%

NPV = 0 NPV = 0
50 80 60 40
x+ 1
+ 2
x+ 1
+ 2
(1+0.12)❑ (1+ 0.12)❑ (1+0.15)❑ (1+0.15)❑
+80 90 + 40 20
3
+ 4
=0 3
+ 4
=0
(1+0.12)❑ (1+0.12)❑ (1+0.15)❑ (1+0.15)❑
x=−RM 222.56 mil x=−RM 120.16 mil
Project A

N 1 PV of CF ,
PVIF @ 12% , n cf
(1+r )❑
(1+r )❑n

0 x 1 -222.56

1 50 0.8929 44.65

2 80 0.7972 63.78

3 80 0.7118 56.94

4 90 0.6355 57.20

NPV =0

Project B

N 1 PV of CF ,
PVIF @ 12% , n cf
(1+r )❑
n
(1+r )❑

0 x 1 -120.16

1 60 0.9523

2 40 0.9070

3 40 0.8638

4 20 0.8227

NPV =0
 (b) Assuming both projects are mutually exclusive, suggest a capital budgeting decision
using Net Present Value (NPV) criteria. Show workings.

Project A Project B

Year CF(RM) DF 5% PV of CF Year CF(RM) DF 5% PV of CF

(RM’ mil) (RM’ mil)

0 -222.56 1 -222.56 0 -120.16 1 -120.16

1 50 0.9524 47.62 1 60 0.9524 57.14

2 80 0.9070 72.56 2 40 0.9070 36.28

3 80 0.8638 69.10 3 40 0.8638 34.55

4 90 0.8227 74.04 4 20 0.8227 16.45

40.76 24.26

Ans: Will choose project A because project A’s NPV is larger than project B, reason being that
it maximizes shareholders wealth.
 (c) Calculate payback period and discounted payback period for both projects.

Payback Period:

Project A
Y0 Y1 Y2 Y3 Y4

CF -222.56 50 80 80 90

Cumulative -222.56 -222.56 + 50 -172.56 + 80 -92.56 + 80 = -12.56 + 90 =

= - 172.56 = -92.56 -12.56 77.44
12.56
Payback Period = 3 + = 3.1395 years
90

Project B
Y0 Y1 Y2 Y3 Y4

CF -120.16 60 40 40 20

Cumulative -120.16 -120.16 + 60 -60.16 + 40 = -20.16 + 40 =

= - 60.16 -20.16 19.84
20.16
Payback Period = 2 + = 2.504 years
40

Discounted Payback Period:

Project A

Y0 Y1 Y2 Y3 Y4

CF -222.56 50 80 80 90

PV of CF -222.56 50 80 80 90
1 2 3 4
(1+0.05)❑ (1+0.05)❑ (1+0.05)❑ (1+0.05)❑
= 47.6190 = 72.5624 = 69.1070 = 74.0432

Cumulative -222.56 -222.56 + -174.94 + -102.38 + -33.27 +

47.6190 = - 72.5624 = - 69.1070 = - 74.0432 =
174.94 102.38 33.27 40.77
33.27
Discounted Payback Period = 3 + = 3.45 years
74.0432
Project B

Y0 Y1 Y2 Y3 Y4

CF -120.16 60 40 40 20

PV of CF -120.16 60 40 40 20
(1+0.05)❑1 (1+0.05)❑2 (1+0.05)❑3 (1+0.05)❑4
= 57.1429 = 36.2812 = 34.5535 = 16.4540

Cumulative -120.16 -120.16 + -63.02 + -26.74 +

57.1429 = - 36.2812 = - 34.5535 =
63.02 26.74 7.8176
26.74
Discounted Payback Period = 2 + = 2.77 year
34.55
(d) Is your capital budgeting decision in (b) - NPV method consistent with the decision using
IRR? Provide reasons.

No, because the NPV method assumes CFs are invested at the discount factor whereas the IRR
method assumes that CFs are reinvested at the IRR. IRR can have multiple values when cash
flows move from negative to positive multiple times during the lifetime of the project

(e) Determine the Modified Internal Rate of Return (MIRR) for Project A.

Year Cashflow Compounded

0 -222.56 -222.56

1 50 50(1.05)^3 57.88

2 80 80(1.05)^2 88.2

3 80 80(1.05)^1 84

4 90 90 90

320.08

MIRR=
√
TV compounded withcost of capital
n

PV cash outflows
−1

MIRR=
√
4 320.08

222.56
−1
MIRR = 0.09509 = 9.51%
 2. The management of NuRobotic Sdn. Bhd. is considering to purchase a new equipment. Its
choice is between Equipment A and Equipment B. Both equipment have five-year useful life
and they are mutually exclusive.

The initial cost (cash outlay) for Equipment A is RM160,000 and for Equipment B is
RM220,000 and their respective scrap values at the end of year 5 are given as follows:
Equipment A Equipment B
Initial Investment RM160,000 RM220,000
Scrap Value (adjust at the RM10,000 RM25,000
last period)
The cash inflows generated are as follows:
Year Equipment A (RM) Equipment B (RM)
1 30,000 70,000
2 40,000 70,000
3 80,000 60,000
4 60,000 60,000
5 60,000 50,000
Required
(a) NuRobotic’s current investment policy is to accept only investments that arerecoverable
within 4.5 years. Calculate the discounted payback period for equipment A and equipment B
if the cost of capital is 12%. Advise the company which new equipment to purchase if they
are mutually exclusive.

Ans:
Discounted Payback Period:

Equipment A

Y0 Y1 Y2 Y3 Y4 Y5

CF -160,000 30,000 40,000 80,000 60,000 60,000 +10,000

PV of CF -160,000 30,000 40,000 80,000 60,000 60,000

1 2 3 4 5
+¿
(1+0.12)❑ (1+0.12)❑ (1+0.12)❑ (1+0.12)❑ (1+0.12)❑
= 26,785.71 = 31,887.76 = = 38,131.08 10,000
56,942.42 (1+0.12)❑5
= 34,045.61 +
5,674
= 39,719.61

Cumulative -160,000 -160,000 + - - - -6253.03+

26,785.71 = - 133,214.29+ 101,326.53 44,384.11+3 39,719.61 =
 133,214.29 31,887.76 = - +56,942.42 8,131.08 = - 33466.58
101,326.53 =- 6253.03
44,384.11
6253.03
Discounted Payback Period (don’t include scrap value) = 4 + = 4.18 years
34,045.61

Equipment B

Y0 Y1 Y2 Y3 Y4 Y5

CF –220,000 70,000 70,000 60,000 60,000 50,000 +

25,000 =
75,000

PV of CF –220,000 70,000 70,000 60,000 60,000 50,000

1 2 3 4 5
+¿
(1+0.12)❑ (1+0.12)❑ (1+0.12)❑ (1+0.12)❑ (1+0.12)❑
= 62,500 = 55,804 = 42,707 = 38,131 25,000
5
(1+0.12)❑
=28,371 +
14,185
= 42,557.01

Cumulative –220,000 -220,000 + -157,500 + - -58989+38,131 = - -

62,500 = - 55,804 = - 101,69+4 20,858 20,858+28,37
157,500 101,69 2,707 = - 1+14,185 =
58,989 21,698
20,858
Discounted Payback Period = 4 + = 4.74 years
28,371
(b) Calculate the Net Present Value (NPV) for equipment A and equipment B given the cost of
capital is 12%.

Equipment A
By using financial calculator:
CFo = -160,000
CO1 = 30,000
CO2 = 40,000
CO3 = 80,000
CO4 = 60,000
CO5 = 60,000 + 10,000

I = 12%
NPV = RM33,467

Equipment B
By using financial calculator:
CFo = -220,000
CO1 = 70,000
CO2 = 70,000
CO3 = 60,000
CO4 = 60,000
CO5 = 50,000 + 25,000

I = 12%
NPV = RM21,700

Ans: choose Project A, because highest NPV value, it can maximize shareholders wealth.

(c) Advise the management on which equipment to purchase based on NPV calculation if
equipment A and equipment B are mutually exclusive. Explain your recommendation.

If equipment A and B are mutually exclusive, the management should select Equipment A
because Equipment A has a higher positive NPV value. This indicates that with a higher NPV,
Equipment A would have a future cash stream that is higher than the amount of money that
was invested in the project.

(d) The simple payback method of investment appraisal is the most popular method used in
practice. Comment on the aforementioned statement.

It is not accurate to say that it is the most popular method because it has both advantages and
disadvantages. It is easy to understand and compute. However, it has several theoretical
limitations. Its disadvantages / limitations are :
- Ignores the time value of money ( It does not consider the timing of the cash flow.)
- Ignores CFs occurring after the payback period. (it does not consider the entire life of
the investment project.)
- It does not consider the riskiness of the cash flow
- It is a measure of profitability.
3. Co XYZ is considering investing in 1 of 2 projects. Its choices are Project A and Project B.
Both are mutually exclusive and can be repeated. Co XYZ’s WACC is 9%. Expected net
cash flow from both projects are as follows:

Expected Net CFs

Year Project A Project B
0 ($120,000) ($120,000)
1 70,000 38,500
2 70,000 38,500
3 - 38,500
4 - 38,500

Required

(a) Compute NPV for both projects. Based on computation of NPV, which project should be
selected?

Project A
By using financial calculator:
CFo = -120,000
CO1 = 70,000
CO2 = 70,000

WACC= 9%
NPV = RM3,137.78

Project B
By using financial calculator:
CFo = -120,000
CO1 =38,500
CO2 =38,500
CO3 =38,500
CO4 =38,500

WACC = 9%
NPV = RM4,729.22

Ans: Project B has higher NPV however we should not choose B based on the above
computation. This is because both projects have unequal life, Project A has a 2 year
lifespan while Project B has a 4 year life span. As both projects can be repeated a
replacement chain analysis should be done.
(b) Conduct a replacement chain analysis on Project A and Project B. Thereafter, make a
recommendation on which project should be selected.

Project A
By using financial calculator:
CFo = -120,000
CO1 = 70,000
CO2 = -120,000 + 70,000 = - 50,000
CO3 = 70,000
CO4 = 70,000

WACC= 9%
NPV = RM5,778.79

Project B
By using financial calculator:
CFo = -120,000
CO1 =38,500
CO2 =38,500
CO3 =38,500
CO4 =38,500

WACC = 9%
NPV = RM4,729.22

Ans: The company should choose Project A, because it has a higher positive NPV value.
4. Using a numerical example and a situation where a company has to decide between 2 choices
of projects with similar lifespan, explain how IRR can help the company arrive at a decision
in its selection of which project to invest in.

Ans: The higher the projected IRR on a project and the greater the amount it exceeds the
cost of capital the more net cash the project generates for the company.

Both company’s IRR is higher than their WACC. If the project is mutually exclusive, then
the company should choose the highest IRR (Project A). If the project is independent, then
the company can choose both projects.

Company A
WACC = 5%
CFo= -120,000
CF1= 40,000
CF2= 65,000
CF3= 55,000
IRR= 15.05%

Company B
WACC = 5%
CFo= -150,000
CF1= 50,000
CF2= 70,000
CF3= 60,000
IRR= 9.41%
5. When is replacement chain analysis needed? Provide an example of replacement chain
analysis. (Lecture example not to be use.)

Ans:
The replacement chain method is used in capital budgeting to rank mutually exclusive
projects with unequal life spans.

Example:
If a company considering to invest in two mutually exclusive projects at same initial cost
RM100,000 and different life spans
Cost of capital raised to finance the project is 10%.
Year 0 1 2 3 4

Project A - RM100,000 RM60,000 RM60,000 - -

Project B - RM100,000 RM33,000 RM33,000 RM33,000 RM33,000

NPV (without replacement chain)

Financial Calculator
Project A Project B
CF0 = -100,000 CF0 = -100,000
CF1 = 60,000 CF1 = 33,000
N = 2 N = 4
I = 10 I = 10
NPV = 4,132 NPV = 4,606

*Project B NPV > Project A NPV

Using Replacement Chain Method
The life span of Project B is 4 years and 2 years for Project A, so the minimum common
multiple lifespan is 4 years, which means that Project A should be repeated twice while
Project B only once.
Project A

Financial Calculator
CF0 CF1 CF2 CF3 CF4 I NPV

-100,000 60,000 -40,000 60,000 60,000 10 RM7,547

Project A NPV = RM 7,545 ( on extended basis)

Project A have higher NPV