Question

Scenario1: Clayton Associates (LO 1a) Rayon Associates is an investment bank who are currently evaluating three options for their client, the BG Group. The options are called Project Diamond, Project Coral and Project Copper. Rayon Associates have hired you to help them make the correct recommendations to their client. They have provided you with the information given below and have asked you to answer a set of questions.

Q 1. The cost of capital, initial outlay and the cash inflows of each project are shown in the table below. Calculate the values below and fill in the table: a. NPV of each project, and provide a brief explanation of its viability. Your answer should include the acceptance criteria for NPV and explain how time value money is related to this investment decision. (7 marks as allocated in the table) b. IRR for each project, and provide a brief explanation for your decision. (5 marks as allocated in the table)

10% Cost of capital Allocati ons of Marks Project Diamond Project Coral Project Copper Initial ($2,400,000) ($2,100,000) ($1,500,000) outlay Inflow year 250,000 140,000 350,000 410,000 310,000 150,000 450,000 520,000 160,000 520,000 480,000 140,000 600,000 510,000 150,000 520,000 610,000 160,000 540,000 625,000 125,000 650,000 130,000 710,000 650,000 400,000 150,000 700,000 190,000 70,000 a. NPV (1 x 3 = 3marks) Based on the NPVS calculated, provide a brief explanation of its viability. Your answer should include the acceptance criteria for NPV and explain how time value of money is related to this investment decision. (4 marks) b. IRR (1 x 3) = 3 marks Based on the calculations of IRR, provide a brief explanation for your decision? (2 marks)

Answer 1

To find the NPV, first we need to find the present value of all the cash flows at the year 0. We will do this by discounting the cash flows to the year 0 at the cost of capital i.e. 10%. You can do this in excel by using the NPV function then input rate=105 and then selecting all the cash flows. This will provide you with the sum of the present values of all the cash flows.

Year	Project Diamond	Project Coral	Project Copper
1	$        250,000.00	$      350,000.00	$           140,000.00
2	$        310,000.00	$      410,000.00	$           150,000.00
3	$        450,000.00	$      520,000.00	$           160,000.00
4	$        520,000.00	$      480,000.00	$           140,000.00
5	$        600,000.00	$      510,000.00	$           150,000.00
6	$        520,000.00	$      610,000.00	$           160,000.00
7	$        540,000.00	$      625,000.00	$           125,000.00
8	$        710,000.00	$      650,000.00	$           130,000.00
9	$        650,000.00	$      400,000.00	$           150,000.00
10	$        700,000.00	$      190,000.00	$             70,000.00
Sum of PV of all cash flows	$     2,996,678.35	$   2,903,399.81	$           865,919.35

The Sum of PV of all the cash flows of each project represents the present value of all the cash flow in the year 0.

Now to find the NPV we will subtract the sum of PV of all the cash flows from the initial investment of the project.

Thus the NPV for project diamond =  $ 2,996,678.35 - $ 2,400,000 = 596,678.35

The NPV for project Coral = $ 2,903,399.81 - $2,100,000 = $ 803,399.81

The NPV for project Copper = $ 865,919.35 - $1,500,000 = -$ 634,080.65

The project with positive NPV are the acceptable projects because they are providing a net positive cash inflow which means that the total money earned is more than the total money invested in the project. Thus the Project Diamond and Project Coral should be accepted whereas project Copper should be rejected as the net total cash inflow from the project is less than the money invested in the project.Time value of money is related to this investment decision as the time value of money concept tells us that the value of money gets depreciated with time. In this question we found the present value of the cash flows because we know that the present value of those cash flows at year 0 will be less than its future value due to time value of money.

The IRR of the project can be calculated by the excel function of IRR and then selecting the whole cash flow from year 0 to year 10. This will provide us the values as follows

the IRR of Project diamond = 15%

The IRR of project Coral = 18%

The IRR of Project Copper = -2%

We will always choose a project whose IRR is more than the cost of capital. Here Project Diamond and Project Coral have an IRR greater than the Cost of Capital i.e. 10%. This is done because the IRR stands for internal rate of return which tells us the rate of return of the project and Cost of capital tells us the return which the company has to pay to its investors/debtors. Thus the return on any project should be more than the cost of capital for the company to get profit from the project. Also, when the projects are mutually exclusive, the project with the highest IRR should be chosen before any other as it is providing the highest return .