Semester Fall 2012
Financial Management (MGT201)
Assignment No. 01
Learning Objectives  The students are expected to understand the application of usual capital budgeting techniques applied particularly to the projects with unequal lives.
Learning Outcomes  After going through this activity, the student would be able to apply capital budgeting techniques especially in the case of projects with unequal lives.
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:
Project
Cash Flows (Rs. ‘000)
FY 0 FY1 FY2 FY3 FY4 FY5 FY6
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]
Show formulas and complete calculations as they carry marks.
Note:
Only in the case of Assignment, 24 hours extra / grace period after the due date is usually available to overcome uploading difficulties which may be faced by the students on last date. This extra time should only be used to meet the emergencies and above mentioned due dates should always be treated as final to avoid any inconvenience.

SOLUTION IDEA
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

1^{st} yr =
8,000/(1.084)^1 = 7380.07
2^{nd} yr =11914.32
3^{rd} yr = 10205.99
4^{th} yr =3621.20
5^{th} yr = 7349.30
6^{th} yr = 6163.45

1^{st} yr =
9,000/(1.084)^1 = 4612.54
2^{nd} yr =12765.34
3^{rd} 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











Gamma

(18,000)

9,000

15,000

12,000

9000

15000

12000

http://vustudents.ning.com/
Now we calculate
PV’s for the 4^{th}, 5^{th} and 6^{th} year.
PV for 4^{th}
= 6518.16
PV for 5^{th}
= 10021.77
PV for 6^{th}
= 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
http://vustudents.ning.com/
Everything done
according to handouts  well most of it. Formula’s used from the handouts
as well. I didn’t understand the hint formula at the end, so I just used what’s
given in the handouts. Pray I pass all my subjects this semester please :(
htt
Solution Idea
 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

1^{st} yr = 8,000/(1.084)^1 = 7380.07
2^{nd} yr =11914.32
3^{rd} yr = 10205.99
4^{th} yr =3621.20
5^{th} yr = 7349.30
6^{th} yr = 6163.45

1^{st} yr = 9,000/(1.084)^1 = 8302.58
2^{nd} yr =12765.34
3^{rd} 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 = 12488.84
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











Gamma

(18,000)

9,000

15,000

12,000

9000

15000

12000

Now we calculate PV’s for the 4^{th}, 5^{th} and
6^{th} year.
PV for 4^{th} = 6518.16
PV for 5^{th} = 10021.77
PV for 6^{th} = 7396.14
Hence the Common Life NPV for Gamma will be = 36424.91
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: 58947.32
 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