CORPORATE FINANCE

Corporate Finance

Corporate Finance

Question 1

Payback period

It is the duration it takes for a capital investment to recover its initial capital employed. (Bhandari, 2009, pp.2)

Project A

Initial capital Year 1 2 3 4 5 6 7 8 9 10 25,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 (22,000)

(19,000)

(16,000)

(13,000)

(10,000)

(7,000)

(4,000)

(1,000)

2,000

24,000 of the investment are recovered in 8 years and remaining 1000 OMR is recovered in the 9th year. Hence payback period of Project A is 8.(1000/3000) years which comes out to be 8.33 years.

Project B

Initial capital Year 1 2 3 4 5 3,000 1,000 1,000 1,000 1,000 1,000 (2,000)

(1,000)

-

 

 

The payback period comes out to be 3 years as the initial investment is covered at the end of 3rd year.

Project C

Initial capital Year 1

2 3 4 5 6 7 8 12,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 (10,000)

(8,000)

(6,000)

(4,000)

(2,000)

-

 

 

The payback period is 6 years as all the investment is recovered at the end of 6th year.

Project D

Initial capital Year 1 2 3 4 5 6 7 8 9 10 20,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 (16,000)

(12,000)

(8,000)

(4,000)

- -

 

 

 

 

The payback period is 5 years

Project E

Initial capital Year 1 2 3 4 5 6 7 8 9 10 11 12 40,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 (32,000)

(24,000)

(16,000)

(8,000)

- -

 

 

 

 

 

 

The payback period is 5 years.

If we rank in these projects strictly in terms of payback period, the ranking would be as follows.

Rank

Project

Payback Period

1

B

3 years

2

D

5 years

2

E

5 years

3

C

6 years

4

A

8.33 years

Internal rate of return

Internal Rate of return (IRR) is the rate at which present value of cash inflows is equal to the outflows. It is the return which in internally earned by a project without considering the external opportunity cost of capital (Lam, 2012, pp. 5). It is calculated by equating present value of inflows with the outflows which in this case in the initial investment. The projects under consideration have a conventional cash flow stream.

Project A

Year

Cash Flows

 

-25000

1

3000

2

3000

3

3000

4

3000

5

3000

6

3000

7

3000

8

3000

9

3000

10

3000

IRR

3%

The IRR by the use of spreadsheet comes out to be 3%.

Project B

Year Cash Flows (3,000)

1

1,000

2

1,000

3

1,000

4

1,000

5

1,000

IRR

20%

The IRR comes out to be 20%.

Project C

Year Cash Flows (12,000)

1

2,000

2

2,000

3

2,000

4

2,000

5

2,000

6

2,000

7

2,000

8

2,000

IRR

7%

The IRR comes out to be 7%.

Project D

Year Cash Flows (20,000)

1

4,000

2

4,000

3

4,000

4

4,000

5

4,000

6

4,000

7

4,000

8

4,000

9

4,000

10

4,000

IRR

15%

The IRR is found to be 15%.

Project E

Year Cash Flows (40,000)

1

8,000

2

8,000

3

8,000

4

8,000

5

8,000

6

8,000

7

8,000

8

8,000

9

8,000

10

8,000

11

8,000

12

8,000

IRR

17%

The IRR for this cash flow stream is ...