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Question 4: Sam Yin Investment Limited received two projects tender namely "Pr...

Oct 6, 2024

Solution by Steps

a. Payback Period and its Criticism

step 1

The payback period is the time it takes for an investment to generate an amount of cash inflows equal to the initial investment

step 2

A major criticism of the payback period is that it does not consider the time value of money, meaning it treats all cash inflows as equal regardless of when they occur

Answer

The payback period is the time required to recover the initial investment, but it fails to account for the time value of money.

--- b. Calculate the Payback Period

step 1

For Project China, the cumulative cash flows are: Year 0: -15,900; Year 1: -9,300; Year 2: -4,500; Year 3: -2,480; Year 4: -0

step 2

For Project Japan, the cumulative cash flows are: Year 0: -15,900; Year 1: -4,883; Year 2: -0; Year 3: 2,513; Year 4: 2,971

step 3

Project China recovers its investment in Year 4, while Project Japan recovers it in Year 2. Since the required payback period is 3 years, Project Japan should be accepted

Answer

Project Japan has a payback period of 2 years, which is within the required 3 years, so it should be accepted.

--- c. Calculate the Net Present Value (NPV)

step 1

The NPV formula is given by:

NPV = \sum_{t=0}^{n} \frac{C_t}{(1 + r)^t}

where

C_t

is the cash flow at time

t

and

r

is the discount rate

step 2

For Project China, the NPV calculation at 12% discount rate is:

NPV_{China} = -15,900 + \frac{6,600}{1.12} + \frac{4,800}{(1.12)^2} + \frac{2,020}{(1.12)^3} + \frac{2,480 + 184}{(1.12)^4} + \frac{3,395}{(1.12)^5}

step 3

For Project Japan, the NPV calculation is:

NPV_{Japan} = -15,900 + \frac{11,017}{1.12} + \frac{4,883}{(1.12)^2} + \frac{2,513}{(1.12)^3} + \frac{458}{(1.12)^4} + \frac{321}{(1.12)^5} + \frac{103}{(1.12)^8}

step 4

After calculating both NPVs, compare them. The project with the higher NPV should be accepted

Answer

The project with the higher NPV should be accepted; calculate both NPVs to determine which is greater.

--- d. Evaluate Cash Flows and Time Value of Money

step 1

Cash flows refer to the actual inflows and outflows of cash, which are critical for assessing the viability of an investment

step 2

The time value of money concept states that a dollar today is worth more than a dollar in the future due to its potential earning capacity

step 3

NPV considers the time value of money by discounting future cash flows, while IRR is the discount rate that makes the NPV equal to zero. NPV provides a dollar value, while IRR provides a percentage return

Answer

Cash flows are essential for investment analysis, and the time value of money indicates that money today is worth more than the same amount in the future. NPV and IRR are both methods for evaluating investments, with NPV providing a dollar value and IRR providing a rate of return.