Exercise 1

Year Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7

0 (5,000.00) (10,000.00) (15,000.00) (25,000.00) (25,000.00) (30,000.00) (35,000.00)
1 1,000.00 1,000.00 1,700.00 1,000.00 11,000.00 (3,000.00) (9,000.00)

2 1,000.00 2,000.00 1,700.00 1,200.00 10,000.00 10,000.00 (3,000.00)

3 1,000.00 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00

4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00

5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00

6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00 12,000.00
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.00
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.00

9 500.00 2,000.00 1,700.00 12,000.00 3,000.00 3,000.00 14,000.00

10 500.00 2,000.00 1,700.00 20,000.00 5,000.00 3,000.00 14,000.00

Sum of the Cash inflows 7,500.00 25,000.00 17,000.00 68,200.00 68,000.00 52,000.00 86,000.00
Excess of Cash inflow over initial
2,500.00 15,000.00 2,000.00 43,200.00 43,000.00 19,000.00 39,000.00
investment (Cash outflow)

Question 1 Rank the projects simply by inspecting the cashflows (excess of cash inflows over cash outflows)

Answer
Net Cashflow 2,500.00 15,000.00 2,000.00 43,200.00 43,000.00 19,000.00 39,000.00

Ranking 6 th 5 th 7 th 1 st 2 nd 4 th 3 rd

Rank the projects usind the various quantitative methods, assume that all projects are from the same risk
Question 2 class and appropriate discount rate is 9%. Breifly explain the various methods, and specify which
quantitative ranking methods are better and why?
Answer
Payback periods 5.57 4.67 8.82 6.69 2.44 5.33 7.21
Ranking 4 th 6 th 1 st 3 rd 7 th 5 th 2 nd

NPV 106.13 5,562.84 (4,089.98) 11,224.35 22,488.69 1,710.47 1,406.67

Ranking 6 th 3 rd 7 th 2 nd 1 st 4 th 5 th

IRR 9.56% 19.13% 2.34% 15.03% 32.39% 10.26% 9.51%

Ranking 5 th 2 nd 7 th 3 rd 1 st 4 th 6 th

Profitability Index 0.98 0.44 1.27 0.55 0.10 0.94 0.96

Ranking 2 nd 6 th 1 st 5 th 7 th 4 th 3 rd

Explanations of the quantitative methods

Payback period in capital budgeting refers to the time required to recoup the funds expended in an
Payback periods
investment, or to reach the break-even point.

Net present value (NPV) is the difference between the present value of cash inflows and the present value of
NPV
cash outflows over a period of time.

IRR or Internal Rate of Return is the discount rate at which the sum of Net Present Value (NPV) of the current
IRR
investment and all future cashflow (positive or negative) is zero.

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the
Profitability Index ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows
you to quantify the amount of value created per unit of investment.

Discussion for which quantitative method is better and why?

The projects can’t be ranked just simply by inspecting the cash flows. In order to rank the projects we must bring all cash flows to the same
point in time (present) before we can even compare. There are various quantitative methods can be used to rank the project (accept or
reject) decision which includes IRR, payback period, NPV and profitability index.

NPV in the best ranking based on the realsitic result and reinvestment rate while IRR only works if there is a series of cash flows that
shows results in an initial outlay followed by future inlay. Any sequence of cash flows that does not support this, will not yield accurate
results with the IRR method. Also, IRR just gives a percentage, which will ignore the magnitude of cash flows. Payback period plainly
ignores the time value of money, which is considered to be a major flaw of this methodology. PI also provides the good result to rank the
project but it gives the short term projects more score than the long term projects. All of the drawbacks of IRR and Payback period and PI,
NPV is usually the best method for capital budgeting.

Compare the ranking obtained by quantitative methods with the ranking obtained by simple inpsection of
Question # 3 cash flows. Do the differe, explain the reasons for this?

Quantitative method vs Simple CF

Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7
Inspection
Net Cashflow 6 th 5 th 7 th 1 st 2 nd 4 th 3 rd
Payback periods 4 th 6 th 1 st 3 rd 7 th 5 th 2 nd

NPV 6 th 3 rd 7 th 2 nd 1 st 4 th 5 th

IRR 5 th 2 nd 7 th 3 rd 1 st 4 th 6 th

Profitability Index 2 nd 6 th 1 st 5 th 7 th 4 th 3 rd

Comments:
In comparision with the simple cashflow method vs payback periods, project 4 is ranked on the 1st and Project 5 is ranked on the 2nd number while
according to the Payback period Project 3 is ranked on the 1st number and Project 7 is ranked on the 2nd similarly all the projects have different
ranking between with these two methods. In a result, payback period will be give more priority over the simple cashflow method.

Similarily when we compare Simple Cash flow method with NPV, the ranking of the projects are display above project5 is ranked on 1st while under
simple CF method project4 is ranked on 1st. NPV consider the time value of money and provide absolute measure of return on investemnet and also
result the maximization of shareholder's wealth,whereas simple cashflow methods does not provide realistic measures.therefore,NPV method gives
better result than anyother quantitative methods.

IRR gives also a better result as the NPV method while it shows the results in the percentage to accept or reject the project. Therefore project 5 agains
on the ranked 1st according to the IRR method. On the other hand simple CF method ranked the Project 4 on 1st. Investors will tend to accept the the
project based on the NPV method.

Profitabilty Index gives a totaly different picture of the appraisal of projects. Under the PI, projects are accepted with PI greater than 1 and in the
current scenario project 3 gives only PI greater than 1. So based on this method only project3 will be accepted.

Recommend the best projects that the firm should accept when the funds available are limited to AED 65
Question# 4
Million, project 4 and 5 are mutually exclusive.

Answer:
If the funds are constrained to the AED 65 milliion instead of AED 145 million then we have to perform the quantitative analysis to accept those
projects whose present values are positives and gives best returns. As we discussed above that NPV gives the most better result than any other
method, so first of all, we will accept the project 4 and 5 as these are mutully exclusives and gives the highest NPV than any other projects. Along with
these mutually exclusive projects we will further accept the project 1 and 2 to use the contrainsted funds and get the option/decisions to increase the
wealth as these projects also have positive NPV and ranked also on 3rd and 6th. However project 1 gives a very low NPV but we will diversify
portofolio and accept these projects to get the maximum returns.
 Payback Period Working
Net CF 2,500.00 15,000.00 2,000.00 43,200.00 43,000.00 19,000.00 39,000.00
Year Project 1 Accum. CF Inflows Project 2 Accum. CF Inflows Project 3 Accum. CF Inflows Project 4 Accum. CF Inflows Project 5 Accum. CF Inflows Project 6 Accum. CF Inflows Project 7 Accum. CF Inflows
0 (5,000.00) (10,000.00) (15,000.00) (25,000.00) (25,000.00) (30,000.00) (35,000.00)
1 1,000.00 1,000.00 1,000.00 1,000.00 1,700.00 1,700.00 1,000.00 1,000.00 11,000.00 11,000.00 (3,000.00) (3,000.00) (9,000.00) (9,000.00)
2 1,000.00 2,000.00 2,000.00 3,000.00 1,700.00 3,400.00 1,200.00 2,200.00 10,000.00 21,000.00 10,000.00 7,000.00 (3,000.00) (12,000.00)
3 1,000.00 3,000.00 2,000.00 5,000.00 1,700.00 5,100.00 3,000.00 5,200.00 9,000.00 9,000.00 16,000.00 6,000.00 (6,000.00)
4 800.00 3,800.00 3,000.00 8,000.00 1,700.00 6,800.00 4,000.00 9,200.00 8,000.00 6,000.00 22,000.00 6,000.00 -
5 800.00 4,600.00 3,000.00 1,700.00 8,500.00 5,000.00 14,200.00 7,000.00 6,000.00 28,000.00 8,000.00 8,000.00
6 700.00 4,000.00 1,700.00 10,200.00 6,000.00 20,200.00 6,000.00 6,000.00 12,000.00 20,000.00
7 600.00 4,000.00 1,700.00 11,900.00 7,000.00 5,000.00 4,500.00 12,000.00 32,000.00
8 600.00 2,000.00 1,700.00 13,600.00 9,000.00 4,000.00 4,500.00 14,000.00
9 500.00 2,000.00 1,700.00 12,000.00 3,000.00 3,000.00 14,000.00
10 500.00 2,000.00 1,700.00 20,000.00 5,000.00 3,000.00 14,000.00

Payback periods 5.57 4.67 8.82 6.69 2.44 5.33 7.21

NPV Working
Discount Rate 9%
Year Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7
0 (5,000.00) (10,000.00) (15,000.00) (25,000.00) (25,000.00) (30,000.00) (35,000.00)
1 1,000.00 1,000.00 1,700.00 1,000.00 11,000.00 (3,000.00) (9,000.00)
2 1,000.00 2,000.00 1,700.00 1,200.00 10,000.00 10,000.00 (3,000.00)
3 1,000.00 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00
4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00
5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00
6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00 12,000.00
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.00
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.00
9 500.00 2,000.00 1,700.00 12,000.00 3,000.00 3,000.00 14,000.00
10 500.00 2,000.00 1,700.00 20,000.00 5,000.00 3,000.00 14,000.00
NPV 106.13 5,562.84 (4,089.98) 11,224.35 22,488.69 1,710.47 1,406.67

𝐶𝐹𝑛
NPV Formula 𝑁𝑃𝑉 = ∑
1+𝑖 𝑛
IRR working
𝑁𝑃𝑉 𝑎
IRR Formula IRR =r 𝑎 + (𝑟 𝑏 − 𝑟 𝑎)
𝑁𝑃𝑉𝑎−𝑁𝑃𝑉𝑏
Discount Rate 9
Year Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7
0 (5,000.00) (10,000.00) (15,000.00) (25,000.00) (25,000.00) (30,000.00) (35,000.00)
1 1,000.00 1,000.00 1,700.00 1,000.00 11,000.00 (3,000.00) (9,000.00)
2 1,000.00 2,000.00 1,700.00 1,200.00 10,000.00 10,000.00 (3,000.00)
3 1,000.00 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00
4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00
5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00
6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00 12,000.00
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.00
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.00
9 500.00 2,000.00 1,700.00 12,000.00 3,000.00 3,000.00 14,000.00
10 500.00 2,000.00 1,700.00 20,000.00 5,000.00 3,000.00 14,000.00
NPV 9.56% 19.13% 2.34% 15.03% 32.39% 10.26% 9.51%
Profitability Index
Discount Rate 9%
Year Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7
0 (5,000.00) (10,000.00) (15,000.00) (25,000.00) (25,000.00) (30,000.00) (35,000.00)
1 1,000.00 1,000.00 1,700.00 1,000.00 11,000.00 (3,000.00) (9,000.00)
2 1,000.00 2,000.00 1,700.00 1,200.00 10,000.00 10,000.00 (3,000.00)
3 1,000.00 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00
4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00
5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00
6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00 12,000.00
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.00
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.00
9 500.00 2,000.00 1,700.00 12,000.00 3,000.00 3,000.00 14,000.00
10 500.00 2,000.00 1,700.00 20,000.00 5,000.00 3,000.00 14,000.00
Profitability Index 0.98 0.44 1.27 0.55 0.10 0.94 0.96