FINANCIAL MANAGEMENT

Answer 1
Initial Outlay = Required Rate of Return = Tax Rate = Project Life = Rs. 20,000 10 % 50 % 5 years

Particulars
Cash flow Tax & Depn after

Year 1
12000 4000

Year 2
6000 4000

Year 3
4000 4000

Year 4
10000 4000

Year 5
10000 4000

(+) Depriciation* Cash flow after Tax

16000

10000

8000

14000

14000

*Calculation for Depreciation = 20000 = Rs. 4000/5

1. Pay Back Period:

It measures the length of time required to recover the cost of investment in a project in the form of expected future cash flows.

Year 1 2 3 4 5

Cash inflows Rs. 16000 20000 10000 8000 14000 14000

Cumulative Cash Inflows 16000 26000 34000 48000 62000

Pay Back Period = 1st year + 4000 10000 st = 1 year + 0.4 = 1.4 years The Pay Back Period for the project is 1.4 years.

2. Average rate of Return:

It measures the return; an investment gives over a period of time. These returns are usually calculated on annual basis. The annual returns of a project are expressed in terms of percentage of the net investment in the project. ARR = Average Profits after Tax (PAT)

Initial Investment up to the

Start of business

ARR = 12000 + 6000 + 4000 + 10000 + 1000 5 = Rs. 8,400 ARR = 8400 X 100 = 42% 20000 The ARR for the project is 42%.

3. Net Present Value:

The Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows. This calculation lays down the profitability factor of an investment or a project. NPV = PVC1 - PVC2 Where, PVC1 = Present Value of Cash Inflows PVC2 = Present Value of Cash Outflows = [(16000 X 0.909) + (10000 X 0.826) + (8000 X 0.751) + (14000 X 0.683) + (14000 X 0.621)] 20000 = 47068 20000 = Rs. 27068

The Net Present Value for the project is Rs. 27068.

4. Profitability Index:
It is an index that tries to identify the relationship between the costs and the benefits arising out of the proposed project, generally measured in terms of a ratio. P.I. = = = PVC1 PVC2 47068 20000 2.3534 times

The profitability index of the project is 2.3534 times.

5. Internal Rate of Return:

It is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. The IRR is used to rank several the different projects under consideration. It is also referred to as the Economic Rate of Return.

Present value of cash inflows:

At 60%
Year 1 2 3 4 5 Cash inflows 16000 10000 8000 14000 14000 Total PV Factor 0.625 0.391 0.244 0.153 0.095 Present Value of Cash Flows 10000 3910 1952 2142 1330 19334

At 50%
Year 1 2 3 4 5 Cash inflows 16000 10000 8000 14000 14000 Total PV Factor 0.667 0.444 0.296 0.198 0.132 Present Value of Cash Flows 10672 4440 2368 2772 1848 22100

At At Difference

IRR 50% 60% 10% IRR = 50% + 22100-20000 *10% 22100-19334 = 57.59%

PVCI 22100 19334 2766

The IRR for the project is 57.59%.

Answer 2

Introduction
The company is considering the manufacturing of Dry Less Soaps and has to make a decision of selecting one out of the two projects available. In order to exercise this option, the company will have to make a comparative analysis taking into consideration the Net Present Value method. On the basis of this evaluation, the best project shall be taken into consideration. Option 1 Godrej can buy four machines with a capacity of producing 30,000 soaps each for a cost of Rs.115 million for each machine. Option 2 The company can buy one large machine with a capacity of 120,000 soaps for a cost of Rs. 500 million.

Present Value of Cash Inflow

(Rs. in millions) Particulars Revenue from Sales

(Rs.1200 x 120000 units)

Time 1 10

PV Factor
@ 10%

Amount 144.00

Present Value 813.60 813.60

5.65

Present Value of Cash Inflow

Option 1
Number of Machines: 4 Cost of Machine: Rs. 115 million each (Total =Rs. 460 millions) Operation & Manufacturing Costs: Rs. 535
Present Value of Cash Outflows:

(Rs. in millions) Particulars Cost of Machine (4 machines x Rs. 115 million) Operation & Management Costs
(Rs. 535 x 30000 units x 4 machines)

Time 0

PV Factor
@ 10%

Amount 460

Present Value 460

1 - 10

5.65

64.2

362.73 822.73

Present Value of Cash Outflow

Net Present Value = Present Value of - Present Value of Cash Inflow Cash Outflow = 813.60 - 822.73 = (Rs. 9.13 Million)

Option 2
Number of Machines: 1 Cost of Machine: Rs. 500 million Operation & Manufacturing Costs: Rs. 450 Present Value of Cash Outflows:

(Rs. in millions) Particulars Cost of Machine (1 machine x Rs. 500 million) Operation & Management Costs
(Rs. 450 x 120000 units)

Time 0 1 10

PV Factor
@ 10%

Amount 500 54

Present Value 500 305.10 805.10

1 5.65

Present Value of Cash Outflow

Net Present Value = Present Value of - Present Value of Cash Inflow Cash Outflow = = 813.60 - 805.73 Rs. 8.50 Million

Decision Tree
A decision tree explains the losses / benefits arising from both the projects and therefore is prepared to understand the financial decision of Godrej. As there were two options available with the company, it started with evaluating both the projects. The cost that was incurred in case of Option 1 for purchasing the machines was Rs. 460 million adding the operation and management costs of Rs. 535 million. The total cost incurred by the company in case of Option 2 included Rs. 500 million for the purchase of single machine in addition to the operation and management costs amounting to Rs. 450 million. The total cash inflow for the company was calculated to be Rs 1200 million. All the figures were then calculated to their present value and tabulated as above to aid the comparison process. Thus the Net Present value of Cash Inflow for both projects was calculated to be Rs. 813.60 million. Then the cash inflows for the projects stood at Rs. 822.73 million for option 1 and Rs 805.10 million for option 2. Calculating for NPV, option 1 gave a negative cash proceed of Rs. 9.13 million while option 2 gave a positive inflow of cash of Rs. 8.50 million. Going by the accept-reject criterion for the NPV method, option 1 is ruled out as it gives a negative inflow of cash. Therefore option 2 is more viable for the company and hence Godrej should go for Option 2.

Conclusion
Thus looking at the above calculations, we can observe that the NPV in case of Option 1 is negative and stands at -9.13 million while the NPV in case of Option 2 is positive and stands at 8.50 million. The accept-reject criterion under the Net Present Value method states that the project whose NPV stands positive should be selected while the project whose NPV stands as negative should be rejected. A positive NPV signifies that the present value of the inflows for a particular project is more than the present value of its outflows. In other words, a positive NPV corresponds to an excess of benefits over the cost in absolute terms. Thus going by the NPV method, Godrej should go for option 2 since it gives a positive inflow of cash over the cost incurred to start off the project. This is not the case if the company takes up option 1, hence the company should go for Option 1.

REFERENCES

Khan,MY. and Jain,PK. (2011): Financial Management.Delhi: The McGraw-Hill Companies. http://www.investopedia.com/terms (accessed 10/10/2011) www.businessdictionary.com/defination/net-present-valueNPV.htm (accessed 10/10/2011) www.investorwords.com/IRR.html (accessed 10/10/2011)

www.mindtools.com/dectree.html (accessed 10/10/2011)

BIBLIOGRAPHY
www.studyfinance.com/templates/NPV.xls(accessed 10/10/2011) www.thedecisiontree.com (accessed 10/10/2011)