Project Evaluation Using Different Methods

This assignment presents a case study where a company is considering investing in a new machine. The student is tasked with evaluating the project's feasibility using three common methods: Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. The analysis involves calculating these financial metrics, comparing them to the required rate of return, and ultimately making a recommendation on whether to accept or reject the project. The assignment emphasizes understanding the strengths and limitations of each method in decision-making.

Running head: FUNDAMENTAL OF FINANCE
Fundamental of finance
Name of the student
Name of the university
Author note

1FUNDAMENTAL OF FINANCE
Table of Contents
Part 1..........................................................................................................................................2
Part 2..........................................................................................................................................5
(a) Net present value.........................................................................................................5
(b) Internal rate of return...................................................................................................5
(c) Payback period............................................................................................................6
(d) Selected method for evaluating the project.................................................................6
(e) Project to be accepted or not.......................................................................................6
Bibliography...............................................................................................................................7

2FUNDAMENTAL OF FINANCE
Part 1
Cost of debt
Face value of debt = $1600,000
Maturity = 8 years
Coupon rate = 6% p.a paid semi annually
The debt rating of the company is A, hence according to the credit rating table the yield on
bond for 8 years is 1.15%.
Cost of debt = 1.15%
Cost of Preference share
Annual dividend = $1.48
Price of share = $10.44
Cost of preferred capital = annual dividend / price of share
= 1.48 / 10.44
= 14.18%
Cost of Equity
Risk free rate is considered as the 10 year yield on A rated bond which is 1.47%.
Beta = 1.6
Market risk premium = 9.6%
Cost of equity = Rf + (Beta * market risk premium)
= 1.47% + (1.6*10%)
= 17.47%
For weights of each capital, the market value is determined as follows:

3FUNDAMENTAL OF FINANCE
Market value of debt
Price of bond = C*F * ((1-(1+r)-t) / r
= 0.03 * 16,00,000 * ((1-(1+0.0115)-16) / 0.0115
= $697,837.50
Market value of preferred capital
No. of shares = 500,000
Market value = 500000 * 10.44
= 52,20,000
Market value of equity
Dividend = $0.63
Growth rate for next three years = 8%
Constant growth rate = 4%
Year Growth rate Dividend
0 $0.63
1 8% $0.68
2 8% $0.73
3 8% $0.79
4 4% $0.83
Price of share = expected dividend / (cost of equity – growth rate)
Price of share at end of 3rd year = 0.83 / (17.47% - 4%)
= $ 6.16
Present value of cash flows
Year Cash Flow Present value
1 $0.68 $0.58

4FUNDAMENTAL OF FINANCE
2 $0.73 $0.53
3 $0.79 $0.49
3 $6.16 $3.80
Total present value $5.40
No. of equity share = 1700000
Market value of equity = 1800000 * 5.40
= $97,20,000
WACC
Capital Market Value Weights
Cost of
capital
Weighted
cost of capital
Debt
$697,837.50
0.04 0.0115 0.00046
Preferred capital $52,20,000 0.33 0.1418 0.04679
Equity $97,20,000 0.62 0.1747 0.10831
$ 156,37,838 1 15.56%
Therefore, the WACC is 11.8%

5FUNDAMENTAL OF FINANCE
Part 2
(a) Net present value
Calculation of Net present value
Particulars Year 0 Year 1 Year 2 Year 3 Year 4
Cost of the equipment
$
(25,000.00)
Depreciation
$
(6,250.00)
$
(6,250.00)
$
(6,250.00)
$
(6,250.00)
Increase in revenue
$
13,400.00
$
13,395.00
$
12,725.25
$
12,088.99
Operating cost
$
2,800.00
$
2,800.00
$
2,800.00
$
2,800.00
Maintenance cost
$
1,100.00
$
1,400.00
$
1,700.00
$
2,000.00
Additional working capital
$
(1,800.00)
Loss of opportunity cost
$
2,000.00
$
2,000.00
$
2,000.00
$
2,000.00
Cost of feasibility study
$
(4,000.00)
Recovery of working capital
$
1,800.00
Salvage value of machine
$
2,500.00
Cash inflow/(outflow)
$
(30,800.00)
$
13,050.00
$
13,345.00
$
12,975.25
$
16,938.99
Discounting factor @
15.56% 1 0.865 0.749 0.648 0.56
Present value
-
30,800 11,288 9,995 8,408 9,486
Net present value 8,377
As it can be seen from the above calculation that the company is able to cover the outflow
and the positive NPV of the project is $ 8,601, the project is acceptable.
(b) Internal rate of return
IRR = P0 + P1 / (1+IRR) + P2 / (1+IRR)2 + P3 / (1+IRR)3 + P4 / (1 +IRR)4

6FUNDAMENTAL OF FINANCE
Where, P0 to P4 represents the cash flow in year 0 to Year 4 and IRR represents the internal
rate of return.
Through the trial and error method, the IRR = 10.81%
As the IRR is less than the required rate of return that is 15.56%, the project shall not be
accepted.
(c) Payback period
Payback period = Years before full recovery + unrecovered cost at the start of the year / cash
flow during the year
Payback period = 3 + 1108/9,710 = 3.12 years
(d) Selected method for evaluating the project
The payback period method is to be used for evaluation as the NPV and IRR both the
method do not measure the required period to cover up the outflows of the project. However,
to accept the project, it is very important to know the cost cover up period.
(e) Project to be accepted or not
Though the NPV of the project is positive and the payback period is also less than the
useful life of the asset, as the IRR is less than the required rate of return, the project will not
be feasible to be accepted and therefore, shall not be accepted.

7FUNDAMENTAL OF FINANCE
Bibliography
Bell, P., 2017. Introducing the Net Present Value Profile.
Vernimmen, P., Le Fur, Y., Dallochio, M., Salvi, A. and Quiry, P., 2017. Investment
Criteria. Corporate Finance: Theory and Practice, Fifth Edition, Fifth Edition, pp.508-525.