Project Evaluation and Capital Rationing

This assignment evaluates two projects, A and B, using Net Present Value (NPV) and Equivalent Annual Cost (EAC). It compares their profitability and provides insights into selecting the better project. The assignment also delves into the concept of capital rationing, explaining how companies restrict investments to manage budgets effectively.

Answer 1:
A: Formula for holding period return for the security:
= (Value of the security in current Year-Value of Security
in previous year)/Value of the security in previous year
Year Value of Security
0 $ 100.00
1 $ 102.50
2 $ 103.72
3 $ 101.34
4 $ 102.81
5 $ 103.95
Holding period return at year 1: (102.50-100.00)/100.00 = 2.50%
Similarly holding period return in rest of years is as follows:
Year Value of Security
Annual Holding Period
Return
0 $ 100.00
1 $ 102.50 2.50%
2 $ 103.72 1.19%
3 $ 101.34 -2.29%
4 $ 102.81 1.45%
5 $ 103.95 1.11%
B:
Arithmetic average annual rate of return= Sum of Returns of in all the years/Number of years
= (2.50+1.19-2.29+1.45+1.11)/5
= 3.96/5 i.e. 0.79%
Formula of geometric mean:
=5
√(1+0 . 025)∗(1+0 . 0119)∗(1+(−0 . 0229))∗(1+0 . 0145)∗(1+ 0 . 0111)
= 0.779%

C: The geometric average annual rate of return helps the investors to select an appropriate
investment option through calculating the returns provided by each one of them. It is mainly used
for calculating the average rate per period of investment that have a compounding return (Petty
et al., 2015).
Answer 2:
Par or face Value of Bond $1000
Maturity Years 10 years
Yield to maturity (YTM) or market interest rate 5%
A: Formula to coupon interest payment
Coupon Interest Rate 7% per annum
How coupon interest is paid annually
market interest rate 5%
Period 10 years
Coupon Payment= $1000*7% = $70
Price of Bond=
Where c = Coupon interest, f = face value, r = yield to maturity
Price of Bond = (7% × $1000) × (1 − (1 + 5%)-10 ) / 5% + $ 1000 / (1 + 5%) 10
= $540.52 + $613.91 = $1,154.43
B:
Coupon Interest Rate 3.5% per half year
How coupon interest is paid Semi annually
market interest rate 2.5% half year
Period 20 half year
Coupon Payment= $1000*3.5% = $35

Price of Bond=
Where c = Coupon interest, f = face value, r = yield to maturity
Price of Bond = (3.5% × $1000) × (1 − (1 + 2.5%)-20 ) / 2.5% + $ 1000 / (1 + 2.5%) 20
= $545.62 + $610.27 = $1,155.89
C: Answers in above A and B questions is greater than the par or face value of price of bond
because coupon rate is greater than the market interest rate or yield to maturity.4
D: The market prices of bonds are determined on the basis of their specific characteristics and
are subject to daily fluctuations. The market price of bonds is inversely related with yield to
maturity of bonds due to interest rate changes. The bond prices fall when interest rates rises in
order to equalize the bond value. The value of bond rises with the decrease in interest rates as
investors cannot purchase a new issue bond with a coupon as high as yours (Petty et al., 2015).
Answer 3:
A:
Cost of Preference Share (After Tax) = Preference Dividend / Issuing Price (1-Floation Cost)
Annual Preference dividend $ 0.27
Current Market Price per share $ 2.00
Flotation Cost 0
Cost of Preference Share 13.50%
Cost of Debt After tax = Interest Rate (1-Tax Rate)
Interest Rate 10.00%
Tax Rate 30.00%
Cost of Bond (After Tax) 7.00%
Cost of Ordinary Shares = (Next Year's Annual Dividend / Current Stock Price) + Dividend
Growth Rate
Next Year's Annual Dividend or current dividend $ 0.12

Current Stock Price $ 1.00
Dividend Growth Rate 5.00%
Cost of Equity 17.00%
B:
After tax weighted average cost of capital = (ke Ve + kp Vp + kd (1 – T)Vd )/ (Ve + Vp + Vd )
Market Value of Equity Ve $ 3,681,000.00
Market Value of Preference Share Vp $ 268,000.00
Market value of Bonds Vd $ 1,083,000.00
Cost of Preference Share kp 13.50%
Cost of Bond (After Tax) kd (1 – T) 7.00%
Cost of Equity Ke 17.00%
Tax Rate 30.00%
After tax weighted average cost of capital 14.66%
C: The weighted average cost of capital provides the overall cost of capital of a firm in which
each of the capital components is calculated in proportion of is weight. It can be used as discount
rate in capital budgeting projects as it helps a business entity to analyze the interest has to pay for
meeting its finances. It is used as a discount rate for cash flows that have as similar risk as
compared to the overall company (Berk et al., 2013).
Answer 4:
A:
Formula: Present Value of Cash Inflows less Present Value of cash outflows
Years PVF @ 8%
CF of
Project A
PV of
Project A @
8%
CF of
Project B
PV of Project
B @ 8%
1 0.926
$
100,000.00
$
92,592.59
$
100,000.00
$
92,592.59
2 0.857
$
200,000.00
$
171,467.76
$
50,000.00
$
42,866.94
3 0.794
$
150,000.00
$
119,074.84
$
150,000.00
$
119,074.84
4 0.735
$
200,000.00
$
147,005.97
Present Value of Cash
Inflows
$
383,135.19
$
401,540.34

Particulars Project A Project B
Present value of cash Inflows $ 383,135.19 $ 401,540.34
Present value of cash outflows $ 250,000.00 $ 250,000.00
NPV $ 133,135.19 $ 151,540.34
In this case decision on the basis of NPV calculation cannot be taken as there is difference of
years in cash inflows from both projects. In project A there are cash inflows for 3 years whereas
in project B there are cash inflows for 4 years.
B: Equivalent annual cost (EAC):
Formula:
EAC of Project A : (0.08* $ 133,135.19)/(1-(1+0.08)-3
: $51,660.92
EAC of Project B : (0.08* $ 151,540.34)/(1-(1+0.08)-4
: $45,753.18
Company should select project A as it provides higher return of cash inflows relative to time of
the investment.
C: Capital rationing refers to restricting the amounts of new investments of a project that are
undertaken by a company. This is achieving by placing higher cost of a capital for consideration
of investment that helps in reducing the budget of a project (Javaid, 2015).

References
Berk, B. et al. 2013. Fundamentals of Corporate Finance. Pearson Higher Education AU.
Javaid, J. 2015. Costs and benefits of raising capital through different sources. GRIN Verlag.
Petty, J.W. et al. 2015. Financial Management: Principles and Applications. Pearson Higher
Education AU.