Investment Decision Under Certainty Al Imam Mohammad Ibn Saud Islamic University College of Economics and Administrative Sciences Department of Finance and Investment Level 4: All branches EXERCISE 2 Investment Decision Under Certainty

Problem 1 Assuming that your firm is considering investment in a new project with the cash flows shown below, that the required rate of return on this project is 10%, and that the maximum allowable payback and discounted payback statistics for your company are 3 and 3.5 years, respectively. Time 1 2 3 4 5 C F -70000 15000 20000 40000 45000 50000

Questions Use the payback decision rule to evaluate this project; should it be accepted or rejected? Justify your answer. Use the DPB decision rule to evaluate this project; should it be accepted or rejected? ? Justify your answer. Use the Net Present Value (NPV) decision rule to evaluate this project; should it be accepted or rejected? Use the Profitability Index (PI) decision rule to evaluate this project; should it be accepted or rejected? Use the IRR decision rule to evaluate this project; should it be accepted or rejected? Use the MIRR decision rule to evaluate this project; should it be accepted or rejected?

Answer 1: Cumulative PV Cash flows Periods -70000 -55000 15000 1 -55000 15000 1 -35000 20000 2 5000 40000 3 50000 45000 4 100000 5 35000/40000 =0.88 0.88*12=10.56 months 0.56*30=16.8 days 2 years , 10 month , 17days

Answer 2: Cumulative PV DCF Cash flows Period -70000 1 -56364 13636 -56364 13636 15000 -39835 16529 20000 2 -9782 30053 40000 3 20954 30736 45000 4 52000 31046 50000 5 9782/30736 =0.32 0.32*12 =3.84 months 0.84*30=25.2 days 3 years , 3 months , 26 days

Answers 3 & 4: NPV : NPV = 51999.55 PI : PI = 1.74

Answer 5: 1- IF K1 is 30%, guess IRR NPV = 802 2- then guess IRR at 31%: NPV = -862 IRR

Answer 6: MIRR Given that reinvestment rate is 10% MIRR =22.93%

Problem 2 Consider the following abbreviated financial statements for a proposed investment Years  1 2 3 Sales  400,000 600,000 800,000 Costs  140,000 300,000 Depreciation  Gross Profit Taxes (20%)  Net Income 

Questions: If the total investment cost of this project is 600,000 Saudi Riyals, what is the average accounting return (ARR) for the proposed investment? Calculate the (NPV), (IRR) and the (PI) for this investment? (the required rate of return on projects of this risk class is 8%).

Answer 1: Average net profits = 48000+ 80000+ 160000 = 96000 Average Investment= 600,000+ 400,000+ 200,000 + 0 =1,200,000/4 = 300,000 Or (600,000 + 0)/2= 300,000

Answer 2: NPV & PI NPV NPV = 155464.11

Answer 2: IRR NPV if IRR 20% NPV = 9444.44 NPV if IRR 21%

Answer 2: MIRR MIRR= 16.62

Problem 3 ALHILAL Inc. is considering two mutually exclusive projects with widely differing lives. The company's cost of capital is 14%. The project cash flows are summarized as follows: Cash flows Project A Project B CF0 -30,000 -28,000 CF1 17,500 8,200 CF2 CF3 CF4   CF5 CF6 CF7 CF8 CF9

Questions 1- Compare the two projects by using NPV. 2- Compare the projects by using the replacement chain approach. 3- Compare the projects by using the EAA method. 4- Chose a project and justify your choice.

Answer 1 NPV of Project A NPV = 10629 NPV of Project B NPV = 12560

Answer 2 Year Project 1st Renewal 2nd Renewal Total Annual Cash Flow Discounted CF -30000 1 17500 15351 2 13466 3 -12500 -8437 4 10361 5 9089 6 -5695 7 6994 8 9135 9 5381 22645

Answer 3 We choose Project A