Question 3 Blue Moon plc is looking to take on a new investment. The company will evaluate two mutually exclusive projects, whose details are given below. The company's cost of capital is 12%.

Answer Q.3 Answer 3.1 Introduction: In this question, a company named Bluemoon Plc is considering two mutually exclusive projects for a new investment. Both the projects have useful life of 5 years. The cost of capital of the company is 12%. We have to analyze the project on the basis of following appraisal methods: (1) Payback Period (2) Net Present value (3) Internal Rate of Return Apart from analyzing, we also have to critically analyze the merits of appraisal methods. We also have to advise the company regarding the investment. Payback Period: it is the time taken to recover the initial investment Payback Period of Project ‘A’ = 3 Years Payback Period of Project ‘B’ = 2 years + (152-140)/50 = 2.24 Years. Answer 3.2 Net Present Value: It is calculated by discounting all the future inflows and then deducting the initial investment from discounted inflows. NPV of Project A NPV =[CF1/(1+r) ^1 + CF2/(1+r) ^2………. CFn/(1+r) ^n] – Initial Investment NPV of Project A = [40/ (1.12) + 50/ (1.12) ^2 + 60/ (1.12) ^3 + 60/ (1.12) ^4 + 85/ (1.12) ^5] – 150 By solving this we get an NPV of project A = AED 54.64 Millions NPV of Project B NPV = [80/ (1.12) + 60/ (1.12) ^2 + 50/ (1.12) ^3 + 40/ (1.12) ^4 + 30/ (1.12) ^5] – 152 By solving this we get an NPA of Project B = AED 45.29 Millions Answer 3.3 Internal Rate of Return: IRR is a rate which makes the NPV 0(zero). Simply it is a rate of return on investment. [CF1/(1+IRR) + CF2(1+IRR) ^2…. CFn/(1+IRR) ^n] – Initial Investment = 0 IRR of Project A [40/ (1+IRR) + 50/ (1+IRR) ^2 + 60/ (1+IRR) ^3 + 60/ (1+IRR) ^4 + 85/ (1+IRR) ^5] – 150 = 0 Now solving for IRR We get an IRR = 24.18% IRR of Project B [80/ (1+IRR) + 60/ (1+IRR) ^2 + 50/ (1+IRR) ^3 + 40/ (1+IRR) ^4 + 30/ (1+IRR) ^5] – 152 =0 Now solving for IRR We get an IRR = 25.84% Answer 3.4 Payback Period: It is a capital investment appraisal method. It is very simple to calculate and can easily be understood. It is quite useful for small businesses. However, there are some drawbacks to this, such as the fact that it does not account for the time value of money and only focuses on recovering the initial investment. Net Present Value (NPV): is the most widely used appraisal method for capital investments. It helps in maximising the firm’s The most important benefit of NPV is that it considers the concept of time value of money. It gives the utmost priority to the profitability and risk of the project. There are some disadvantages also, like that it is a bit complex. When there are unequal life projects, it may not give correct decisions. IRR: It considers the time value of money. There is no need to have a required rate of return to calculate IRR; we just need simple cash outflows and inflows. It helps senior management to make a rough estimate of the required rate of return. There are some disadvantages too, like: It ignores economies of scale. It is not useful in deciding on mutually exclusive projects. The reinvestment theory of IRR is impracticable. Results of the evaluation So above are the summarized results of the evaluations. We will decide the investment project on the basis of NPV, as it is the most widely and most accurate method. We will choose that project, which gives highest NPV. The company should select the Project ‘A’ as it has higher NPV than Project ‘B’.