- 15 Marks
PM – May 2023 – L2 – SA – Q5 – Risk Assessment and Internal Control
Evaluate which project (A or B) the company should invest in, based on projected cash flows and cost of capital.
Question
A company is considering whether or not to invest in any of the two projects where the initial cash investment would be ₦13,000,000 for Project A and ₦14,000,000 for Project B. The project would have a five-year life, and the estimated annual cash flows are as follows:
Project A
| Year | Cash inflows (₦) | Cash outflows (₦) |
|---|---|---|
| 1 | 6,000,000 | 3,000,000 |
| 2 | 8,000,000 | 4,000,000 |
| 3 | 10,000,000 | 4,000,000 |
| 4 | 9,000,000 | 3,000,000 |
| 5 | 6,000,000 | 3,000,000 |
| Total | 39,000,000 | 17,000,000 |
Project B
| Year | Cash inflows (₦) | Cash outflows (₦) |
|---|---|---|
| 1 | 10,000,000 | 5,000,000 |
| 2 | 9,000,000 | 4,000,000 |
| 3 | 8,000,000 | 3,000,000 |
| 4 | 8,000,000 | 3,000,000 |
| 5 | 4,000,000 | 2,000,000 |
| Total | 39,000,000 | 17,000,000 |
The company cost of capital is 10%.
The estimates of cash outflows are considered fairly reliable. However, the estimates of cash inflows are much more uncertain. Several factors could make the annual cash flows higher or lower than expected.
- Factor 1: There is a 20% probability that government measures to control the industry will reduce annual cash inflows by 25%.
- Factor 2: There is a 30% probability that another competitor will also enter the market; this would reduce the estimated cash inflows by 10%.
- Factor 3: There is a 40% probability that demand will be stronger than expected. The company would not be able to supply more products to the market, but it would be able to sell at higher prices and cash inflows would be 5% higher than estimated.
Required:
a. Calculate the expected net present value of the two projects. (10 Marks)
b. Which of the projects will be more profitable? (5 Marks)
Find Related Questions by Tags, levels, etc.
- Tags: Cash Inflows, Cash Outflows, Cost of Capital, Investment decisions, Project A, Project B
- Level: Level 2
- Topic: Risk Assessment and Internal Control
- Series: MAY 2023
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