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1. SONY Corporation is considering signing a one year contract with one of two computer- based marketing firms. Although one is more extensive, it offers a more extensive program and thus will provide higher after tax net cash flows. Assume these two options are mutually exclusive and that the required rate of return is 12%. Given the following after tax net cash flows

Year                   Option-A                 Option-B

0                      - 10000 AED              40000 AED

1                      20,000 AED               70000 AED

1. Calculate the net present value
2. Calculate the profitability index
3. If there is no capital rationing constraint, which project should be selected?

Note: Answers Should be in Word or Excel

Answer 1

Based on the given data, pls find below the calculations:

Assumptions:

- In Option B, the initial outflow is given as 40000AED; Hence, assumed it as -40000AED and further Year 1 Cash inflows are 70000AED;

a) NPV of Option A is AED 7857 and NPV of Option B is AED 22500;

b) Profitabillity Index of Option A is 1.79 and that of Option B is 1.56;

c) Based on IRR and Payback calculations and Profitability Index, Option A is better than Option B; However, if there is no Capital rationing constraint, it is preferable to go for Option B, as the potential volume of returns are higher as compared to Option A;

Computations:

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of Net Present Value (NPV) based on the Disounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) = 1/(1+12%) = 0.8929;

Next, the cashflows need to be multplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.

Profitability Index: Profitability Index = Present Value of Future Cash Flows / Initial Investment;