Question

The financial manager of Dizzy Inc. is trying to decide whether or not to purchase a new machine. Dizzy Inc. uses a discount rate of 10% to evaluate projects such as this one and has a policy of accepting projects that payback within 3 years. If the investment is undertaken, the following cashflows will be generated.

Year	Cash Flow (€)
0	-200,000
1	50,000
2	60,000
3	70,000
4	200,000

  (i)         Calculate the Net Present Value, the payback period, the discounted payback period, and the profitability index and advise the financial manager whether the investment should be undertaken and clearly explain why you are making the recommendation.

(ii)        The financial manager is worried that the estimated future cash flows he has projected may be incorrect. What further analysis would you suggest he carry out given these concerns?                 

(b)       Explain what is meant by hard capital rationing.

Answer 1

a)
i)	Year	Cash Flow	Cumulative Cash Flow	PVIF at 10%	PV at 10%	Cumulative PV
	0	$         -2,00,000	$   -2,00,000	1.00000	$      -2,00,000	$         -2,00,000
	1	$              50,000	$   -1,50,000	0.90909	$           45,455	$         -1,54,545
	2	$              60,000	$      -90,000	0.82645	$           49,587	$         -1,04,959
	3	$              70,000	$      -20,000	0.75131	$           52,592	$            -52,367
	4	$          2,00,000	$    1,80,000	0.68301	$       1,36,603	$              84,236
					$           84,236
	NPV = $84,236
	Payback period = 3+20000/200000 =			3.10	Years
	Discounted payback = 3+52367/136603 =			3.38	Years
	Profitability index = 284236/200000 =			1.42
ii)	A sensitivity analysis may be done by varying the inputs by a specified % up or down.
	For instance the initital investment may be increased or decreased by 10% or the
	cash flows could be increased or decreased by 10% and so on for other variables.
b)	Capital rationing arises in situations where the firm has difficulty in raising additional funds
	externally through equity or debt. It is enforced from outside and can lead to shortage of
	capital in future.