Question

When you arrived at work on Friday morning, you found the following memo on your desk addressed to you: “From: Jason Katz, Chief Financial Officer RE: Project Evaluation As you are aware, we are in the process of imposing a greater financial discipline. From now on, only those projects will be funded that generate sufficient cash-flows to pay the financing cost every year. The project that you have analysed will be funded entirely through a bank loan which will be paid-off in 10 equal annual instalments. Your project must be able to generate sufficient cash-flows to pay these annual instalments, otherwise, it will not be funded. To understand this requirement better, I am providing everyone with the following example: Suppose a project with a 3 life of 3 years generates cash-flows of 200 million, 150 million, and 80 million in years 1, 2, and 3 respectively. The project is financed through a loan that requires a repayment of 100 million every year for the next 3 years. This project will not be funded because it generates only 80 million in year 3, which is not sufficient to meet the instalment of 100 million that year. I would like you to take another look at your proposed project and get back to me by Monday morning with the answer to the following question: Assuming that your project is funded entirely through a bank loan that must be paid-off in 10 equal annual instalments, what is the maximum interest rate on the loan which lets us meet our financial discipline requirement? I would also like you to provide me with your feedback regarding this new requirement” Do the following:

a) Answer the question raised in the memo.

b) Provide your feedback on the new requirement (what are its pros and cons?)

Answer 1

A) here the best way to know whether the project is able to generate enough cash flow by following payback period method which actually divides cost of investment by the average annual cash flow to validate life of the project,

here we are having 10 bank installment so for ex.if our cash flow is having 1,00,000 $ cost so by dividing with 10 so we require $10000 per annum from the project to cover up our bank installments which is around 10% for 10 installments and than project will be funded,

B) according to me one should analyse the amount of bank loan and accordingly validate cash flow so that it wont impact on our financial discipline.

and if one wont study properly about generation of cash flow for 10 installments than it would be loss making deal for the company.