CASE STUDY 1: CASFLOW STATEMENTS ASSIGNMENT 2

CASE STUDY 1
QUESTION 1

Comprehensively, a rise in interest rates will push Asif’s Cash Flow further into the negative. Asif is likely to witness
a major downturn of both credit and cash sales. A rise in interest rates will increase mortgage rates, thus constricting
the discretionary income of customers. This essentially is a disincentive to spending, while on the other hand, higher
interest rates promote increased savings in banks. Low sales culminate in lower cash inflows into Asif’s proposed
business. Debtors will take longer to pay their outstanding amounts. Quite a number of these outstanding amounts
may be written off as bad debts. In principle, cash inflows will be low and fragmented, overally keeping the cash
balance negative.

The second impact of a rise in interest rates is the upsurge of the cost of working capital (investment in stock). The
procurement of stock comes at an extra cost which means further outflows which will take relatively longer to reverse.
A cutback in consumer spending effects little stock turnover. Cash flow is restricted in the negative region because
Asif will buy stock at a higher cost and leave cash tied up in stock for a long until it’s finally disposed.

QUESTION 2

If inflation did rise, cash outflows would increase because Asif has to project for higher capital expenditure. Inflation
is detrimental to the macro economy. The cost of capital, regardless of the source, will escalate simultaneously with
the rise in inflation. The outcome subsequently translates to higher cash outflows from Asif’s business for he is
limited of cheap sources of investment funds. Inflation is not entirely adverse to Asif’s business. In the short term,
inflation might spur speculative buying (demand push inflation) as buyers take advantage of credit purchase which
allows them to initiate transactions that can be fully covered later when money would have lost some value to
inflation. Well-negotiated credit transactions virtually generate instant cash deposits. Therefore, if Asif sets a sensible
mark-up on his products he could attract decent cash inflows.

QUESTION 3

The cash flow statement is more objective. Profit is very subjective that is why Asif possibly opted to use the cash
flow statement on documenting his business plan. Cash flow is unaffected by the discretion of accounting conventions
and practices which limit the relevance of profit-based evaluation.

Creditors are more interested in the ability of a business to repay its loans. The availability of liquid cash, guards
against unforeseen circumstances such as the sudden rise of working capital cost, which has to be effectively
contained before the business falls into excessive debt.

However, the cash flow statement is inadequate for a comprehensive ideal business plan. Cash flows may appear to be
decent, while an unfavourable current ratio is disguised. An explanation is necessary to articulate why the start up loan
Asif requires is insufficient to reverse monthly cash flows into a positive cash balance at the end of the projected six
months. The bank is likely not to be forthcoming unless Asif draws up a balance sheet.

QUESTION 4

Asif should revise his business prospects by cutting down on the amount of material he is considering to procure.
Effected by the recent interest hike, materials will cost more, causing higher cash outflow and further negative cash
balances. Asif can alternatively enter the market as a brick maker/supplier in order to reduce turnover period of
materials so as to generate cash in the shortest possible period following material procurement. Asif also has to
streamline his labour cost with respect to the prevailing inflation. During periods of rising inflation demand for new
houses is generally low, hence Asif needs to retain only labour which is effectively being utilized. By so doing he can
reduce cash outflow that covers wages/salaries.
CASE STUDY 2; 3 & 4: INVESTMENT APPRAISAL ASSIGNMENT 2

CASE STUDY 2
QUESTION 1
The present value $10 000 expected in four years’ time at the rate of 10%
PRESENT VALUE, PV = PRINCIPAL × DISCOUNT FACTOR VALUE OF THE PROJECTED YEAR
= $10 000 × 0.68
= $6 800

QUESTION 2

The present value of $2 000 expected in six years at the prevailing rate of 16%
PRESENT VALUE, PV = PRINCIPAL × DISCOUNT FACTOR VALUE OF THE PROJECTED YEAR
= $2 000 × 0.41
= $820

QUESTION 3

The present value of $6 000 expected in one year’s time at the prevailing rate of 20%
PRESENT VALUE, PV = PRINCIPAL × DISCOUNT FACTOR VALUE OF THE PROJECTED YEAR
= $6 000 × 0.83
= $4 980

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CASE STUDY 2; 3 & 4: INVESTMENT APPRAISAL ASSIGNMENT 2

CASE STUDY 3
QUESTION 1

× DISCOUNT
YEAR CASFLOW FACTOR (16%) DISCOUNTED CASHFLOW
0 (10 000) 1 (10 000)
1 5 000 0.86 4 300
2 4 000 0.74 2 960
3 3 000 0.64 1 920
4 2 000 0.55 1 100
NET PRESENT VALUE   820

The net present value is 820, which is 1630 less than the NPV derived using discount factor 8%. This is because 16%
indicates a relatively higher borrowing cost. Net Present Value decreases the further one chooses a higher rate to
discount cash flows.

QUESTION 2

Within the confines of the concept of Net Present Value and with no direct comparison to the NPV at 8%, it is viable
to borrow to finance at the rate of 16%. This is because the NPV has a positive value. However, comparing with the
NPV of $1 920 discounted at 8%, the business should never consider borrowing at 16% because borrowing cost is
high and this cuts deep into annual cash flows.

QUESTION 3

× DISCOUNT DISCOUNTED CASHFLOW

YEAR CASFLOW ($)
FACTOR (10%) ($)
0 (10 000) 1 (10 000)
1 5 000 0.91 4 550
2 4 000 0.83 3 320
3 3 000 0.75 2 250
4 2 000 0.68 1 360
NET PRESENT VALUE   1 480

If the criterion rate for this project was 10%, this project would be deemed acceptable. At 10%, the Net Present Value
is positive. The project could be successful.

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CASE STUDY 2; 3 & 4: INVESTMENT APPRAISAL ASSIGNMENT 2

CASE STUDY 4
QUESTION 1

PAYBACK PERIOD FOR:

PROJECT A PROJECT B
YEAR ANNUAL ANNUAL
COUNT EFFECTED FROM YEAR 0 CASHFLOW RESULTANT EFFECTEDFROM YEAR 0 CASHFLOW RESULTANT

1 (12 000) 3 000 8 000 (12 000) 6 000 6 000

2 8 000 4 000 4 000 6 000 5 000 1 000
4 000 ÷ 5 1 000 ÷ 5
... ...
  5 000 00 3 000 000

Payback Period = Year Count + Resultant. Therefore, it is:

(a) For Project A = 2 + (4 000 ÷ 5 000) = 2.8 years.

(b) For Project B = 2 + (1 000 ÷ 3 000) = 2.33 years.

QUESTION 2

ANNUAL RATE OF RETURN = INCREASE IN EXPECTED AVERAGE ANNUAL OPERATING INCOME

INITIAL INVESTMENT

(a) For project A, ARR = Annual Cash flows ÷ No. of Years × 100%
Initial Investment
= (3000+4000+5000+6000) ÷ 4 × 100%
12000
= 37.5%

(b) For Project B, ARR = Annual Cash flows ÷ No. of Years × 100%
Initial Investment
(6000+5000+3000+2000) ÷ 4 × 100%
12000
= 33.3%

QUESTION 3

The Payback method and Accounting Rate of Return produce contrasting results. On one hand, Project A has a
relatively shorter payback period, thus recommended as the best suitable option in payback terms. On the other hand,
Project B has a relatively higher rate of return - the ideal choice among the two projects on the basis of the ARR
approach. The manager would have been in a better position to decide easily provided the shortest payback period and
highest rate of return would be attributable to one project altogether.

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CASE STUDY 2; 3 & 4: INVESTMENT APPRAISAL ASSIGNMENT 2

QUESTION 4

× DISCOUNT FACTOR
YEAR CASFLOW ($) (10%) DISCOUNTED CASHFLOW ($)
0 (12 000) 1 (12 000)
1 8 000 0.91 2 730
2 4 000 0.83 3 320
3 5 000 0.75 3750
4 6 000 0.68 4 080
NET PRESENT VALUE   1 880

4. (a) (i). The Net Present Value for Project A = $ 1 880

× DISCOUNT FACTOR
YEAR CASFLOW ($) (10%) DISCOUNTED CASHFLOW ($)
0 (12 000) 1 (12 000)
1 6 000 0.91 5 460
2 5 000 0.83 4 150
3 3 000 0.75 2 250
4 2 000 0.68 1 360
NET PRESENT VALUE   1 220

(a)(ii). The Net Present Value for Project B = $1 220

× DISCOUNT FACTOR
YEAR CASFLOW ($) (20%) DISCOUNTED CASHFLOW ($)
0 (12 000) 1 (12 000)
1 3 000 0.83 2 490
2 4 000 0.69 2 760
3 5 000 0.58 2 900
4 6 000 0.48 2 880
NET PRESENT VALUE   (970)
4. (b) (i). The Net Present Value for Project A = ($970)

× DISCOUNT FACTOR
YEAR CASFLOW ($) (20%) DISCOUNTED CASHFLOW ($)
0 (12 000) 1 (12 000)
1 6 000 0.83 4 980
2 5 000 0.69 3 450
3 3 000 0.58 1 740
4 2 000 0.48 960
NET PRESENT VALUE   (870)
(b)(ii). The Net Present Value for Project B = ($870)

QUESTION 5

At 20% discount rate, both Project A and Project B are unacceptable because they produce negative Net Present
Values. Basing on the Net Present Value calculated using the discount factor of 10%, Project A is the most viable
project because it’s the one that guarantees a higher return to investment. However, the Net Present Value data,
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CASE STUDY 2; 3 & 4: INVESTMENT APPRAISAL ASSIGNMENT 2

independent of another useful indicator such as Internal Rate of Return (IRR), does not provide thorough information
to evaluate projects.

QUESTION 6

Project A is the most ideal project to invest in. It yields the highest, positive returns to investment according to the Net
Present Value technique. Net present value takes into account the time value of money and is dependent on cash flows
for its calculation; therefore, the most objective of all appraisal methods used.

He should not be confused into assuming that since Project B had the shortest payback period; it would have been a
better project. Payback disregards cash flows beyond the payback period. Timing of return is also disregarded, while it
essentially reflects the impact of interest fluctuations on money invested. Annual Rate of Return is subjective and not
an ideal appraisal technique. It relies on profit for its calculations. And profit is a sum of revenue inclusive of virtual
distortions such as provision for bad debts and depreciation. These do not entail the actual presence of cash and its
circulation in the business. Creditors would disqualify any assumption of a worthwhile investment opportunity if it is
evaluated on the basis of the ARR technique.

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