Financial Management

REPORT ON

COMPARISON BETWEEN TWO INVESTMENTS APPRAISALS -A CASE STUDY ON PRAN-RFL GROUP

Patuakhali Science and Technology UniversityDumki, Patuakhali

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SUBMITTED TO

M. Zakir HosenLecturer

Department of Accounting and Information SystemFaculty of Business Administration and Management

SUBMITTED BY

Group: 05 (liberty) Level: 03; Semester: 01

Faculty of Business Administration and Management

01 Md. Mofizer Rahaman Member 12 0067102 Dipayan Chakma Member 17 0067603 K.M. Assaduzzaman Member 06 0066504 Tanjia Sultana Member 10 0066905 Azmiry Khanom Member 20 0067906 Shofiq Uddin Khan Member 23 00682

Financial Management-IICourse code: FBK-313

Date of Submission: 26 April, 2008

Patuakhali Science and Technology UniversityDumki, Patuakhali

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COMPARISON BETWEEN TWO INVESTMENTS APPRAISALS- A CASE STUDY ON PRAN-RFL GROUP

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LETTER OF TRANSMITTAL

Date: 26 April, 2008

M. ZAKIR HOSEN

Lecturer Department of Accounting and Information SystemPatuakhali Science and Technology University

Subject: Submission Term Paper on “Comparison between two investments appraisals.”Dear Sir,

Here we are submitting our term paper on “Comparison between two investments appraisals” prescribed by you on your course Financial Management-II. For this purpose, we have gone through internet, different books, articles, journals, interview of authorities and employees of the respective organization’s for the relevant information of the assigned topic.

Please call us for any further information at your convenient time and place.

Yours truly,

Group 05 (Liberty)BBALevel- III Semester- ISession: 2004-2005 Patuakhali Science and Technology University

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LETTER OF AUTHORIZATION

Date: 26 April, 2008

M. ZAKIR HOSEN Lecturer Department of Accounting and Information SystemPatuakhali Science and Technology University

Subject: Declaration regarding the validity of the report.

Dear Sir,

This is our truthful declaration that the “Comparison between two investments appraisals” we have prepared is not a copy of any report previously made by any group.

We also express our honest confirmation in support of the fact that the said “Report” has neither been used before to fulfill any other course related purpose nor it will be submitted to any other person or authority in future.

Yours truly,

Group 05 (liberty)BBALevel-III Semester-ISession: 2004-2005Patuakhali Science and Technology University

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ACKNOWLEDGEMENT

During the period of surveying PRAN-RFL group and preparing the report, we had gained altruistic assistance from a number of persons including our honorable and respectable course teacher M. ZAKIR HOSEN, Lecturer, Department of Accounting and Information System, Faculty of Business Administration and Management.

We are thankful to the respective personnel specially M. Rafiq Uddin Khan of this organization because they showed their highest degree f temperament in answering our relentless questions. Such if their friendly cooperation and kindness did not even allow us to strive for a single moment for.

Last of all, thanks to every members of this group. They put their spontaneous endeavors and best effort to complete the report successfully.

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TABLE OF CONTENTS[

Contents Page no.[

Letter of transmittal iiiLetter of authorization ivAcknowledgement vExecutive summary viii[

CHAPTER: 1 [[[

1.1 INTRODUCTION 021.2 JUSTIFICATION OF THE TERM PAPER 031.3 OBJECTIVES OF THE TERM PAPER 03[

CHAPTER: 2 OVERVIEW OF THE PROJECT 1 AND PROJECT 2

2.1 INTRODUCTIONS 052.1.1 Overview of PRAN-RFL group 05-06

2.1.2 Overview of Project 1 (G) 062.1.3 Overview of Project 2 (S) 06CHAPTER: 3 Profitability measure of the two projects[

3.1 INTRODUCTION 08

1. Pay back period 08-09 2. Net present value (NPV) 09-10

3. Internal rate of return (IRR) 10-11

3.2 CALCULATION FOR THE CASH IN FLOWS OF THE TWO PROJECTS 12 3.2. a Cash inflows for Grinding machine 12-14 3.2. b Cash inflows for Stone Crusher machine 15-173.3 CALCULATION OF PAYBACK PERIOD OF TWO PROJECTS 153.3.a Calculation of Pay back period of grinding machine 18-19

3.3. b Pay back period of stone crushing machine 19-20

3.4. CALCULATION OF NET PRESENT VALUE OF TWO MACHINES

3.4. a Calculation OF NET present value (NPV) of grinding machine 21

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3.4.b Calculation of Net present value (NPV) of Stone Crusher 22

3.5 CALCULATION OF INTERNAL RATE OF RETURN OF TWO PROJECTS

3.5. a Calculation of Internal rate of return (IRR) of Grinding machine 23TABLE OF CONTENTS ( CONTINUE)-3.5. b Calculation of Internal rate of return (IRR) of Stone Crusher Machine 233.6 NPV PROFILE OF GRINDING MACHINE AND STONE CRUSHER MACHINE 24-253.7 PROFITABILITY INDEX (PI) OR BENEFIT-COST RATIO

(B/C RATIO) OF THE TWO PROJECTS 3.7 a Calculation for profitability Index of Grinding Machine 263.7. b Calculation of profitability index for Stone Crusher Machine 263.8 COMMENTS ON THE OVERALL CALCULATION

3.8.1 Comments in respect of NPV 27

3.8.2 Comments in respect of IRR 27

3.8.3 Comments in respect of profitability index 27-28

CHAPTER: 4 Summary, Conclusion & Recommendation4.1 SUMMARY 304.2 CONCLUSION 314.3 RECOMMENDATION 324.4 Bibliography 33

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EXECUTIVE SUMMERY

This report is an assigned job as partial fulfillment of course requirement by honorable course teacher M. ZAKIR HOSEN, Lecturer, Department of Accounting and Information System, faculty of Business Administration and Management, Patuakhali Science and Technology University, Dumki, Patuakhali. The view of this report is to find out the comparison between two investments proposals ( of PRAN-RFL group).

PRAN-RFL group is now in a great position in the business sector not only in Bangladesh but also in the world. For this reason to earn adequate profit and compete extremely well with the other business organization PRAN-RFL group need to calculate their investment appraisals. According to our survey, we found that PRAN-RFL group tries to calculate the profitability measures to accept or reject any project.

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CHAPTER: 1

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1.1 INTRODUCTION

Investment is very much important for business. It is absurd to earn profit with out investment. But there is an important thing in investment is investment decision. The investment decision must be taken in that way that the firm can earn the maximum profit. Any default in making investment decision can make a serious damage for any firm. For this reason, they have to follow a structured process. In the language of finance, it is called Capital Budgeting. Capital Budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. This benefit may be either in the form of increase revenues and or reduced costs.

Capital expenditure management therefore, include addition, disposition, modification and replacement of fixed assets. The term Capital Budgeting is used interchangeably with—

Capital expenditure decision,

Capital expenditure management,

Long-term investment decision,

Management of fixed assets and so on.

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1.2 JUSTIFICATION OF THE TERM PAPER

This term paper is about the comparison between two investments appraisal. Which is very much related with the capital budgeting techniques. So the techniques or procedure of justify capital budgeting are also the elements of justify this term paper. That is why, to justify this term paper we can use some capital budgeting evaluation techniques. They are—

1. Pay back period (PB)

2. Net present value (NPV)

3. Internal rate of return (IRR)

4. Profitability index (PI) or benefit -cost ratio (BC).

1.3 OBJECTIVES OF THE TERM PAPER

As a business expectative of future, we should have to gather experience beside our institutional education. We should not concern our lesson only in classroom but to implement it in practical life that will help us in our future life.

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So, identify objectives is very much important. Our purpose of preparing the repot is:

To identify and know the techniques of investment decision.

To identify how the organization make their investment decisions.

To find out how effectively the Capital Budgeting technique works.

To learn about the investment appraisal.

CHAPTER: 2OVERVIEW OF THE PROJECT 1 AND PROJECT

2

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2.1 INTRODUCTIONS

2.1.1 Overview of PRAN-RFL group

“Poverty and hunger are curses”- mission of PRAN-RFL group. So their aim is “to generate employment and earn dignity and self respect for our competitors” through profitable enterprises.

For the achievement of this mission and aim the most recognized PRAN-RFL group was established and started manufacturing in 1982.

PRAN means,

P- Program for R- Rural A-Advancement N- Nationality

RFL means,R- Rangpur F- FoundryL- Limited

(It is a water pump and plastic pipe industry)

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From the time being it has now 17 associated firms and they are beverage, property, agro based, tube wells, plastic pipes, etc. these associated industries are in—

Natore Rangpur Ghorashal and Dhaka

It has already been obtained the ISO certificate. Their ISO mark is ISO-9001 and it was obtained after the three years of their manufacturing.

Major General (Ret) Amzad Khan Chowdhry people of Natore, was the founder and the managing director of PRAN-RFL group. His son Mr. Ahsan Khan Chowdhury is the deputy managing director of this group. PRAN-RFL group is now one of the greatest and significant and most successful company in Bangladesh. They are now challenging the other multinational companies. They are now sending their products to abroad by ensuring their quality. Their export products such as rice, dal, mango bar, juice, mineral water, chatni, tea, white vinegar etc. They are a raising and developing company in Bangladesh. They may be and ideal for infant industries of our country.

2.1.2 Overview of Project 1 (G)

PRAN-RFL group has 17 firms. With in 17 firms spices firm is one of the major firms in their business. It is marely a new firm. But this is a profitable one. They earn a lot of profit from this business. Now a days, they are now thinking of expanding it, because the demand of their product is increasing day by day. And they are now exporting it into several foreign countries. There is an another thing that two exists in the competitive foreign trade market they need modern equipment, and makes some promotional activities with the old product. To crush and dust the several spices in a proper way they need a new crusher machine. And in the market they have opportunity to buy two different machines. And the one of them is “Grinding machine (G).” This machine is made in Japan and the cost of this machine is $ 29000. This machine has 15 years of estimated life. This machine can produce raw materials for the next department for about 10000 units (1 packet = 50 gram) per day. It has no other installation cost and no additional modification cost. After 15 years it can be sold by $2000.

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2.1.3 Overview of Project 2 (S)

The another option is the “Stone crusher machine.” This machine is made from Germany and the purchase price is $ 35000. This machine has also 15 years of estimated life. After that, it can be sold by $ 2000. It has no other installation cost and no additional modification cost. The machine can produce raw materials for the next department for about 12000 units (1 packet = 50 gram) per day.

So the management are in a dilution that which machine will be purchased to earn more profit and which can increase their inflows. This dilution can be removed through some measurement. They are the NPV calculation, IRR calculation and profitability index calculation.

CHAPTER: 3 Profitability measure of the two

projects

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3.1 INTRODUCTION

Profitability measurement is an important thing to increase a firm’s future growth. There are three popular methods in business to evaluate capital budgeting projects. They are

1. Pay back period (PB)2. Net present value (NPV) 3. Internal rate of return (IRR)

There is a another measurement which is profitability index (PI).

1. Pay back period

It is a non-discounting technique to evaluate the capital budgeting process. The back period can be defined as the length of time the original cost of an investment is recovered from the expected cash flows. To compute a project’s pay back period, simply add up the expected cash flows for each year until the cumulative value equals the amount that is initially invested.

The exact payback period can be found using the following formula—

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Number of years beforefull recovery of initial

investment

Amount of investmentunrecovred at start of the the recovery year

Total cash flow generated during the recovery year

Payback period = +

Accept-reject criterion

As a general rule, a project is considered acceptable if its payback is less than the maximum cost recovery time established by the firm. The payback method is simple, which explain why payback traditionally has been one of the most popular capital budgeting techniques. But, because payback ignores the time value of money, for this reason this method can be lead to incorrect decisions at least if our goal is to maximize value. If a project has a payback of three years, we know how quickly the initial investment will be covered by the expected cash flows, but this information does not provide any indication of whether the return on the project is sufficient to cover the cost of the funds invested. In addition, when payback is used, the cash flow beyond the payback period are ignored. Alternatively, the pay back can be used as a ranking method. When mutually exclusive projects are under consideration, they may be ranked according to the length of pay back period. Thus the project having the shortage pay back may be assigned rank 1, followed in that order so that the project with the longest pay back would be ranked last. Obviously, project will shorter pay back period will be selected.

2. Net present value (NPV)

It is a discounted cash flow technique, which include the time value of money. To find the project’s NPV, we compute the present value of all the future cash flows that the project is expected to generate and then subtract (add a negative cash flow) the projects initial investment (original cost). The result is the net benefit that the firm will realize from investing in the project. If the net benefit computed on a present value basis- that is, NPV- is positive, then the project is considered an acceptable investment. NPV is computed using the following equation—

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NPV =

=

Here is the expected net cash flow at Period t, and k is the rate of return required by the firm to invest in the project. Cash out flows are treated as negative cash flows.An NPV of zero signifies that the project’s cash flows are sufficient to repay the investment capital and to provide the required rate of return on that capital.


If a project has a positive NPV, then it generates a return that is greater than is needed to pay for funds provided by investors and this excess return accrues solely to the firm’s stockholders. Therefore, if a firm takes on a positive NPV, the position of the stockholders' position is improved because the firm’s value is greater. In general a project is considered acceptable if its NPV is positive, it is not acceptable if its NPV is negative. As a decision criterion, this method can be also used to make a choice between mutually exclusive projects. On the basis of NPV method various proposals would be ranked of the net present values. The project with the highest NPV would be assigned the first rank, followed by the other in the descending order.

3. Internal rate of return (IRR)

Internal rate of return is the discount rate that forces the PV of a project’s expected cash flows to equal its initial cost. IRR also the rate of return the firm expects to earn if the projects is purchased and held for its economic life. As long as the project’s IRR, which is its expected return, is greater than the rate if return required by the firm for such an investment, the project is acceptable.

We can use the following equation to solve for a project’s IRR:

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A project is acceptable if its IRR is greater than the firm’s required rate of return. To solve the IRR we need the firms required rate of return. Taking of a firm’s project’s whose IRR exceed its required rate of return, or cost of funds, increases shareholders wealth.

Net Present Value Profiles (NPV profiles)

NPV profile is a curve showing the relationship between a project’s NPV and various discount rate (required rate of return).

Profitability index (PI) or Benefit cost ratio (BC)

Yet another time adjusted capital budgeting technique is profitability index (PI) or benefit -cost ratio (BC). It is similar to the NPV approach. The profitability index approach measures the present value of return per TK invested, while the NPV is based on the difference between the present value of future cash inflows and the present value of cash outlays. A major shortcoming of NPV method is that, being and absolute, measure, it is not a reliable method to evaluate projects requiring different initial investment. The PI method provides a solution to this kind of problem. It is, in other wards, a relative measure. It may be defined as the ratio which is obtained dividing the present value of future cash inflows by the present value of cash outlays. Symbolically,

PI =

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investment



This method is also known as the B/C ratio because the numerator measures benefits and the denominator costs. A more appropriated description would be present value index.

Accepted-rejected rules

Using the B/C ratio or the PI, a project will qualify for acceptance if its PI exceeds one. When PI is equals one then the firm is indifferent to the projects. When PI is greater than equal to or less than one, the net present value is greater than, equal to or less than zero respectively. In other wards, the NPV will be positive when the PI is greater than one, will be negative when the PI is less than one. Thus, the NPV and PI approaches give the same result regarding the investment proposal. The selection of projects with the PI method can also be done on the basis of ranking. The highest rank will be given to the project with the highest PI, followed by the others in the same order.

3.3 CALCULATION OF PAYBACK PERIOD OF TWO PROJECTS

3.3.a Calculation of Pay back period of grinding machine

Payback period = +

Discounted payback period of grinding machine

At 10% discounting rate

Years Year 1

509111

1963

24628

121784

21


investment




investment



34207

131622

43825

141475

53477

152059

63161

72874

82612

92375

102159

Discounted payback period of grinding machine

+ +

= +

= 8+

= 8.053

3.3. b Pay back period of stone crushing machine

Payback period = +

22

Discounted payback period of S

At 10% discounting rate

Years Years1

572710

2429

25207

112208

34733

122007

44303

131825

53912

141659

63556

152466

73233

82939

92672

23


investment



Discounted payback period of Stone Crusher

= +

= 9+

= 9.30

3.4. CALCULATION OF NET PRESENT VALUE OF TWO MACHINES

3.4. a Calculation OF NET present value (NPV) of grinding machine

Net present value at 14% of RRR:

=

=

= (30000) + 34815

= 4815

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Net present value of G at 18% of RRR:

=

=

= (30000) + 28767

= (1233)

3.4.b Calculation of Net present value (NPV) of Stone Crusher


=

=

= (37000) + 39255

= 2255


=

=

25

= (37000) + 32416

= (4584)

3.5 CALCULATION OF INTERNAL RATE OF RETURN OF TWO PROJECTS

3.5. a Calculation of Internal rate of return (IRR) of Grinding machine

IRR =

= 14% +

= 17.18%

3.5. b Calculation of Internal rate of return (IRR) of Stone Crusher Machine

IRR =

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= 14% +

= 15.32%

3.6 NPV PROFILE OF GRINDING MACHINE AND STONE CRUSHER MACHINE

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Maturity 0% 57000 615005% 29571 3031810% 13311 1187415% 3112 32820% (3625) (7287)

This figure shows that, the NPV profile for Grinding machine (G) and Stone crushing machine (S) decline as the discount rate increases. However, that project S has the higher NPV at low discount rates, where as project G has the higher NPV at high discount rates. According to the graph,

when the discount rate, k equals 6.5 percent. We call this point the crossover rate because bellow this rate , above this rate,

-that is, the crossover rate at 6.5 percent.

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The figure is also indicates that Stone crushing machine’s NPV is more sensitive to change in the discount rate than is . That is, Stone crushing machine’s net present value profile has the stepper slope, indicating that a given change in k has a large effect on than on .

If Project G and Project S are mutually exclusive rather than independent, then only one project can be accepted. We know, mutually exclusive projects, is a set of project in which acceptance of one project means the other cannot be accepted. If we use IRR to make the decisions as to which project in better, we can choose Project G because , if we use NPV to make the decision, we might reach a different conclusion depending on the firm’s required rate of return. From the figure, if the required rate of return is less than the crossover rate of 6.5 percent, , and

if the required rate of return is greater than 6.5 percent. As a result Project S would be preferred if the firm’s required rate of return is less than 6.5 percent, but the Project G would be preferred if the firm’s required rate of return is greater than 6.5 percent.

As long as the firm’s required rate of return is greater than 6.5 percent, using either NPV or IRR will result in a same decision- that is, Project G should be purchased because and . On the other hand, if the firm’s required rate of return is less than 6.5 percent, a person who uses NPV will reach a different conclusion as to which project should be purchased. The organization will choose the Project S because . In this situation if the required rate of return is less than 6.5 percent, there is a conflict exist because NPV says choose Project S over Project G, where as IRR says just the opposite.

3.7 PROFITABILITY INDEX (PI) OR BENEFIT-COST RATIO (B/C RATIO) OF THE TWO PROJECTS.

3.7 a Calculation for profitability Index of Grinding Machine

Profitability index of Grinding machine =

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=

= 1.16

3.7. b Calculation of profitability index for Stone Crusher Machine

Profitability index of Stone crusher machine =

=

= 1.06

3.8 COMMENTS ON THE OVERALL CALCULATION

3.8.1 Comments in respect of NPV:

These project (grinding machine & stone crusher) are mutually exclusive projects. Here, NPV at 14% required rate of return of grinding machine is 4815 and NPV at 14% required rate of return of stone crusher is 2255.

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We know that, if NPV is positive than the project is accepted other than it will be rejected. If both project’s NPV are positive than the project of higher NPV is accepted in mutually exclusive project.

Here the NPV of both projects is positive. But the NPV of Grinding machine is higher than the NPV of stone crusher machine. So the company should accept the first option that is- Grinding machine.

3.8.2 Comments in respect of IRR:

These projects (grinding machine & stone crusher) are mutually exclusive projects. Here, IRR of grinding machine is 17.18% and IRR of stone crusher is 15.32%.

We know that, if IRR is higher than the required rate of return (RRR) than the project is accepted other than it is rejected. If both project’s IRR is higher than the required rate of return than the higher IRR’s project will be accepted.

Here the IRR of both projects is greater than the required rate of return. But the IRR of Grinding machine is higher than the IRR of stone crusher. So the company should accept the first option that is- Grinding machine.

3.8.3 Comments in respect of profitability index

Using the profitability index, a project will qualify for acceptance if its profitability index exceeds one, when profitability index is equals 1, the firm is indifferent to the project. When PI is greater than, equal to or less than 1, the net present value is greater than, equal to or less than zero respectively. In other words the NPV will be positive when the PI is greater than 1; will be negative when the PI is less than 1.

In the Grinding and Stone crusher machine, the PI would be 1.16 for Grinding machine; the PI would be 1.06 for Stone crusher machine.

Since the PI for both the machines is greater than 1, both the machines are acceptable, but the company has to accept the project of greater profitability index. Because, it shows greater net present value. In this case the Grinding machine project is accepted.

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CHAPTER: 4 Summary, Conclusion &

Recommendation

4.1 SUMMARY

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PRAN-RFL group can determine the profitability measure of the two projects with the help of above calculation. The both projects life time is same; the salvage value is also same. But the purchase price of the Stone crusher machine is higher than the Grinding machine. The production capacity of two machines is also different. These two projects are in existence in this current market. PRAN-RFL group should purchase Grinding Machine between the two projects Grinding and Stone Crusher. For recover the cost of machine, the Grinding machine is appropriate because its pay back period is lower than the stone crusher machine. In case of NPV, the NPV of Grinding machine and Stone crusher machine at 14% required rate of return are both positive. But the NPV of grinding machine is higher. For that reason, the PRAN-RFL group should purchase Grinding machine in respect of greater NPV. In case of IRR, both machines IRR is higher than required rate of return. But the Grinding machine possesses higher IRR, for this, the PRAN-RFL group should purchase the Grinding Machine. If the profitability index is higher than 1 then it indicates that, the NPV is also higher. In case of both Grinding machine and Stone crusher machine, the profitability index is higher than 1. But the profitability index of Grinding machine is more higher than the Stone crusher machine. For the entire situation, the PRAN-RFL group should purchase the Grinding Machine.

4.2 CONCLUSION

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Forecasting in a profitable project is very much important to existence any business in this competitive business market. It is needed to use various machineries for conducting production activities of the company. For this the company have to purchase various machineries, for this reason capital budgeting is very much important for corporations. But if the firm invest too much in assets, it will be incurred unnecessarily heavy expenses. And if it does not spend enough on fixed assets, it might find that inefficient production and inadequate capacity lead to lost sales that are difficult, if it is not possible to recover. Timing is also important in capital budgeting, Capital assets must be ready to come on line when they are needed; otherwise, opportunities must be lost. Effective capital budgeting can improve both the timing of assets acquisition and the quality of assets purchased. A firm that forecast its needs for capital assets in advanced will have an opportunity to purchase and installs the assets before they are needed.

4.3 RECOMMENDATION

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1. For recover the cost of machine, the Grinding machine is appropriate because its pay back period is lower than the stone crusher machine. PRAN-RFL group should purchase Grinding Machine between the two projects Grinding and Stone Crusher.

2. The NPV of grinding machine is higher. For that reason, the PRAN-RFL group should purchase Grinding machine in respect of greater NPV.

3. In case of IRR, both machines IRR is higher than required rate of return. But the Grinding machine possesses higher IRR, for this, the PRAN-RFL group should purchase the Grinding Machine.

4. If the profitability index is higher than 1 then it indicates that, the NPV is also higher for that project. In case of both Grinding and stone crusher profitability index is more than 1. Here the company should purchase the Grinding machine which profitability index is more higher.

5 If the firm invests too much in assets, it will be incurred unnecessarily heavy expenses, for this reason the PRAN-RFL group should purchase the Grinding Machine. Because it is less cost.

6. Which project pay back period is lower that project should be accept because it indicates more capacity of recovery. In Grinding machine pay back period is lower for this reason the company should purchase it.

4.4 Bibliography

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1. Besley Scott & Brigham Eugene F.; Essentials of Managerial Finance 13th

edition, Thomson South Western.

2. Van Horne James C. & Wachowicz John M.; Financial Management 11th edition, Pearson Eucation Asia.

3. Khan M Y & Jain P K ; Financial Management 3rd edition, Tata Mc Graw Hill Publishing Company ltd.

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Financial Management

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