Financial management revision question and answer

P. Muli was recently appointed to the post of investment manager of Masada Ltd. a quoted company. The company has raised Sh.8,000,000 through a rights issue.

P. Muli has the task of evaluating two mutually exclusive projects with unequal economic lives. Project X has 7 years and Project Y has 4 years of economic life. Both projects are expected to have zero salvage value. Their expected cash flows are as follows:

The amount raised would be used to finance either of the projects. The company expects to pay a dividend per share of Sh.6.50 in one year‟s time. The current market price per share is Sh.50.
Masada Ltd. expects the future earnings to grow 7% per annum due to the undertaking of either of the projects. Masada Ltd. has no debt capital in its capital structure.

Required:

(a) The cost of equity of the firm.

(b) The net present value of each project.

(c) The Internal Rate of return (IRR) of the projects. (Rediscount cash flows at 24%
for project X and 25% for Project Y).

(d) Briefly comment on your results in (b) and (c) above

(e) Identify and explain the circumstances under which the Net Present Value (NPV) and
the Internal Rate of Return (IRR) methods could rank mutually exclusive projects in a conflicting way.
ANSWER


(d) -N.P.V method ranks project X as number one
– I.RR method ranks project Y as number one
– There is conflict in ranking of mutually exclusive projects

(e) Conflict between N.P.V and I.R.R
– Incase of difference in economic lives of projects
– Incase of difference in size of the projects
– Incase of difference in timing of cash flow
– Incase of non-conventional cash flows

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