Financial management revision question and answer

The finance manager of Bidii Industries Ltd., which manufactures edible oils, has identified the following three projects for potential investment:

Project I

The project will require an initial investment ofSh.18 million and a further investment of Sh.25 million at the end of two years. Cash profits from the project will be as follows:


Project II

This project will involve an initial investment of Sh.50 million on equipment and Sh.18 million on working capital. The investment on working capital would be increased toSh.20 million at the end of the second year. Annual cash profit will be Sh.20 million for five years at the end of which the investment in working capital will be recovered.

Project III

The project will require an initial investment on capital equipment of Sh.84 million and Sh.24 million on working capital. The profits from the project will be as follows:
Fixed costs include an annual depreciation charge ofSh.3 million. At the end of year 3, the working capital investment will be recovered and the capital equipment will be sold for Sh.8 million.

Bidii Industries Ltd.‟s cost of capital is 12%. Ignore taxation.

Required:
(i) Evaluate each project using the net present value (NPV) method.

(ii) Which of the three projects should Bidii Industries Ltd. accept?
ANSWER

(ii)         Project II, which has the highest NPV should be accepted.

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