Question

University of the Southern Caribbean have been considering to construct two extension sites in other Caribbean Islands. After they reviewed and analysed several proposals, the options were narrowed down to two possible extension sites. The St. Lucia extension site is estimated to cost $950,000 with an expected cost of capital to be 10%. Grenada’s extension site is closer to Trinidad so the cost is anticipated to be $750,000 with a cost of capital of 12%. The anticipated net cash inflows for the next 6 years are projected below.
Years St. Lucia Extension Site Grenada Extension Site
1 230,000 230,000
2 228,000 280,000
3 278,000 295,000
4 283,000 180,000
5 273,000 200,000
6 280,000 150,000

Requirements:
1. USC would like the payback period to be by year 4 for the latest. Based on that, which investment would you recommend and if they both meet the criteria, rank them.
2. USC has $1,750,000 available for the projects. Use the NPV method for the basis of your recommendation.
3. Make an overall recommendation after reviewing both the payback and NPV methods.

Answer 1

Answer:

a. Payback period method works by finding out if the investment will payback its initial investment within a certain period.

Payback period is a maximum of 4, find out which investment paid back in 4 years:

St Lucia:

= Cash flows for first 4 years - initial investment

= 230,000 + 228,000 + 278,000 + 283,000 - 950,000

= $69,000

Payback period = Year before payback + (Amount left for payback / Cashflow in payback year)

= 3 + ( (950,000 - 230,000 + 228,000 + 278,000) / 283,000)

= 3.76 years

Granada:

Payback period = Year before payback + (Amount left for payback / Cashflow in payback year)

= 2 + ( ( 750,000 - 230,000 - 280,000) / 295,000)

= 2.81 years

Both of them meet criteria but Granada site has lower payback period of 2.81 years so should rank higher than St. Lucia site.

2. St Lucia NPV:

= (230,000 / (1 + 10%)) +  (228,000 / (1 + 10%)²) +  (278,000 / (1 + 10%)³) +  (283,000 / (1 + 10%)⁴)  +  (273,000 / (1 + 10%)⁵) +  (280,000 / (1 + 10%)⁶) - 950,000

= $177,243

Granada NPV:

= (230,000 / (1 + 12%)) +  (280,000 / (1 + 12%)²) +  (295,000 / (1 + 12%)³) +  (180,000 / (1 + 12%)⁴)  +  (200,000 / (1 + 12%)⁵) +  (150,000 / (1 + 12%)⁶) - 750,000

= $192,420

USC has enough money to fund both projects and so should embark on both of them as they both bring in a positive Net Present Value.

3. On the basis of both the Payback period and the NPV, the Granada site performs better than the St. Lucia so if USC does not have enough money for both projects, they should invest in the Granada project.