MGT201 Assignment # 1 Solution

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“Capital Budgeting Techniques”


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The Premier National Bank has just a single banking office located in a small city Chitral. As per the changing style of population and emerging trends in the banking sector, Premier National Bank has seen its share of both local banking deposits and profits decline. Two of the bank’s vice presidents have proposed that Premier National Bank should try to reverse the trend by building a branch in a new location of this small city. They have presented the following information to the Bank’s executive committee.
The initial cost of the bank building and equipment is Rs.1 million. This facility is expected to have a useful life of 10 years. Also, in 10 years at the end of the project, the branch building and its equipment are expected to be sold for Rs.200,000 salvage value. The branch building and equipment will be depreciated over their 10-years life using straight-line depreciation. Moreover, the bank’s building is to be constructed on land leased for Rs.20,000 per year.
Based on customer survey, population trends, the location of competitors, and the experience other area banks have had with their branches, it is estimated that the annual revenues from the new branch will be:
Year 1-6
Rs. 510,000 each year
Year 7
410,000
Year 8
450,000
Year 9
500,000
Year 10
400,000
In addition to Rs.20,000 annual expenses for the land lease, the new branch will incur about Rs.230,000 per year in other expenses including personnel costs, utilities and interest paid on accounts. Both expenses and revenues are expected to remain approximately constant over the branch’s 10-year life. The bank’s cost of capital is 9% after taxes.
Based on the information contained in the case, use Net Present Value decision criteria to suggest whether it is feasible for Premier National Bank to start the new branch in such a small city.
SSoolluuttiioonn::
Initial investment = 1 million
Salvage value = Rs.200,000
PV of Salvage value = 200,000 (PVIF 9%, 10) OR 200,000 / (1 + 0.09) 10
As it is to be received after 10 years
PV of Salvage value = 200,000 (0.422)
PV of Salvage value = Rs.84,400
PV of lease payments = CCF [1-1/(1+i)n]
i
= 20,000 [1-1/(1+0.09)10] OR 20,000 (PVIFA 9%, 10)
0.09
= 20,000 (6.418)
= Rs.128,360
Depreciation of building and equipment = Cost – Salvage value/ Useful life
Depreciation of building and equipment = 1 million – 200,000/10
Depreciation of building and equipment = Rs.80,000 per year
Since depreciation is a non-cash expense so Depreciation is to be deducted from expenses. As only cash items or cash flows are considered in NPV calculations. So, other expenses are Rs.150,000 (230,000- 80,000).
PV of other expenses = 150,000 [1-1/(1+0.09)10] OR 150,000 (PVIFA 9%, 10)
0.09
= 150,000 (6.418)
= Rs.962,700
Present value of cash inflows of 1st six years:
PV of 1-6 Year Cash Inflows = 510,000 [1-1/(1+0.09)6] OR 510,000 (PVIFA 9%, 6)
0.09
= 510,000 (4.486)
= Rs.22,87,860
PV of Year 7 Cash Inflow = 410,000 (PVIF 9%, 7) OR 410,000 / (1 + 0.09) 7
= 410,000 (0.547)
= Rs.224,270
PV of Year 8 Cash Inflow = 450,000 (PVIF 9%, 8) OR 450,000 / (1 + 0.09) 8
= 450,000 (0.502)
= Rs.225,900
PV of Year 9 Cash Inflow = 500,000 (PVIF 9%, 9) OR 500,000 / (1 + 0.09) 9
= 410,000 (0.460)
= Rs.230,000
PV of Year10 Cash Inflow = 400,000 (PVIF 9%, 10) OR 400,000 / (1 + 0.09) 10
= 400,000 (0.422)
= Rs.168,800
NPV = -IO + ΣCF t / (1+i) t
= – initial investment + PV of all Cash flows
= -1 Million + 22,87,860 + 224,270 + 225,900 + 230,000 + 168,800 + 84,400 - 128,360 - 962,700
= Rs.1,130,170
(Negative sign with some cash flows shows that these are cash outflows and cash outflows are subtracted from cash inflows)
As NPV is Positive, so it is feasible for Premier National Bank to start the new branch in Chitral city.

Best of Luck!!!!!!!