Problem: (a) In making investment decisions, cash flows are considered to be more important than accounting profits. Briefly explain why this is the case.
(b) Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each of these projects requires Sh.400,000,000 in initial cash outlay. The details of the two projects are as follows:
Project A
This project is made up of two sub-projects. The first sub-project will require an initial outlay of Sh.100,000,000 and will generate Sh.25,600,000 per annum in perpetuity. The second sub-project will require an initial outlay of Sh.300,000,000 and will generate Sh.85,200,000 per annum for the 8 years of its useful life. This sub-project does not have a residual value at the end of the 8 years. Both sub-projects are to commence immediately.
Project B
This project will generate Sh.87,000,000 per annum in perpetuity.
The company has a cost of capital of 16%.
Required:
(i) Determine the net present value (NPV) of each project.
(ii) Compute the internal rate of return (IRR) for each project.
(iii) Advise Magma Ltd. on which project to invest in, and justify your choice.