Answer on Question #51641, Management, Other

a). A company is considering the following investment projects.

Cash flows in Kes

Project Initial Outlay C1 C2

A (10,000) 10,000

B (10,000) 7,500 7,500 12,000

C (10,000) 2,000 4,000 3000

D (10,000) 10,000 3,000 3,000

Required:

Rank the projects according to:

i. Payback period (1 Marks)

ii. Accounting rate of return (1 Marks)

iii. Internal Rate of Return (2 Marks)

iv. Profitability Index (1 Marks)

v .Net present value (2 Marks)

Use 10% where cost of capital is not given especially in cases of NPV and IRR.

Solution:

i. Payback period.

In given problem we note the data of the task. The information is provided in the Table

Table Projects Cash flows.

Project Year 0 Year 1 Year 2 Year 3 Year 4

A (10,000) 10,000
B (10,000) 7,500 7,500 12,000
C (10,000) 2,000 4,000 3000
D (10,000) 10,000 3,000 3,000
The payback period is the time period required for the amount invested in an asset to be
repaid by the net cash outflow generated by the asset.

In order to determine the payback period we apply the following method of calculation,
we divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by
the amount of net cash flow generated by the project per year.
 Thus, for the Project A the Payback period will be equal.

Original investment 10,000

Payback period of the Project A = = = 1 year
Average cash flow 10,000

For the Project B the Payback period will be equal.

Original investment 10,000

Payback period of the Project B = = = 1.11 year
Average cash flow 9,000

The table indicates that the real payback period is located somewhere between Year 1
and Year 2.

For the Project C the Payback period will be equal.

Original investment 10,000

Payback period of the Project C = = = 3.33 year
Average cash flow 3,000

The table indicates that the real payback period is located somewhere after Year 3.

For the Project D the Payback period will be equal.

Original investment 10,000

Payback period of the Project D = = = 1.875 year
Average cash flow 5333.33

The table indicates that the real payback period corresponds to 1 year.

ii. Accounting rate of return.

Accounting rate of return (ARR) method uses expected net operating income to be
generated by the investment proposal rather than focusing on cash flows to evaluate an
investment proposal. Under this method, the asset’s expected accounting rate of return (ARR) is
computed by dividing the expected incremental net operating income by the initial investment
and then compared to the management’s desired rate of return to accept or reject a proposal.
For the calculation we apply the following formula.

Incremental Accounting income

Accounting rate of return =
Initial Investment
Now we apply this formula to our problem.

Incremental net operating income: Incremental revenues – Incremental expenses

including depreciation.

In first case for ARR depreciation will be deducted to cash flow. For the Project A cash in
flow 10,000 and depreciation is equal to 10,000, hence, the Profit = 0%.

For the Project B the accounting rate of return will be equal.

 (7,500 + 7,500 + 12,000 − 10,000)/3
Accounting rate of return of the Project B =
5,000
5,666.67
= ∙ 100 = 113.3%
5,000
(2,000 + 4,000 + 3,000 − 10,000)/3
Accounting rate of return of the Project C =
5,000
= −6.67%

(10,000 + 3,000 + 3,000 − 10,000)/3

Accounting rate of return of the Project D = = 40%
5,000

If for the calculation we apply the following formula:

Average profit
ARR =
Average investment

Then for the Project A this value will be equal

10,000
ARR = = 100%
10,000

Then for the Project B this value will be equal

(7,500 + 7,500 + 12,000)/3

ARR = = 90%
10,000

Then for the Project C this value will be equal

(2000 + 4000 + 3000)/3

ARR = = 30%
10,000

Then for the Project D this value will be equal

(10000 + 3000 + 3000)/3

ARR = = 53.33%
10,000

iii. Internal Rate of Return.

Internal rate of return (IRR) method also takes into account the time value of money. It
analyzes an investment project by comparing the internal rate of return to the minimum required
rate of return of the company.

The internal rate of return is the rate at which an investment project promises to generate
a return during its useful life. The formula for IRR is:

CF1 CF2 CF3 CFn

[ + + + ⋯ + ] − Initial Investment = 0
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n

Based on the above formula we can calculate the internal rate of return for each Project.
 IRR for Project A

10,000
[ ] = 9900.99
(1 + 0.01)1

Since NPV is fairly close to zero at 1% value of r, therefore IRR ≈ 1%

IRR for Project B

7500 7500 12000

+ + = 10,004.57
(1 + 0.647)1 (1 + 0.647) 2 (1 + 0.647)3

Since NPV is fairly close to zero at 64.7% value of r, therefore IRR ≈ 64.7%

IRR for Project C

The investment's IRR is must be less than 1%, which is the rate that makes the present
value of the investment's cash flows equal to zero. If we have the value of rate equal to 1%, then
we obtain the following result.

2000 4000 3000

+ + = 8813.15
(1 + 0.01)1 (1 + 0.01)2 (1 + 0.01)3

Thus, the IRR must be less 1%.

IRR for Project D

10000 3000 3000

+ + = 10,008.47
(1 + 0.3755)1 (1 + 0.3755)2 (1 + 0.3755)3

The investment's IRR is 37.55%, which is the rate that makes the present value of the
investment's cash flows approximately equal to zero.

iv. Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present

value of future cash flows of a project by the initial investment required for the project.

We create the Table for the first project A.

Year Cash Flow Discounted Cash Flows

0 -10000
1 10000 9090.909

The total PV of future cash flows = 9090.909

Initial Investment = 10,000

 9090.909
PI = = 0.91
10,000

Since we have PI < 1, we make a decision to reject the project.

Next we make the same table for the Project B.

Year Cash Flow Discounted Cash Flows

0 -10000
1 7500 6818.182
2 7500 6198.347
3 12000 9015.778
The total PV of future cash flows = 22,032.307

Initial Investment = 10,000

22,032.307
PI = = 2.203
10,000

Since PI > 1, the project can be accepted.

Now we make calculation for the Project C. As in previous part we create the Table.

Year Cash Flow Discounted Cash Flows

0 -10000
1 2000 1818.182
2 4000 3305.785
3 3000 2253.944

The total PV of future cash flows = 7,377.911

Initial Investment = 10,000
7,377.911
PI = = 0.74
10,000

Since we have PI < 1, we make a decision to reject the project.

Now we make calculation for the Project D. As in previous part we create the Table.

Cash Discounted Cash

Year Flow Flows
0 -10000
1 10000 9090.909
2 3000 2479.339
3 3000 2253.944

The total PV of future cash flows = 13 824.192

 Initial Investment = 10,000
13,824.192
PI = = 1.38
10,000

Since PI > 1, the project can be accepted.

v .Net present value.

The formula for calculating NPV is as follows.

n
CFt
NPV = ∑ − CF0
(1 + R)t
t=1

Where:
NPV – Net Present Value of the project;
CFt – cash flow in period t;
CF0 – cash flow at the initial moment. The initial cash flow is equal to investment capital (CF0 =
IC);
r – the discount rate.
Thus, we apply this formula for calculation the NPV for the first Project A. We obtain the
following result.

10,000
NPV = −10,000 + = −909.09
(1 + 0.10)1

NPV for the Project A equal to − 909.09

We apply formula the same for calculation the NPV for the Project B. We obtain the
following result.

7,500 7,500 12,000

NPV = −10,000 + + + = −10,000 + 22032.31
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3
= 12,032.31

NPV for the Project B equal to 12 ,032.31

We apply the same formula for calculation the NPV for the Project C. We obtain the
following result.

2,000 4,000 3,000

NPV = −10,000 + + + = −10,000 + 7377.91
(1 + 0.10)1 (1 + 0.10) 2 (1 + 0.10)3
= −2,622.087

NPV for the Project C equal to − 2,622.087

We apply the same formula for calculation the NPV for the Project D. We obtain the
following result.
 10,000 3,000 3,000
NPV = −10,000 + + + = −10,000 + 13824.19
(1 + 0.10)1 (1 + 0.10) 2 (1 + 0.10)3
= 3,824.19

NPV for the Project D equal to 3,824.19

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