Question

QUESTION 5

Dolby Enterprises has the option to invest in machinery in Projects M and N but finance is only available to invest in one of them.

	Project M (R)	Project N (R)
Initial cost	450 000	450 000
Net Profit
Year 1	36 000	69 000
Year 2	75 000	69 000
Year 3	102 000	69 000
Year 4	129 000	69 000
Year 5	81 000	69 000

1. Assume that all cash flows take place at the end of the year except the original investment in the project which takes place at the beginning of the project.

2. Project M machinery is expected to be disposed of at the end of year 5 with a scrap value of R60 000.

3. Project N machinery is expected to be disposed of at the end of year 5 with a nil scrap value.

4. Depreciation is calculated on a straight-line basis.

5. The discount rate to be used by the company is 12%.

5.1 Required:

Use the information provided above by Dolby Enterprises to answer the following questions:

5.1.1 Calculate the Payback Period of Project N. (Answer must be expressed in years and months.)

5.1.2 Calculate the Accounting Rate of Return (on average investment) of Project M.

(Answer must be expressed to two decimal places.)

5.1.3 Calculate the Net Present Value of each project. (Round off amounts to the nearest Rand.)

5.1.4 Using your answers from question 5.1.3, which project should be chosen? Why?

5.2 A machine with a purchase price of R418 000 is estimated to eliminate manual operations and save the company R130 000 cash per year. The machine will last 5 years and have no residual value at the end of its useful life.

Required:

Calculate the Internal Rate of Return (answer expressed to two decimal places).

Answer 1

Question 5.1.1

Payback period = it shows the time required to recover an initial investment in terms of profit and saving in future years.

Formula = Initial investment / Profits in future period.

Project N:

Initial investment = 450 000

Uniform future profit = 69000

Payback period = 450000 / 69000

= 6.52 years or 6 years and 7 months.

Question 5.1.2

Accounting rate of return = it is calculated from the net profit generated from the initial investment. It will not consider the time value of money.

Formula = Average annual profit / Average investment

Average investment = ( Book value at the beginning + Book value at the end of life.) / 2

= ( 450000 + 60000 ) / 2

= 255000

Total depreciation of project M = ( 450000 - 60000 ) = 390000

Average annual profit = ( Total profit through life of the project - Total depreciation ) / Life of the project

= ( 423000 - 390000 ) / 5

= 6600

Accounting rate of return = 6600 / 255000

= 2.59%

Question 5.1.3

Net present value = Present value of future net profit - Initial investments.

Discount rate of company = 12%

Calculation of NPV for both the projects
Project M				Project N
Year	Net profit	PVAF@12%	Present value	Year	Net profit	PVAF@12%	Present value
1	36000	0.893	32148	1	69000	0.893	61617
2	75000	0.797	59775	2	69000	0.797	54993
3	102000	0.712	72624	3	69000	0.712	49128
4	129000	0.636	82044	4	69000	0.636	43884
5	81000	0.567	45927	5	69000	0.567	39123
Total			292518				248745
Investment			450000				450000
NPV			-157482				-201255

Question 5.1.4

Project M is much better as compare to project N Since it has less negative value. With same initial investment , Life of the project and discount rate, Project M gives better return. Hence we should choose project M.