Question

Suppose you were the financial Accountant for Max Company Pty. Ltd. The board of directors promoted you to position of Finance manager considering the satisfactory services that you rendered to the company. The CEO has asked you to analyze two proposed capital investments, Projects Naru and Oheema. The cost of capital for each project is 12%.

The projects’ initial cost and expected net cash flows are as follows. The two projects are mutually exclusive projects.

Year	Cash Flow Naru ($)	Cash Flow Oheema ($)
0	-220000	-60000
1	40000	42900
2	52000	30800
3	48000	153000
4	200000	14200

1. If you apply the pay criterion, which project will you choose? Why?
2. If you apply the NPV criterion, which project will you choose? Why?
3. If you apply the RR criterion, which project will you choose? Why?

Please give the answers with explanations

Answer 1

1.Project Naru

Cash flow in year 1 = $40,000

Cumulative cash flow in year 2 = $92,000

Cumulative cash flow in year 3 = $140,000

Payback period= full years until recovery + unrecovered cost at the start of the year/ cash flow during the year

= 3 years + ($220,000 - $140,000) / $200,000

= 3 years + $80,000 / $200,000

= 3 years + 0.40

= 3.40 years.

Project Oheema

Payback period= full years until recovery + unrecovered cost at the start of the year/ cash flow during the year

= 1 year + ($60,000 - $42,900) / $30,800

= 1 year + $17,100 / $30,800

= 1 year + 0.56

= 1.56 years.

According to the payback period decision criteria, I will choose project Oheema since it has the shortest payback period.

2.Project Naru

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$220,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the cost of capital of 12%.
• Press the down arrow and CPT buttons to get the net present value.  

Net Present value of cash flows at 12% cost of capital is $18,437.43.

Project Oheema

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$60,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the cost of capital of 12%.
• Press the down arrow and CPT buttons to get the net present value.  

Net Present value of cash flows at 12% cost of capital is $120,783.88.

According to the net present value decision criteria, I will choose project Oheema since it generates the largest net present value.

3.Project Naru

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$220,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 81.33%.

According to the internal rate of return decision criteria, I will choose project Oheema since it generates the highest internal rate of return.