Question

Question 1 (a) Uzumba Maramba Pfungwa P/L has the following information about 3 projects A, B and C that are being considered by Executive Committee Year Project A Project B Project C 0 ($15 000) ($15 000) (15 000) 1 11 000 3 500 42 000 2 7 000 8 000 (4 000) 3 4 800 13 000 -Yellowbone, the finance manager, believes all the 3 groups have risk characteristics similar to the average risk of the firm and hence the firm’s cost capital (12%) will apply. You have been asked to prepare a report covering the following: a) Calculate the payback period of Project A and B; b) Calculate the NPV of Projects A, B & C; c) Calculate the IRR for Projects A & B; d) Discuss the merits and demerits of accounting rate of return (ARR) as a project evaluation technique

Answer 1

a) Payback Period

Year	Annual cash flows		Cumulative Annual Cash flows		Payback Period
	Project A	Project B	Project A	Project B	Project A	Project B
1	$                  11,000	$                    3,500	$                   11,000	$                  3,500
2	$                     7,000	$                    8,000	$                   18,000	$                11,500	1 Year and 6.8 Months		1 year + [(15000-11000)/7000]*12
3	$                     4,800	$                  13,000	$                   22,800	$                24,500		2 Year and 3.2 Months	2 year + [(15000-11500)/13000]*12
Total	22,800	$                  24,500
	Initial Investment	15,000.0
	Payback Period	Time at which cumulative cash flow equals initial investment

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b) Net Present Value (NPV)

Year	Annual cash flows			PV Factor @12%	Present Value of cash flows
	Project A	Project B	Project C		Project A	Project B	Project C
0	$                 -15,000	$                -15,000	$                 -15,000	1	$                      -15,000	$                      -15,000	$                -15,000
1	$                  11,000	$                    3,500	$                   42,000	0.893	$                          9,823	$                          3,126	$                  37,506
2	$                     7,000	$                    8,000	$                   -4,000	0.797	$                          5,579	$                          6,376	$                   -3,188
3	$                     4,800	$                  13,000	$                            -	0.712	$                          3,418	$                          9,256	$                           -
				NPV->	$                          3,820	$                          3,758	$                  19,318

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c) IRR

Year	Annual cash flows		PV Factor @12%	PV of cash flows @12%		PV Factor @18%	PV of cash flows @18%
	Project A	Project B		Project A	Project B		Project A	Project B
0	$                 -15,000	$                -15,000	1	$              -15,000	$                      -15,000	1	$                -15,000	$                           -15,000
1	$                  11,000	$                    3,500	0.893	$                  9,823	$                          3,126	0.847	$                    9,317	$                               2,965
2	$                     7,000	$                    8,000	0.797	$                  5,579	$                          6,376	0.718	$                    5,026	$                               5,744
3	$                     4,800	$                  13,000	0.712	$                  3,418	$                          9,256	0.609	$                    2,923	$                               7,917
			NPV->	$                  3,820	$                          3,758	NPV->	$                    2,266	$                               1,626

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IRR =	R1 + [NPV1​ × (R2​−R1​) / (NPV1​−NPV2​)]
	Project A	Project B
	12+(3820*(18-12))/(3820-2266)	12+(3758*(18-12))/(3758-1626)
IRR	26.75	22.58

where:

R1​,R2​=randomly selected discount rates

NPV1​=higher net present value

NPV2​=lower net present value​

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d)

ARR is that it is easy to compute & understand. The main disadvantage of ARR is that it does not consider the time factor in terms of time value of money or risks for long term investments. The ARR is built on evaluation of profits and it can be easily manipulated with changes in depreciation methods. The ARR can give misleading information when evaluating investments of different size.

This technique is based on profits rather than annual cash flow. It ignores cash flow from investment. Therefore, it can be affected by non-cash items such as bad debts and depreciation when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.

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