Question

Ranking Investment Proposals:Payback Period, Accounting Rate of Return, and Net Present Value
Presented is information pertaining to the cash flows of three mutually exclusive investment proposals:

	Proposal X	Proposal Y	Proposal Z
Initial investment	$81,000	$81,000	$81,000
Cash flow from operations
Year 1	80,000	40,500	81,000
Year 2	1,000	40,500
Year 3	41,000	41,000
Disinvestment	0	0	0
Life (years)	3 years	3 years	1 year

Select the best investment proposal  using the payback period, the accounting rate of return on initial investment, and the net present value criteria. Assume that the organization's cost of capital is 14 percent.

Note: Follow rounding instructions noted for each computation. Use a negative sign with your answers, when appropriate.

	Proposal X	Proposal Y	Proposal Z	Best proposal
Payback period (years)				XYZX,YX,ZY,Z
Accounting rate of return; Round answers to 4 decimal places.				XYZX,YX,ZY,Z
Net present value; Round answers to nearest whole number.				XYZX,YX,ZY,Z

Answer 1

ANSWER

Payback period is the period in which investment is recovered.
Proposal X

Year	Cash Flows	Cummulative Cash flows
1	$ 80,000.00	$      80,000.00
2	$     1,000.00	$      81,000.00
3	$ 41,000.00	$   122,000.00

Investment is $81000, at end of year 2 cummulative cash flows is $81000 which is equal to investment, therefore Payback period is 2 years

Proposal Y

Year	Cash Flows	Cummulative Cash flows
1	$ 40,500.00	$      40,500.00
2	$ 40,500.00	$      81,000.00
3	$ 41,000.00	$   122,000.00

Investment is $81000, at end of year 2 cummulative cash flows is $81000 which is equal to investment, therefore Payback period is 2 years

Proposal Z
Cash flow is for one year only i.e. $81000, investment is also $81000, therefore Payback period is 1 year

Accounting Rate of Return = Average Accounting Income / Investment x 100
Proposal X
Depreciation = $81000 / 3 = $27000 per year

Year	Cash Flows	Depreciation	Accounting Income
1	$ 80,000.00	$      27,000.00	$         53,000.00
2	$     1,000.00	$      27,000.00	$       (26,000.00)
3	$ 41,000.00	$      27,000.00	$         14,000.00
			$         41,000.00

Accounting Income = Cash flows - Depreciation
Average Accounting income = $41000 / 3 = $13667
Accounting rate of return = $13667 / $81000 x 100 = 16.87%

Proposal Y

Year	Cash Flows	Depreciation	Accounting Income
1	$ 40,500.00	$      27,000.00	$         13,500.00
2	$ 40,500.00	$      27,000.00	$         13,500.00
3	$ 41,000.00	$      27,000.00	$         14,000.00
			$         41,000.00

Accounting Income = Cash flows - Depreciation
Average Accounting income = $41000 / 3 = $13667
Accounting rate of return = $13667 / $81000 x 100 = 16.87%

Proposal Z
Accounting income = $81000 - $81000 = 0
Depreciation = $81000 / 1 = $81000
Accounting Rate of return = 0 / 81000 x 100 = 0%

Net Present Value = Cash flows x PV factor for year - Investment
Proposal X

Year	Cash Flows	PV Factor	Accounting Income
1	$ 80,000.00	0.8772	$                      70,175
2	$     1,000.00	0.7695	$                            769
3	$ 41,000.00	0.6750	$                      27,674
			$                      98,619
	Investment		$ 81,000
	NPV		$                      17,619

Proposal Y

Year	Cash Flows	PV Factor	Accounting Income
1	$ 40,500.00	0.8772	$                      35,526
2	$ 40,500.00	0.7695	$                      31,163
3	$ 41,000.00	0.6750	$                      27,674
			$                      94,364
	Investment		$                      81,000
	NPV		$                      13,364

Proposal Z
NPV = $81000 x 0.8772 - $81000 = ($9947)

	Proposal X	Proposal Y	Proposal Z	Best proposal
Payback period (years)	2	2	1	Z
Accounting rate of return	16.87%	16.87%	0.00%	X&Y
Net present value	$   17,619	$                13,364	$      (9,947)	X

Project with least payback period is Best proposal.
Accounting rate of return for Proposal X & Y is same and highest, therefore both are best
Net present value for Proposal X is highest, so Proposal X is best.

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