Question

For the following exercise, complete the calculations below. Evaluate different capital investment appraisal techniques by completing the calculations shown below:

Bongo Ltd. is considering the selection of one of two mutually exclusive projects. Both would involve purchasing machinery with an estimated useful life of 5 years.

Project 1 would generate annual cash flows (receipts fewer payments) of £200,000; the machinery would cost £556,000 with a scrap value of £56,000.

Project 2 would generate cash flows of £500,000 per annum; the machinery would cost £1,616,000 with a scrap value of £301,000.

Bongo uses straight-line depreciation. Its cost of capital is 15% per annum.

Assume that all cash flows arise on the anniversaries of the initial outlay, that there are no price changes over the project lives, and that accepting either project will have no impact on working capital requirements.

Assess the choice using the following methods by completing the calculations shown below:

ARR

NPV

IRR

Payback period

Calculate the missing answers:

	Project 1	Project 2
ARR (see workings)	33%	???
NPV (£'000)	???	210
IRR	25%	???
Payback Period (yrs)	???	3.2

ARR workings (Project 1)

Cash flows	200
Less: depreciation (see below)	100
Accounting profits	100

These profits are the same each year in this question.

Annual depreciation (Cost - SV) / 5

(556,000 - 56,000) / 5

100

Average NBV of investments

(556 + 56) /2	306
ARR	33%

Be sure to demonstrate your workings.

Answer 1

	Project 1	Project 2
ARR	33 %	25 %
NPV	142,274	209,731
IRR	25 %	20 %
Payback period	2.78 years	3.23 years

Workings :

Project 1 :

Annual depreciation = (556,000 - 56,000) / 5 = 100,000

Average net book value of asset = ( 556,000 + 56,000 ) / 2 = 306,000.

Annual income = 200,000 - 100,000 = 100,000

ARR = 100,000 / 306,000 = 0.3268

NPV = Annual Cash Flows x PVA 15%, n=5  + Scrap Value x PV 15 %, n=5  - Initial Investment = 200,000 x 3.35216 + 56,000 x 0.49718 - 556,000 = 670,432 + 27,842 - 556,000 = 142,274

Payback period = 556,000 / 200,000 = 2.78 years

Setting the PVA factor at 2.78, IRR works out to be 25 %

Project 2 :

Annual depreciation = (1,616,000 - 301,000) / 5 = 263,000

Average NBV of asset = ( 1,616,000 + 301,000 ) / 2 = 958,500

Net income = 500,000 - 263,000 = 237,000

ARR = 237,000 / 958,500 = 24.73 %

NPV = 500,000 x 3.35216 + 301,000 x 0.49718 - 1,616,000 = 1,676,080 + 149,651 - 1,616,000 = 209,731

Payback period = 1,616,000 / 500,000 = 3.23 years