Question

The Directors of Lolipop Ltd are currently considering two mutually exclusive investment projects. Both projects are concerned with the purchase of new plant. The following data are available for each project

Project A Project B

$'m

Cost( immediate outlay ) 100 60

Expected annual net profit (loss)

Year 1 29 18

Year 2 (1) (2)

Year 3 2 4

Estimated residual value of the plant 7 6

The minimum expected return by the shareholders is 10%. the Industrial average cost of capital is 12%. The company uses the straight line method of depreciation for all non-current (fixed )assets when calculating profit. Neither project would increase the working capital of the business. The business has sufficient funds to meet all capital expenditure requirements . The company expects to pay a total constant dividend of $ million per year for the next three ( 3) years.

Required

a) Calculate for each project

1. Accounting Rate of Return

2. The PayBack period

3. The NPV

4. The approximate IRR

Advise the directors which project should be undertaken

b) State which method of investment appraisal in (a) above you consider to b e most appropriate for calculating investment projects and why

c) Explain three (3) factors that may affect the dividend policy of Lolipop Ltd

Answer 1

	Project A	Project B
Cost	-100	-60
Profit
Year 1	29	18
Year 2	-1	-2
Year 3	2	4
Residual Value	7	6

Answer- 1

Accounting Rate of Return = Average Annual Profit/ Average Investment

(Here; Average Annual Profit = Total Profit during the economic life of project/ Economic Life of the Project

Average Investment = (Intial Investment + Salvage value)/2

	Project A	Project B
Average Annual Profit	29 + (-1) + 2 / 3 = 10	18 + (-2) + 4 / 3 = 6.67
Average Investment	(100 + 7)/2 = 53.5	(60 + 6)/2 = 33
Accounting rate of return	10/53.5 = 18.69%	6.67/33 = 20.21

Answer-2 Pay-Back Period

Before calculating the pay-back period, you need to convert the Net Profit to Profit after tax but before depreciation. So we will add the annual depreciation of project to its annual net profit to get cash inflows as follow:

Depreciation using SLM = (Intial Investment - Salvage value)/ life Span of Project

Annual Depreciation for Project A= ( 100 - 7)/3 = 31

Annual Depreciation for Project B = (60 - 6)/3 = 18

	Project A				Project B
Year	Net Profit	Depreciation	Annual Cash Flow	Cumulative Cash Flow	Net Profit	Depreciation	Annual Cash Flow	Cumulative Cash Flow
1	29	31	60	60	18	18	36	36
2	-1	31	30	90	-2	18	16	52
3	2	31	33	123	4	18	22	74

Pay Back Period for Project A shall lie between 2 to 3 years as clear from cumulative cash flow. Upto 2 years $90 would be recovered and rest $10 of total investment in year 3. So Payback period for project A:

= 2 years + (100 - 90)/33 = 2.30 years

Pay Back period of project lie between 2-3 years as clear from cumulative cash flows of project. Upto 2 years, $52 will be recovered out of total ivestment of $60 and rest $8 in third year. So payback period for project B:

= 2 years + (60-52)/22 = 2.36 years.

Answer- 3 NPV of Project  

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

(Here: Cash Inflows means Profit after tax but before depreciation)

To evaluate the projects we will use minimum expected rate of return (10%) to discount annual cash flow because minimum rate of return depicts the minimum return expected by the investors from project for investing their funds;

	Project A			Project B
Year	Annual Cash Flow (I)	Discount factor @10% (II)	Present Value (I * II)	Annual Cash Flows (I)	Discount Factor @ 10% (II)	Present value (I * II)
1	60	0.90909	54.55	36	0.90909	32.73
2	30	0.82645	24.79	16	0.82645	13.22
3	33	0.75131	24.79	22	0.75131	16.53
Residual Value	7	0.75131	5.26	6	0.75131	4.51
			109.39			66.99

NPV of Project A = 109.39 - 100 = $9.39

NPV of Project B = 66.99 - 60 = $6.99

Answer- 4:

Internal Rate of Return = Present value of cash inflows = Present Value of Cash Outflows

use the excel to calculate IRR by IRR Function with following cash flow pattern;

Year	Project A	Project B
0	-100	-60
1	60	36
2	30	16
3	40	28

(Note: in 3rd year cash flow, salvage value is added to annual cash flows)

IRR for Project A= 15.76%

IRR for Project B= 16.93%