Question

Gumbi Traders are looking to invest in new machinery in view of their expanding operations.

The following information has been extracted from the reports relating to the project:

Investment R1 000 000

Average annual profit R342 500

Life span 4 years

Minimum required rate of return 12%

Net Cash flows:

1 st year R200 000

2 nd year R350 000

3 rd year R400 000

4 th year R420 000

Required:

3.1 Calculate the accounting rate of return (Express the answer to two decimal places). (4)

3.2 Calculate the payback period (answer in years, months and days). (4)

3.3 Calculate the net present value. (Round off amounts to the nearest Rand). (6)

3.4 Would the project be acceptable at a cost of capital of 10%? Motivate your answer with an appropriate calculation.

Answer 1

Answer : Calculation of Accounting Rate of return :

Accounting Rate of Return = Average Annual Profit / Investment

= 342500 / 1,000,000

= 34.25%

(b.) Calculation of Payback Period :

Below is the table showing Cash Flows and Cumulative Cash Flows

Year	Cash Flows	Cumulative Cash Flows
1	200,0000	200,000
2	350,000	550,000
3	400,000	950,000
4	420,000	1,370,000

Payback Period = Complete Year + (Initial Investment - Cash Flow recovered ) / Cash Flow of the year to be recovered from

= 3 + (1,000,000 - 950,000) / 420000

= 3 years 1 months and 13 days

(c.) Below is the table showing calculation of Net Present Value at Minimum acceptable Rate of return:

Year	Cash Inflow	Present Value Factor @12%	Present value of cash inflow
1	200000	0.892857143	178571.4286
2	350000	0.797193878	279017.8571
3	400000	0.711780248	284712.0991
4	420000	0.635518078	266917.5929
		Total Present value of cash inflow	1009218.978
		Less : Cash outflow	1000000
		Net Present Value	9218.98 or 9219

3.4) To decide whther the project will be acceptable at 10% or not calculate Net Present Value at 10%:

Year	Cash Inflow	Present Value Factor @10%	Present value of cash inflow
1	200000	0.909090909	181818.1818
2	350000	0.826446281	289256.1983
3	400000	0.751314801	300525.9204
4	420000	0.683013455	286865.6513
		Total Present value of cash inflow	1058465.952
		Less : Cash outflow	1000000
		Net Present Value	58465.95 or 58466

Since Net Present Value is positive when cost of capital is 10%, therefore project will be acceptable.