Question

Welsh Industries is evaluating two alternative investment opportunities. The controller of the company has prepared the following analysis of the two investment proposals.

  

	Proposal A		Proposal B
Required investment in equipment	$	400,000	$	576,000
Estimated service life of equipment		5 years		6 years
Estimated salvage value	$	80,000	$	0
Estimated annual cost savings (net cash flow)		100,000		192,000
Depreciation on equipment (straight-line basis)		64,000		96,000
Estimated increase in annual net income		36,000		57,600

Required:
a. For each proposed investment, compute the following. Assume discounted at an annual rate of 10 percent. Use Exhibits 26-3 and26-4 where necessary.

(1) Payback period
(2) Return on average investment
(3) Net present value

b. Based on your computations in part a, which proposal do you consider to be the better investment?

Answer 1

Answer a
Answer 1
Calculation of payback period
Payback period of Proposal A				Payback period of Proposal B
Year	Cash flows	Cumulative Cash flow		Year	Cash flows	Cumulative Cash flow
0	-$400,000.00	-$400,000.00		0	-$576,000.00	-$576,000.00
1	$100,000.00	-$300,000.00		1	$192,000.00	-$384,000.00
2	$100,000.00	-$200,000.00		2	$192,000.00	-$192,000.00
3	$100,000.00	-$100,000.00		3	$192,000.00	$0.00
4	$100,000.00	$0.00		4	$192,000.00	$192,000.00
5	$180,000.00	$180,000.00		5	$192,000.00
Payback period of Proposal A= 4 years				6	$192,000.00
				Payback period of Proposal B= 3 years
Answer 2
Return on average investment = Increase in net Income / Investment
Return on average investment for Proposal A= $36000 / $400000 = 9%
Return on average investment for Proposal B= $57600 / $576000 = 10%
Answer 3
Calculation of net present value
Year	Discount factor @ 10%	Proposal A		Proposal B
A	B	C	B*C	D	B*D
		Cash Flow	Present Value	Cash Flow	Present Value
0	1.00000	-$400,000.00	-$400,000.00	-$576,000.00	-$576,000.00
1	0.90909	$100,000.00	$90,909.09	$192,000.00	$174,545.45
2	0.82645	$100,000.00	$82,644.63	$192,000.00	$158,677.69
3	0.75131	$100,000.00	$75,131.48	$192,000.00	$144,252.44
4	0.68301	$100,000.00	$68,301.35	$192,000.00	$131,138.58
5	0.62092	$180,000.00	$111,765.84	$192,000.00	$119,216.89
6	0.56447			$192,000.00	$108,378.99
Net Present Value			$28,752.38		$260,210.05
Answer b
Proposal B is a better investment as it has shorter payback period,higher return on average investment
and high NPV compared to Proposal A.