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 less 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

Correct Answer:

	Project 1	Project 2
ARR	33%	25%
NPV ( '000)	142	210
IRR	25	20%
Payback period (yrs.)	2.8	3.2

Working:

ARR project 2:

Cash flows	$ 500,000.00
Less: Depreciation	$ 263,000.00
Accounting profits	$ 237,000.00

Annual depreciation = (cost of project - Scrap value)/5
( 1616000-301000 ) / 5	=	$ 263,000.00

Average NBV of investments
( $ 1,616,000 + 301,000 )/2	=	$ 958,500.00
ARR( Accounting profits / Average NBV of investment)	=	25%

NPV Project 1:

		Present value of Annuity factor @ 15%
Cash outflow	$ (556,000.00)	1	$ (556,000.00)
Cash inflow	$    200,000.00	3.35216	$    670,431.02
Scrap value	$      56,000.00	0.49718	$      27,841.90
NPV project 1			$    142,272.92

Present value of annuity table	years	PV = 1/1.15^year
	1	0.86957
	2	0.75614
	3	0.65752
	4	0.57175
PV$1 @15%	5	0.49718
PV of Annuity @15%	Total	3.35216

Project 2 IRR = R1 + ( NPV1/(Npv1-NPV2) * (R2-R1)

		Present value of Annuity factor @ 15%		Present value of Annuity factor @ 25%
Cash outflow	$ (1,616,000.00)	1	$ (1,616,000.00)	1	$ (1,616,000.00)
Cash inflow	$ 500,000.00	3.35216	$ 1,676,077.55	2.68928	$ 1,344,640.00
Scrap value	$ 301,000.00	0.49718	$ 149,650.20	0.32768	$ 98,631.68
					-
NPV project 2		NPV1 =	$ 209,727.75	NPV2 =	$ (172,728.32)

R1	15%
R2	25%
(R2-R1)	10%
NPV1	$                209,727.75
NPV2	$              (172,728.32)
NPV1-NPV2	$                382,456.07
NPV1/(NPV1-NPV2)	0.548370819
NPV1/(NPV1-NPV2) * (R2-R1)	0.054837082
IRR Project 2	20%

Payback period project 2: cost of project / annual cash inflows

		Project 1
A	initial investment	$ 556,000.00
B	cash inflows	$ 200,000.00
C = A/B	Payback period	2.8 Years

End of answer.

Thanks.