Question

Hightex Ltd is currently considering whether it should invest in Project Y.  The following data have been collected in connection with the project:

Project Y

1. An initial investment of £120 million will be required on 1 January 2009. The project has a three year life with a nil residual value.  Depreciation is to be calculated on a straight line basis.

2. The revenues and costs expected as a result of proceeding with Project Y are as follows:
   
   

Year	Revenue	Cost
2009	£110 million	£45 million
2010	£70 million	£35 million
2011	£95 million	£48 million

Assume that all cash flows other than the initial investment take place at the end of each year.  Ignore taxation in your calculations.

A discount factor of 8% is to be used to evaluate Project Y.

Requirement

1. Calculate the accounting rate of return (ARR), payback and net present value (NPV) for Project Y.
   
   

2. Should Hightex Ltd invest in Project Y?  State clearly your reasons.
   
   
   

3. Outline the advantages and disadvantages of each of the methods calculated in part (a) and suggest other factors that should be taken into account before making a final decision.
   
   

   
   

Answer 1

a.

Initial investment = £ 120,000,000

Cash flow year 1 = £ 110,000,000 - £ 45,000,000 = £ 65,000,000

Cash flow year 2 = £ 70,000,000 - £ 35,000,000 = £ 35,000,000

Cash flow year 3 = £ 95,000,000 - £ 48,000,000 = £ 47,000,000

Accounting rate of return = Average accounting profit/Initial investment

= [(£ 65,000,000 + £ 35,000,000 + £ 47,000,000)/3]/ £ 120,000,000

= [(£ 147,000,000)/3]/ £ 120,000,000

= £ 49,000,000 / £ 120,000,000

= 0.40833333 or 40.83 %

Computation of Payback period:

Project Y
Year	Cash Flow	'Cum Cash Flow
0	£                        (120,000,000)	£                     (120,000,000)
1	£                             65,000,000	£                       (55,000,000)
2	£                             35,000,000	£                       (20,000,000)
3	£                             47,000,000	£                         27,000,000

Payback Period = A +B/C

Where,

A= Last period with a negative cumulative cash flow = 2

B = Absolute value of a cumulative cash flow at the end of the period A = £ 20,000,000

C = Total cash flow during the period after A = £ 47,000,000

Payback Period = 2+?£ (20,000,000) ?/ £ 47,000,000

                           = 2 + £ 20,000,000/ £ 47,000,000

                           = 2 + 0.425532 = 2.43 years

      Computation of NPV:                    

Project Y
Year	Cash Flow(C)	PV Factor calculation	PV Factor(F)	PV( C x F)
0	£                        (120,000,000)	1/(1+0.08)^0	1	£ (120,000,000.00)
1	£                             65,000,000	1/(1+0.08)^1	0.925925926	£     60,185,185.19
2	£                             35,000,000	1/(1+0.08)^2	0.85733882	£     30,006,858.71
3	£                             47,000,000	1/(1+0.08)^3	0.793832241	£     37,310,115.33
			NPV	£        7,502,159.22

b.

Project Y should be accepted based on accounting rate of return, payback period and NPV, as accounting rate of return is higher than discount rate, payback period is less than project’s life and NPV is positive at the discount rate of 8 %.

c.

Accounting rate of return is useful in quick calculation of profitability of an investment. But it does not consider time value of money. The value of cash return during later years of investment is not equal worth as that of starting years of investment.

Payback period is used to compute time period required for an investment to recover its initial cost. This method also ignores time value of money.

Net present value method measures the profit or loss of an investment considering all negative and positive cash flows discounted at a given rate. The major drawback of NPV is it is entirely dependable on discount rate. Slight change in discount rate can alter the result of NPV. Also NPV relies on other two assumptions such as investment cost and projected return which may change during the course of project.

Other factors like Discount payback period, IRR, MIRR should be considered before making the final decision.