Question

Ranking Investment Proposals: Payback Period, Accounting Rate of Return, and Net Present Value Presented is information pertaining to the cash flows of three mutually exclusive investment proposals: Proposal A Proposal B Proposal C Initial investment $ 60,000 $ 60,000 $ 60,000 Cash flow from operations Year 1 50,000 30,000 60,000 Year 2 6,000 30,000 Year 3 29,000 25,000 Disinvestment 0 0 0 Life (years) 3 years 3 years 1 year (a) Select the best investment proposal using the payback period, the accounting rate of return on initial investment, and the net present value criteria. Assume that the organization's cost of capital is 12 percent. Round payback period (years) to two decimal places. Round accounting rate of return to four decimal places. Round net present value to the nearest whole number. Use negative signs with your answers, when appropriate. Proposal A Proposal B Proposal C Best proposal Payback period (years); Round answers 2 decimal places. Answer 2.14 Answer 2 Answer 1 Answer Accounting rate of return; Round answers to 4 decimal places. Answer 94.4443 Answer 94.4443 Answer 0 Answer Net present value; Round answers to nearest whole number. $Answer 10,080 $Answer 8,500 $Answer (6,420) Answer (b) Factors explaining the differences in rankings include all of the following except: The accounting rate of return considers profitability while payback only considers the time required to recover the investment. While the accounting rate of return explicitly considers the cost of the asset as part of annual depreciation the net present value method considers the cost of the asset as part of the initial investment. Net present value considers the timing of cash flows while payback considers only total cash flows. The net present value method considers the cost of capital while the payback method does not discount future cash flows.

Answer 1

Accounting rate of return

Proposal A

Annual Depreciation = 60000/3 = 20000

Net Income in year 1 = 50000-20000 = 30000

Net Income in year 2 = 6000 - 20000 = -14000

Net Income in year 3 = 29000-20000 = 9000

Average Annual Net Income = (30000 - 14000 + 9000)/3

= 8333

Accounting rate of return = Average Annual Net Income/Initial Investment

Accounting rate of return = 8333 / 60000

Accounting rate of return = 13.89%

Proposal B

Annual Depreciation = 60000/3 = 20000

Net Income in year 1 = 30000-20000 = 10000

Net Income in year 2 = 30000 - 20000 = 10000

Net Income in year 3 = 25000-20000 = 5000

Average Annual Net Income = (10000 + 10000 + 5000)/3

= 8333

Accounting rate of return = Average Annual Net Income/Initial Investment

Accounting rate of return = 8333 / 60000

Accounting rate of return = 13.89%

Proposal C

Annual Depreciation = 60000= 60000

Net Income in year 1 = 60000-60000 = 0

Accounting rate of return = Average Annual Net Income/Initial Investment

Accounting rate of return = 0 / 60000

Accounting rate of return = 0%

BEST PROPOSAL = A,B

NPV = Present value of cash inflow - PV of cash outflow

PROPOSAL A

0 1 2 3

Initial Investment -60000

Cash flow 50000 6000 29000

Total cash flow -60000 50000 6000 29000

PVF (12%) 1 0.892857 0.797194 0.71178

PV of cash flow -60000 44642.86 4783.163 20641.63

NPV 10068

PROPOSAL B

0 1 2 3

Initial Investment -60000

Cash flow 30000 30000 25000

Total cash flow -60000 30000 30000 25000

PVF (12%) 1 0.892857 0.797194 0.71178

PV of cash flow -60000 26785.71 23915.82 17794.51

NPV 8496

PROPOSAL C

0 1 2 3

Initial Investment -60000

Cash flow 60000 0 0

Total cash flow -60000 60000 0 0

PVF (12%) 1 0.892857 0.797194 0.71178

PV of cash flow -60000 53571.43 0 0

NPV -6428