Question

QUESTION TWO                                                                                                                               [20]

Onta Enterprises is seeking to expand operations and is considering increasing production capacity by purchasing the latest plant and equipment. The following two plants are being considered for acquisition as they are technically superior to the current plant and will enable higher production volumes with lower cost inputs. The finance department has projected the cash flows for the life of the plant and has asked you as the investment manager to advise the Board on which of these plants to acquire. Onta’s current cost of capital is 12%.

The following information relates to the two plants that are being considered:

	Plant Alpha	Plant Beta
Initial cost	R550 000	R 400 000
Expected useful life	4 years	4 years
Depreciation	R137 500 p.a.	R100 000 p.a.
	Net cash inflows	Net cash inflows	Net profit
Expected net cash inflows	R	R	R
1st year 2nd year 3rd year 4th year	180 000 190 000 210 000 160 000	130 000 130 000 130 000 130 000	30 000 30 000 30 000 30 000

Calculate the:

2.1       Payback Period for both plants. (Answers must be expressed in years, months and days.)                                                                                                                                                       (6)

2.2       Accounting Rate of Return for Plant Beta on initial investment.                                             (4)

2.3       Net Present Value of each plant. (Round off amounts to the nearest Rand.)             (9)

2.4       Based on your results in 2.1.3 which plant should be accepted?                                           (1)

Answer 1

Answer . 2.1) Calculation of Payback Period

Payback Period of Plant Alpha

Below is the table showing cumulative cash Flows

Year	Cash Inflows	Cumulative Cash Inflows
1	180,000	180,000
2	190,000	370,000
3	210,000	580,000
4	160,000	740,000

Payback Period = Complete Years + Remaining Cash flow / Cashflow for the year to be recovered

= 2 years +(550000 - 370000) / 210000

= 2.85714285714 years or 2 years 10 months 29 days (approx)

Calculation of Payback Period of Plant Beta :

When calculating the Pay-back period of the project with equal cash flows :-

Payback Period = Initial Cash flow / Annual Cash flows

= 400,000 / 130,000

= 3.07692307692 years or 3 years 0 months 28 days

2.2 Calculation of Accounting Rate of Return (ARR)

Accounting Rate of Return = Average Net Income / Initial Investment

Net Income = Cash Flows - Depreciation

Calculation of ARR of Plant Alpha

Year	Cash Flows( given in Q)	Depreciation (Non-Cash item)	Profit = Cash Flows - Dep
1	180000	137500	42500
2	190000	137500	52500
3	210000	137500	72500
4	160000	137500	22500
		Total	190000

Average Net Income = 190000 / 4 = 47500

Accounting Rate of Return = 47500 / 550000 = 8.64%

Calculation of ARR of Project Beta

Accounting Rate of Return = Average Net Income / Initial Investment

ARR = 30000 / 400000

= 7.5%

2.3 Calculation of Net Present Value

Net Present Value = Present Value of Cash Inflow - Present Value of Cash Outflow

Net Present Value of Project Alpha :

Year	Cash Inflow	Present Value Factor @ 12%	Present value of cash inflow
1	180000	0.892857143	160714.2857
2	190000	0.797193878	151466.8367
3	210000	0.711780248	149473.852
4	160000	0.635518078	101682.8925
		Total Present value of cash inflow	563337.867
		Less : Cash outflow	550000
		Net Present Value	13337.8670

Calculation of Net Present Value of Project Beta

Year	Cash Inflow	Present Value Factor @ 12%	Present value of cash inflow
1	130000	0.892857143	116071.4286
2	130000	0.797193878	103635.2041
3	130000	0.711780248	92531.43222
4	130000	0.635518078	82617.35019
		Total Present value of cash inflow	394855.4151
		Less : Cash outflow	400000
		Net Present Value	-5144.5849

2.4) Based on the results calculated above we will accept Project Alpha as it has lower payback Period, Higher   Accounting Rate of Return and Highest NPV.