Question

QUESTION TWO [30]

The following 2 mutually exclusive projects (Project A and Project B) are available to Simonsbosch Farm. They are producers of Rooi Bos tea. The initial cash outlay and cash flows are shown below and Simonsbosch will use straight line depreciation over each of the assets 4 year life and there will be no residual value on either investment.

Years	Cash Flows (A)	Cash Flows (B)
0 (Investment)	-240 000	-90 000
1	28 000	40 000
2	38 000	40 000
3	100 000	30 000
4	200 000	7 000

Additional information:

a. The company requires a minimum accounting rate of return of 25% on all its investments.

b. It rigidly applies a payback period of no more than 3.5 years.

c. Their after tax cost of capital is 12%. d. Applicable tax rate is 30%.

Required:

2.1. Which project is more lucrative if the payback rule is applied? (5)

2.2. Apply the Accounting Rate of Return (ARR) test. Which project is more viable? (8)

2.3. Determine which project is more lucrative if the NPV rule is applied. (13)

2.4. Which of the above projects will you recommend to Simonsbosch. Explain in details your choice of answer (by critically assessing each of the above calculations that you have made.)

Answer 1

ARR = average net profit / average investment

net profit each year = cash flow / depreciation

Project A is more viable with the ARR test. However, neither project has the minimum ARR of 25%.

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = last in year in which cumulative cash flow is negative + (cash flow required in next year for cumulative cash flow to equal zero / next year cash flow)

If the payback rule is applied, both projects have a payback period lower than the maximum payback period. However, Project B has a lower payback period than Project A, and is therefore more lucrative.

NPV is calculated using NPV function in Excel

Project A has the higher NPV and is more lucrative.

It is recommended to accept Project A because it has the higher NPV. A project with higher NPV creates more value for investors. Payback period and ARR methods are not recommended because they do not consider the time value of money.