Question

Problem 2 - Gavin and Alex, baseball consultants, are in need of a microcomputer network for their staff. They have received three proposals, with related facts as follows:

	Proposal A	Proposal B	Proposal C
Initial investment in equipment	$90,000	$90,000	$90,000
Annual cash increase in operations:
Year 1	80,000	45,000	90,000
Year 2	10,000	45,000	0
Year 3	45,000	45,000	0
Salvage value	0	0	0
Estimated life	3 yrs	3 yrs	1 yr

The company uses straight-line depreciation for all capital assets.

Question 1: Compute the payback period, net present value, and accrual accounting rate of return with initial investment, for each proposal. Use a required rate of return of 14%.

Question 2: Rank each proposal 1, 2, and 3 using each method separately. Which proposal is best? Why?

Answer 1

Answer to Q. 1: Computation of Payback period, Net Present Value (NPV), and Accrual Accounting rate of return (IRR) are as below:

Notes: 1) Payback period is period where cumulative cash inflows equals to cash outflow. For project A, cumulative cash flows equals to cash outflow at the end of 2nd year, same happens for project B, but for project C, payback period is just one year as company receives cash inflows equal to cash outflows at the end of 1st year itself.

2) Net present value (NPV) is total of discounted cash flows at the required rate of return of the company.

3) Accrual accounting rate of return is rate where discounted cash inflows equals to cash outflows. In other words, at this rate, NPV becomes Zero. This can be calculated using trial & error method.

Answer to Q. 2:

Conclusion: Proposal A is best as NPV and IRR is max for this proposal.