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	$ 100,000	$ 100,000	$ 100,000
Cash flow from operations
Year 1	60,000	25,000	110,000
Year 2	40,000	40,000
Year 3	35,000	70,000
Disinvestment	0	0	0
Life (years)	3 years	3 years	1 year

Rank these investment proposals 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% and that all investments are in depreciable assets.

Note: Follow rounding instructions noted for each computation. Use a negative sign with your answers, when appropriate.

	Proposal A	Proposal B	Proposal C	Best proposal
Payback period (years); Round answers 2 decimal places.	Answer	Answer	Answer	AnswerABCA,BA,CB,C
Accounting rate of return; Round answers to 4 decimal places.	Answer	Answer	Answer	AnswerABCA,BA,CB,C
Net present value; Round answers to nearest whole number.	Answer	Answer	Answer	AnswerABCA,BA,CB,C

Answer 1

Solution:

	Proposal A	Proposal B	Proposal C	Best Proposal
Payback Period (Years)	2	2.5	0.91	Proposal C
Accounting Rate of Return	11.67%	11.67%	76.67%	Proposal C
Net Present Value	$10,371	$4,034	($1,786)	Proposal A

Part 1 – Payback Period

It is the length of time within which original investment amount in project returned back to the firm

In case of different annual cash flow, we need to first calculate cumulative cash flows.

Year	Proposal A	Proposal B	Proposal C
	Cash Flow	Cumulative Cash Flow	Cash Flow	Cumulative Cash Flow	Cash Flow	Cumulative Cash Flow
1	$60,000	$60,000	$25,000	$25,000	$110,000	$110,000
2	$40,000	$100,000	$40,000	$65,000
3	$35,000	$135,000	$70,000	$135,000

Proposal A

Payback Period = 2 Years

Explanation – Initial Cash required $100,000 and the same is recovered in year 2. SO the payback period is 2 Years.

Proposal B

Payback Period = 2 Years + ($100,000 – 65,000) / 70,000

= 2 Years + 0.50 Years

= 2.5 Years

Proposal C

Payback Period = 100,000 / 110,000

= 0.91 Years

Part 2 – Accounting Rate of Return

	Cash Flow
Year	Proposal A	Proposal B	Proposal C
1	$60,000	$25,000	$110,000
2	$40,000	$40,000
3	$35,000	$70,000
Total Cash Flow	$135,000	$135,000	$110,000
Divide by: Life of Proposal	3	3	1
Average Annual Cash Flow	$45,000	$45,000	$110,000
Less: Annual Depreciation (Initial Investment / Life)	$33,333	$33,333	$33,333
Net Income	$11,667	$11,667	$76,667
Accounting Rate of Return
Average Annual Net Income	$11,667	$11,667	$76,667
Divide by: Initial Investment	$100,000	$100,000	$100,000
Accounting Rate of Return	11.67%	11.67%	76.67%

Part 3 – Net Present Value

		Proposal A	Proposal B	Proposal C
Year	PVIF @ 12%	Cash Flow	Present Value of Cash Flow	Cash Flow	Present Value of Cash Flow	Cash Flow	Present Value of Cash Flow
0	1.000	($100,000)	($100,000)	($100,000)	($100,000)	($100,000)	($100,000)
1	0.893	$60,000	$53,571	$25,000	$22,321	$110,000	$98,214
2	0.797	$40,000	$31,888	$40,000	$31,888		$0
3	0.712	$35,000	$24,912	$70,000	$49,825		$0
Net Present Value		$10,371		$4,034		($1,786)

Hope the above calculations, working and explanations are clear to you and help you to understand the concept of question.... please rate my answer...in case any doubt, post a comment and I will try to resolve the doubt ASAP…thank you