Question

Presented is information pertaining to the cash flows of three mutually exclusive investment proposals: Proposal X Proposal Y Proposal Z Initial investment $52,000 $52,000 $52,000 Cash flow from operations Year 1 50,000 26,000 52,000 Year 2 2,000 26,000 Year 3 27,000 27,000 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 10 percent. Round accounting rate of return four decimal places. Round net present value to the nearest whole number. Use negative signs with your answers, when appropriate. Proposal X Proposal Y Proposal Z Best proposal Payback period (years) Answer 2 Answer 2 Answer 1 Answer Accounting rate of return Answer 0.173 Answer 0.5065 Answer 0.1 Answer Net present value Answer 15,393 Answer 13,409 Answer (4,732) Answer (b) Factors explaining the differences in rankings include all of the following except: The net present value method considers the cost of capital while the payback method does not discount future cash flows. Net present value considers the timing of cash flows while payback considers only total cash flows. 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. The accounting rate of return considers profitability while payback only considers the time required to recover the investment. Mark 1.00 out of 1.00

Answer 1

A) Payback period - In this method , proposals are ranked on the basis of the time they require to cover their cost.Proposal with minimum time will be considered the best project.

Particulars	Proposal X		Proposal Y		proposal Z
	cash flow	cumulative cash flow	cash flow	cumulative cash flow	cash flow	cumulative cash flow
Year 1	50000	50000	26000	26000	52000	52000
year 2	2000	52000	26000	52000	0	52000
year 3	27000	79000	27000	79000	0	52000

initial cost of all the proposals are 52000 which is covered in following period:-

Proposal x = 2 years

Proposal y = 2 years

Proposal z = 1 years

Hence on the basis of payback period Z is first while X & Y are on second number

B) Accounting rate of return method:-

In this method, Average rate of return is calculated and on that basis ranking is given.

average rate of return = Average revenue / initial investment

calculation of average revenue

= total revenue in three years ( i. e. cumulative cash flows) / no of years

Proposal x = 79000/3 = 26333.33

Proposal y = 79000/3 = 26333.33

Proposal z = 52000/1 = 52000

calculation of average rate of return

Proposal x = 26333.33/52000 = 50.64%

Proposal y = 26333.33/52000 = 50.64%

Proposal z = 52000/52000 = 100%

Again proposal z is ranked 1st while proposal x and y are on 2nd place.

C) Net present value method

in this method, Present value of future cashflows is calculated and then difference between present value and initial investment is calculated , which is called net present value.

Particulars		Proposal X		Proposal Y		proposal Z
	Present value factor @ 10%	cash flow	present value	cash flow	present value	cash flow	present value
Year 1	0.9090	50000	45450	26000	23634	52000	47268
year 2	0.8264	2000	1652.8	26000	21486.4	0	0
year 3	0.7513	27000	20285.1	27000	20285.1	0	0
	TOTAL		67387.9		65405.5		47268
	Less - initial invest		(52000)		(52000)		(52000)
	NPV		15387.9		13405.5		-4732
	RANK		1st		2nd		3rd

B) Factors explaining the differences in rankings include all of the following except

ANSWER - Net present value considers the timing of cash flows while payback considers only total cash flows.