Question

Presented is information pertaining to the cash flows of three mutually exclusive investment proposals:

Proposal A                     Proposal B             Proposal C

Initial investment…………………………….................$60,000                           $60,000                  $60,000

Cash flow from operations

Year 1………………………………...............................50,000                               30,000                     60,000

Year 2………………………………................................6,000                                30,000          

Year 3………………………………...............................29,000                               25,000          

Disinvestment………………………………......................0                                       0                               0

Life (years)………………………………….....................3 years                              3 years                       1 year

Required

1. Rank these investment proposals using the payback period, the accounting rate of return on initial investment, and the present value criteria. Assume that the organization’s cost of capital is 12 percent. Round calculations to four decimal places.
2. Explain the difference in rankings. Which investment would you recommend?

Answer 1

A)

Ranking on basis of Payback Period:

It is clear that in Proposal C the Investment gets returned in 1st year itself, while in Proposal B it is happening in 2nd year and in case of Proposal A in 3rd year so Ranking would be as below

1st Rank - Proposal C

2nd Rank - Proposal B

3rd Rank - Proposal A

Ranking on basis of Accounting Rate of Return:

The total outcome from Proposal C is same as Initial Investment while in case of Proposal A and B the total outcome is $85,000 which is $25,000 more then the initial Investment and hence ranking would be as below

1st Rank - Proposal A and B

2nd Rank - Proposal C

Ranking on basis of Present Value

		proposal A		proposal B		proposal C
Year	Factoring @ 12%	Cash Flow	Present Value	Cash Flow	Present Value	Cash Flow	Present Value
1	0.8929	50000	44645	30000	26787	60000	53574
2	0.7972	6000	4783.2	30000	23916
3	0.7118	29000	20642.2	25000	17795
Present Value			70070.4		68498		53574
Net Present Value			10070.4		8498		-6426
Ranks			1		2		3

B)

The difference in ranking is due to the method followed the Payback period considers the time under which Initial Investment can be recovered while Accounting return considers the Income earned and Net present value takes into consideration present value of money. The suggested method would be Net present value method as it takes into consideration.