Question

In: Accounting

A company is considering a capital investment proposal where two alternatives involving differing degrees of mechanisation,...

A company is considering a capital investment proposal where two alternatives involving differing degrees of mechanisation, are being considered. Both investments would have a five-year life. In Option 1 new machinery would cost £278,000, and in Option 2 £805,000. Anticipated scrap values after 5 years are £28,000 and £150,000 respectively. Depreciation is provided on a straight line basis. Option 1 would generate annual cash inflows of £100,000, and Option 2, £250,000. The cost of capital is 15%. Required:

Calculate for each option:

(i) the payback period

(ii) the accounting rate of return, based on average book value

(iii) the net present value

(iv) the internal rate of return.

Solutions

Expert Solution

Answer to Requirement 1.

Option 1:

Payback Period = Initial Investment / Annual Cash Inflow
Payback Period = 278,000 / 100,000
Payback Period = 2.78 years

Option 2:

Payback Period = Initial Investment / Annual Cash Inflow
Payback Period = 805,000 / 250,000
Payback Period = 3.22 years

Answer to Requirement 2.

Option 1:

Accounting rate of return= Annual Net Income / Average Investment * 100
Average Investment = (278,000 + 28,000)/ 2 = 153,000

Depreciation per year = (278,000 – 28,000) / 5 = 50,000

Annual Net Income = Annual Cash Inflow – Depreciation
Annual Net Income = 100,000 – 50,000 = 50,000

Accounting rate of return= 50,000 / 153,000 * 100
Accounting rate of return= 32.68%

Option 2:

Accounting rate of return= Annual Net Income / Average Investment * 100
Average Investment = (805,000 + 150,000)/ 2 = 477,500

Depreciation per year = (805,000 – 150,000) / 5 = 131,000

Annual Net Income = Annual Cash Inflow – Depreciation
Annual Net Income = 250,000 – 131,000 = 119,000

Accounting rate of return= 119,000 / 477,500 * 100
Accounting rate of return= 24.92%


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