In: Accounting
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.
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%