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a) Calculate the following, explaining your answer in each case:
i. The payback period.
Year |
Cash Flows |
Cumulative Cash Flow |
0 |
-210,000 |
-210,000 |
1 |
53,000 |
-157,000 |
2 |
49,500 |
-107,500 |
3 |
46,000 |
-61,500 |
4 |
42,500 |
-19,000 |
5 |
39,000 |
|
6 |
32,000 |
|
7 |
25,000 |
|
The payback period is calculated as follows
Payback |
|
4 years + (19,000/39,000 x 1) |
|
4.49 years |
The company expects to be repaid their initial investment in 4.5 years.
ii. The accounting rate of return.
This requires the calculation of the total profit for the project which can be calculated as total relevant cash flows less depreciation. The calculations are as follows
ARR |
Total project profit (287,000 - 210,000) |
77,000 |
|
Average annual profit |
77,000/7 |
|
11,000 |
|
Average investment |
210,000 +0/2 |
105,000 |
|
|
|
|
|
|
|
ARR |
11,000/105,000 |
|
10.47% |
| |
|
|
|
|
|
|
The overall average annual return on investment offered by the project, not taking into account the time value of money is 10.47%.
iii. The net present value of the project.
Year |
Cash Flows |
Disc 12% |
Present Value |
0 |
-210,000 |
1 |
-210000 |
1 |
53,000 |
0.893 |
47329 |
2 |
49,500 |
0.797 |
39451.5 |
3 |
46,000 |
0.712 |
32752 |
4 |
42,500 |
0.636 |
27030 |
5 |
39,000 |
0.567 |
22113 |
6 |
32,000 |
0.507 |
16224 |
7 |
25,000 |
0.452 |
11300 |
|
NPV |
|
-13800.5 |
The NPV of the project is €13,800 negative. The present value of the cash outflows exceed the present value of the cash inflows by €13,800. Thus the project is not acceptable as it will not offer a return on capital greater than the cost of capital.
iv. The internal rate of return for the project.
As the NPV of the project is negative one must calculate a positive NPV. This is achieved by discounting the cash flows at a lower cost of capital.
Year |
Cash Flows |
Disc 12% |
Present Value |
|
Disc 8% |
Present Value |
0 |
-210,000 |
1 |
-210000 |
|
1 |
-210000 |
1 |
53,000 |
0.893 |
47329 |
|
0.926 |
49078 |
2 |
49,500 |
0.797 |
39451.5 |
|
0.857 |
42421.5 |
3 |
46,000 |
0.712 |
32752 |
|
0.794 |
36524 |
4 |
42,500 |
0.636 |
27030 |
|
0.735 |
31237.5 |
5 |
39,000 |
0.567 |
22113 |
|
0.681 |
26559 |
6 |
32,000 |
0.507 |
16224 |
|
0.63 |
20160 |
7 |
25,000 |
0.452 |
11300 |
|
0.583 |
14575 |
|
|
|
-13800.5 |
|
|
10555 |
The IRR is calculated as follows
8 + ( 10555 x 12 – 8) = 9.73%
10555 + 13800
b) State, with reasons, whether you feel the project is viable
This project is not viable as it offers a return less than the cost of capital
- The accounting rate of return is 10.5% less than the cost of capital of 12%
- The IRR is less than the ARR (as it takes into account the extra cost of waiting) at 9.73%. This is well below the cost of capital or minimum required return for the business and thus the project should be rejected.
- The NPV of the project is €13,800 negative. The present value of the cash outflows, exceed the present value of the cash inflows by €13,800. Thus the project is not acceptable as it will not offer a return on capital greater than the cost of capital.
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