Ranking Investment Proposals: Payback Period, Accounting Rate of Return, and Net

Question

Ranking Investment Proposals: Payback Period, Accounting Rate of Return, and Net Present

Value

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

............................................................................................Proposal A Propsal B Propsal C

Initial Investment............................................................... 60000 60000 60000

Cash flow from oeprations:   

Year 1 50000 30000 60000

Year 2 6000 30000

Year 3 29000 25000

Disinvestment 0 0 0

Life (years) 3 3 1

Required

a.  Rank these investment proposals 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 12

percent. Round calculations to four decimal places.

b.  Explain the difference in rankings. Which investment would you recommend?

Explanation / Answer

Proposal A Year Cash flow C Cumulative cash flow Discount factor 15% D Discounted Cash flow D PV of cash inflow 0 -60000 -60000 1 -60000 1 50000 -10000 0.8929 44645 44645 2 6000 -4000 0.7972 4783.2 4783 3 29000 25000 0.7118 20642.2 20642 NPV 10070 70070 Payback Period = A + A+B/c A is the last period with a negative cumulative cash flow B is the absolute value of cumulative cash flow at the end of the period A C is the total cash flow during the period after A Payback = 2+(4000/29000) 2.14 Accounting rate of return 8333.333/60000*100 13.89 Cash flow from operations -Depreciation to calculate Net Income Avg Income 8333.333 (50000-20000+6000-20000+29000-20000)/3 Initial Investment 60000 Proposal B Year Cash flow C Cumulative cash flow Discount factor 15% D Discounted Cash flow D 0 -60000 -60000 1 -60000 1 30000 -30000 0.8929 26787 2 30000 0 0.7972 23916 3 25000 25000 0.7118 17795 NPV 8498 Payback Period = A + A+B/c A is the last period with a negative cumulative cash flow B is the absolute value of cumulative cash flow at the end of the period A C is the total cash flow during the period after A Payback = 2 Accounting rate of return 8333.333/60000*100 13.89 Cash flow from operations -Depreciation to calculate Net Income Avg Income 8333.333 (30000-20000+30000-20000+25000-20000)/3 Initial Investment 60000 Proposal C Year Cash flow C Cumulative cash flow Discount factor 15% D Discounted Cash flow D 0 -60000 -60000 1 -60000 1 60000 0 0.8929 53574 2 0 0 0.7972 0 3 0 0 0.7118 0 NPV -6426 Payback Period = A + A+B/c A is the last period with a negative cumulative cash flow B is the absolute value of cumulative cash flow at the end of the period A C is the total cash flow during the period after A Payback = 1 Accounting rate of return 0% (60000-60000)/60000*100 ans 1 Proposal A Proposal B Proposal C Proposal Payback period 2.14 2 1 C ARR 13.89% 13.89% 0 A and B NPV 10070 8498 -6426 A ans 2 ARR considers profitability of each proposal while payback considers the time required to recover the investment made. The best method is NPV as it takes into account the present value of cash flows. So according to it Proposal A is best and also ARR is equal for A and B So best proposal is A

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