Project A
1.RWE Enterprises Pty Ltd is a small manufacturing firm located in Brisbane. RWE is considering setting-up a new plant. The plant has an upfront cost of $3 million. The proposed plant will have a life of 10 years at the end of which it can be sold for an after-tax scrap value of $200,000. The management estimates that the new plant will add 700,000 to after-tax profits during each year of its life. Midway through its life, that is, at the end of 5 years, the plant will have to be refurbished at a cost of $2 million.
a)What are the full 10 year cash flows associated with the plant? That is, make a cash flow diagram showing the yearly cash flows from year 0 to 10.
b)If RWE uses a 10% discount rate to evaluate investments of this type, what is the net present value of the project? What does this NPV indicate about the potential value RWE might create by purchasing the new production line? Explain.
c)Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability? Explain.
d)Calculate the payback period for the proposed investment. Interpret your findings.
2.Jason Katz graduated from University of the Sunshine Coast in December and has started working for Innovative Investments. When Jason arrived at work on Monday morning, he found the following memo on his desk
“To: Jason Katz, Financial Analyst
From: George Adams, CFO
RE: Project Evaluation
Provide an evaluation of two proposed projects with the following cash flow forecasts:
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Project A
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Project B
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Initial Outlay
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(275000)
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(275000)
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Year 1
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50000
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100,000
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Year 2
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75000
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100,000
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Year 3
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100,000
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100,000
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Year 4
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125,000
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100,000
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Year 5
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175,000
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100,000
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The company requires a rate of return on both projects equal to 12%. As you are no doubt aware, we rely on a number of criteria when evaluating new investment opportunities. In particular, we require that projects that are accepted have a payback of no more than three years, provide a positive NPV and have an IRR that exceeds the firm’s discount rate.
Give me your thoughts on these two projects by 9 am tomorrow morning.”
Jason was not surprised by the memo, for he had been expecting something like this for some time. Innovative Investments followed a practice of testing each new financial analyst with some type of project-evaluation exercise after the new hire had been on the job for a few months.
After re-reading the memo, Jason decided on his plan of attack. Specifically, he would first do the obligatory calculations of payback, NPV and IRR for both projects. Jamie knew the CFO would grill him thoroughly on Tuesday morning about his analysis, so he wanted to prepare well for the experience. One of the things that occurred to Jason was that the memo did not indicate whether the two projects were independent or mutually exclusive. So, just to be safe, he thought he had better rank the two projects in case he was asked to do so tomorrow morning. Jason sat down and made up the following ‘to do’ list:
(a) Calculate payback, NPV and IRR for both projects.
(b) Evaluate the two projects’ acceptability using all three decision criteria (listed above) and based on the assumption that the projects are independent. That is, both could be accepted if both are acceptable.
(c) Rank the two projects and make a recommendation as to which (if either) project should be accepted under the assumption that the projects are mutually exclusive.
Assignment—Prepare Jason’s evaluation for his Tuesday meeting with the CFO by filling out your response
Project A
The cash flows associated with the project for the period of coming 10 years is as follows(Alexander, 2016). All the costs and revenues have been considered in the same.
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Inputs for the project
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Particulars
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Amount in $
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Upfront cost
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3,000,000
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Life of the plant (years)
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10
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After tax scrap value
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200,000
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Per year after tax profits
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700,000
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Refurbishment cost at the end of 5th year
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2,000,000
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Yearly cash flow from the project
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Years
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Cash Flow
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Cumulative Cash Flow
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0
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(3,000,000)
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(3,000,000)
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|
1
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700,000
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(2,300,000)
|
|
2
|
700,000
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(1,600,000)
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|
3
|
700,000
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(900,000)
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4
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700,000
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(200,000)
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|
5
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(1,300,000)
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(1,500,000)
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|
6
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700,000
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(800,000)
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|
7
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700,000
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(100,000)
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|
8
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700,000
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600,000
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|
9
|
700,000
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1,300,000
|
|
10
|
900,000
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2,200,000
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Total
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2,200,000
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The final net cash inflow from the given project is $ 2200000. This is before applying the discounting factors
In case 10% discount rate is being applied in the given case to evaluate the investments and the project, the net present value would be computed in the below mentioned way.
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Capital Budgeting Project
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NPV
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Required Return =
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10%
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Year
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CF
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Formula
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Disc CFs
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0
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(3,000,000.00)
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=(-3000000)/(1.1)^0 =
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(3,000,000.00)
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1
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700,000.00
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=(700000)/(1.1)^1 =
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636,363.64
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2
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700,000.00
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=(700000)/(1.1)^2 =
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578,512.40
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3
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700,000.00
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=(700000)/(1.1)^3 =
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525,920.36
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4
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700,000.00
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=(700000)/(1.1)^4 =
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478,109.42
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5
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(1,300,000.00)
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=(-1300000)/(1.1)^5 =
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(807,197.72)
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6
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700,000.00
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=(700000)/(1.1)^6 =
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395,131.75
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7
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700,000.00
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=(700000)/(1.1)^7 =
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359,210.68
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8
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700,000.00
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=(700000)/(1.1)^8 =
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326,555.17
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9
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700,000.00
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=(700000)/(1.1)^9 =
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296,868.33
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10
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900,000.00
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=(900000)/(1.1)^10 =
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346,988.96
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|
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136,462.99
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The NPV calculated above in the table indicates that the project creates value for the RWE enterprises Pty Limited. The NPV for the 10 year project is $ 136463, which is positive and hence the company should go ahead with the purchasing of the new production line (Chron, 2017).
The internal rate of return is one of the capital budgeting techniques being used by the companies to analyse whether to accept the project or not. It is the discount rate which makes the NPV of all the cash flows for the given project to be zero. It is the rate of discount at which the present value of the inflows is equal to the present value of the outflows. It relies on the same formula as NPV does and the word internal indicates that no external factors are being used like the cost of capital or the inflation factor(Bizfluent, 2017).
On the other hand, profitability index also known as the value investment ratio or the profit investment ratio may be defined as ratio of the present value of the future cash flows to the initial investment. It is very important capital budgeting tool that is being used in the ranking of the projects when there are several projects in hand out of which only few needs to be chosen. In short, it is value created per unit of investment (Bromwich & Scapens, 2016).
In case of RWE Enterprises the calculation of PI and IRR has been shown below:
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Calculation of IRR and PI
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Years
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Cash Flow
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|
0
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(3,000,000)
|
|
1
|
700,000
|
|
2
|
700,000
|
|
3
|
700,000
|
|
4
|
700,000
|
|
5
|
(1,300,000)
|
|
6
|
700,000
|
|
7
|
700,000
|
|
8
|
700,000
|
|
9
|
700,000
|
|
10
|
900,000
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|
IRR
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11.05%
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|
Present value of inflows (a)
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3,136,463
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|
Initial Investment (b)
|
3,000,000
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|
Profitability Index (a/b)
|
1.05
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The IRR is more than the discount rate i.e., 11.05% which indicates that the project is profitable. Furthermore, the profitability index of the project is also above 1, i.e., 1.05, therefore the project should be accepted (Farmer, 2018).
The payback period may be defined as the period or time taken by the project or investment to recover the initially invested amount in terms of savings or profits.
It is one of the capital budgeting techniques which is generally not being used as it ignores the time value of money as well as the cash flows beyond the cut off date. It gives biased results at times and can be thus deceiving (Dichev, 2017).
Project B
In case of RWE enterprises Pty Limited, the payback as shown in the below calculation is 7.14 years. Therefore, the company would be able to reciver its investments in 7.14 years and hence, the project should be accepted.
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Yearly cash flow from the project
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Years
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Cash Flow
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Cumulative Cash Flow
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|
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0
|
(3,000,000)
|
(3,000,000)
|
|
|
1
|
700,000
|
(2,300,000)
|
|
|
2
|
700,000
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(1,600,000)
|
|
|
3
|
700,000
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(900,000)
|
|
|
4
|
700,000
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(200,000)
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|
|
5
|
(1,300,000)
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(1,500,000)
|
|
|
6
|
700,000
|
(800,000)
|
|
|
7
|
700,000
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(100,000)
|
|
|
8
|
700,000
|
600,000
|
|
|
9
|
700,000
|
1,300,000
|
|
|
10
|
900,000
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2,200,000
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|
|
Total
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|
2,200,000
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|
|
|
|
|
|
|
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Payback = Year 7 + (100000/700000)
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|
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Payback = 7.14 years
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In the given case, Innovative Investments is proposing 2 projects for which the financial analysis has been shown below (Sithole, et al., 2017). The inputs from te hquestion has also been summarised in the below tables.
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Inputs for the project
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|
Particulars
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Project A
|
Project B
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|
Initial Outlay
|
(275,000)
|
(275,000)
|
|
Year 1
|
50,000
|
100,000
|
|
Year 2
|
75,000
|
100,000
|
|
Year 3
|
100,000
|
100,000
|
|
Year 4
|
125,000
|
100,000
|
|
Year 5
|
175,000
|
100,000
|
|
|
|
|
|
Requirements for the project
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|
Particulars
|
Project A
|
Project B
|
|
Required rate of return
|
12%
|
12%
|
|
Payback Period
|
<3 years
|
<3 years
|
|
NPV
|
Positive
|
Positive
|
|
IRR
|
> Firm's discount rate
|
> Firm's discount rate
|
- The payback period, Internal rate of return and the net present value calculation of each of the given 2 projects has been shown below(Félix, 2017):
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Formula : Payback Period = Time period in which initial investment is recovered
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|
|
|
|
|
|
|
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Particulars
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Year
|
Yearly cash flows
|
Cumulative cash flows
|
|
Project A
|
Project B
|
Project A
|
Project B
|
|
Cost
|
0
|
(275,000)
|
(275,000)
|
(275,000)
|
(275,000)
|
|
Cash Inflows
|
1
|
50,000
|
100,000
|
(225,000)
|
(175,000)
|
|
|
2
|
75,000
|
100,000
|
(150,000)
|
(75,000)
|
|
|
3
|
100,000
|
100,000
|
(50,000)
|
25,000
|
|
|
4
|
125,000
|
100,000
|
75,000
|
125,000
|
|
|
5
|
175,000
|
100,000
|
250,000
|
225,000
|
|
|
|
Payback period
|
3.40
|
2.75
|
|
Formula : NPV = Sum total of PV of inflows - PV of outflows
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PV factor @ 12%
|
PV @ 12%
|
|
Particulars
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Year
|
Project A
|
Project B
|
|
Project A
|
Project B
|
|
Cost
|
0
|
(275,000)
|
(275,000)
|
1.0000
|
(275,000)
|
(275,000)
|
|
Cash Inflows
|
1
|
50,000
|
100,000
|
0.8929
|
44,643
|
89,286
|
|
|
2
|
75,000
|
100,000
|
0.7972
|
59,790
|
79,719
|
|
|
3
|
100,000
|
100,000
|
0.7118
|
71,178
|
71,178
|
|
|
4
|
125,000
|
100,000
|
0.6355
|
79,440
|
63,552
|
|
|
5
|
175,000
|
100,000
|
0.5674
|
99,300
|
56,743
|
|
|
|
NPV
|
79,350
|
85,478
|
|
|
|
|
|
|
|
|
|
IRR : IRR is the rate at which PV of inflows is equal to the PV of outflows, i.e., NPV=0
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Check
|
|
|
|
|
|
|
|
|
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PV factor @ 20.97%
|
PV factor @ 23.92%
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Present values
|
|
Particulars
|
Year
|
Project A
|
Project B
|
|
1.2097
|
1.2392
|
Project X
|
Project Y
|
|
Cost
|
0
|
(275,000)
|
(275,000)
|
|
1.0000
|
1.0000
|
(275,000)
|
(275,000)
|
|
Cash Inflows
|
1
|
50,000
|
100,000
|
|
0.8267
|
0.8070
|
41,333
|
80,697
|
|
|
2
|
75,000
|
100,000
|
|
0.6834
|
0.6512
|
51,251
|
65,120
|
|
|
3
|
100,000
|
100,000
|
|
0.5649
|
0.5255
|
56,489
|
52,550
|
|
|
4
|
125,000
|
100,000
|
|
0.4670
|
0.4241
|
58,371
|
42,407
|
|
|
5
|
175,000
|
100,000
|
|
0.3860
|
0.3422
|
67,554
|
34,221
|
|
|
IRR
|
20.97%
|
23.92%
|
|
NPV
|
(2)
|
(4)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PV factor @ 12%
|
PV @ 12%
|
|
Particulars
|
Year
|
Project A
|
Project B
|
Project A
|
Project B
|
|
Cost
|
0
|
(275,000)
|
(275,000)
|
1.0000
|
(275,000)
|
(275,000)
|
|
Cash Inflows
|
1
|
50,000
|
100,000
|
0.8929
|
44,643
|
89,286
|
|
|
2
|
75,000
|
100,000
|
0.7972
|
59,790
|
79,719
|
|
|
3
|
100,000
|
100,000
|
0.7118
|
71,178
|
71,178
|
|
|
4
|
125,000
|
100,000
|
0.6355
|
79,440
|
63,552
|
|
|
5
|
175,000
|
100,000
|
0.5674
|
99,300
|
56,743
|
|
|
|
PV of inflows (A)
|
354,350
|
360,478
|
|
|
|
Initial Outflows (B)
|
275,000
|
275,000
|
|
|
|
Profitability Index (A/B)
|
1.29
|
1.31
|
|
|
|
|
|
|
|
|
- Based on the above results and assuming that both the projects are independent of each other and both could be accepted if viable and meets the given condition, following I steh table which shows the acceptability as per the given criterias in the question(Heminway, 2017).
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Particulars
|
Requirements for the project
|
Acceptability of the project
|
|
Project A
|
Project B
|
Project A
|
Project B
|
|
Payback Period
|
<3 years
|
<3 years
|
No
|
Yes
|
|
NPV
|
Positive
|
Positive
|
Yes
|
Yes
|
|
IRR
|
> Firm's discount rate
|
> Firm's discount rate
|
Yes
|
Yes
|
From the above table it can be concluded that Project B meets all the given criteria of NPV, IRR and the payback period whereas Project A meets 2 of the criterias of NPV and IRR, missing out narrowly in payback period. Therefore, as per the above assessment, project B should be accepted and Project A should be rejected (Goldmann, 2016).
Based on the above assessment and results, the ranking sheet has been prepared for both the projects on the basis of each criteria and then the final ranking has also been given(Linden & Freeman, 2017).
|
Particulars
|
Rankings for the project
|
|
Project A
|
Project B
|
|
Payback Period
|
Rank 2
|
Rank 1
|
|
NPV
|
Rank 2
|
Rank 1
|
|
IRR
|
Rank 2
|
Rank 1
|
|
Profitability Index
|
Rank 2
|
Rank 1
|
|
Final Decision
|
Rank 2
|
Rank 1
|
Therefore, given that the projects are mutually exclusive, Project B should be chosen and Project A should be rejected as it is failing to meet the criteria of Payback period (Jefferson, 2017)
References
Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.
Bizfluent, 2017. Advantages & Disadvantages of Internal Control. [Online]
Available at: https://bizfluent.com/info-8064250-advantages-disadvantages-internal-control.html
[Accessed 07 december 2017].
Bromwich, M. & Scapens, R., 2016. Management Accounting Research: 25 years on. Management Accounting Research, Volume 31, pp. 1-9.
Chron, 2017. five-common-features-internal-control-system-business. [Online]
Available at: https://smallbusiness.chron.com/five-common-features-internal-control-system-business-430.html
[Accessed 07 december 2017].
Dichev, I., 2017. On the conceptual foundations of financial reporting. Accounting and Business Research, 47(6), pp. 617-632.
Farmer, Y., 2018. Ethical Decision Making and Reputation Management in Public Relations. Journal of Media Ethics, pp. 1-12.
Félix, M., 2017. A study on the expected impact of IFRS 17 on the transparency of financial statements of insurance companies. MASTER THESIS, pp. 1-69.
Goldmann, K., 2016. Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, Volume 4, pp. 103-112.
Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, pp. 1-35.
Jefferson, M., 2017. Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland. Technological Forecasting and Social Change, pp. 353-354.
Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), pp. 353-379.
Sithole, S., Chandler, P., Abeysekera, I. & Paas, F., 2017. Benefits of guided self-management of attention on learning accounting. Journal of Educational Psychology, 109(2), p. 220
