Question

A manufacturing business is considering investing in some new equipment. The management accountant has estimated the future net cash flows from the investment as follows.

Initial investment	(£1,360,000)
Year 1	£470,000
Year 2	£580,000
Year 3	£580,000
Year 4	£500,000

This business uses straight-line depreciation and its cost of capital (the discount rate for investment appraisal is 10%). It is assumed that the new equipment will have a residual value of zero at the end of four years.

Required:

1. Calculate the payback period,

2. accounting rate of return (ARR) and

(6 marks)

(6 marks)

3. the net present value (NPV) for the proposed investment.

(6 marks)

4. Advise the business whether, on financial grounds, it should invest in the new equipment.

(2 marks)

5. Explain why the NPV method is considered superior to the payback period and accounting rate of return methods of appraising potential capital investments.

(10 marks)

6. Explain the effect of non-financial/non-quantitative factors on project appraisal by using relevant examples.

(10 marks) (Question 3 total: 40 marks)

Answer 1

a)	Payback Period
	Year	Cash Flow	Accumulated Cash Flow
	£                        -	-£         13,60,000	-£                          13,60,000
	£                          1	£            4,70,000	-£                            8,90,000
	£                          2	£            5,80,000	-£                            3,10,000
	£                          3	£            5,80,000	£                             2,70,000
	£                          4	£            5,00,000	£                             7,70,000
	payback petiod = 2 years + 310000/580000
		=2.53years
b)	Annual Depreciation = Intial investment - salavage value / life of the asset
		=(1360000-0)/4
		=340000 per year
	Calculation of annual net income
	Net Income = Annual cash flow - annual depreciation
	Year	Cash Flow	Depreciation	Net Income
	£                    1.00	£      4,70,000.00	£                       3,40,000.00	£         1,30,000.00
	£                    2.00	£      5,80,000.00	£                       3,40,000.00	£         2,40,000.00
	£                    3.00	£      5,80,000.00	£                       3,40,000.00	£         2,40,000.00
	£                    4.00	£      5,00,000.00	£                       3,40,000.00	£         1,60,000.00
	Total			£         7,70,000.00
	Average Net Income = 770000/4 years
		=192500
	Average Assets = (Opeaing Assets+Salvage Value) /2
	=(1360000-0)/2
	=680000
	Accounting rate of return= average net income / average investment
	=192500/680000
	=28.31%
c)	Net Present value
	Year	Cash Flow	PV factor	PV of cash flow
	0	-£   13,60,000.00	£                                     1.00	-£      13,60,000.00
	1	£      4,70,000.00	£                                     0.91	£         4,27,272.73
	2	£      5,80,000.00	£                                     0.83	£         4,79,338.84
	3	£      5,80,000.00	£                                     0.75	£         4,35,762.58
	4	£      5,00,000.00	£                                     0.68	£         3,41,506.73
	NPV			£         3,23,880.88
d)	Since the NPV of the new equipment is positive, the company should invest in the equipment.