Question

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Presented is information pertaining to the cash flows of three mutually exclusive investment proposals: Proposal X Proposal Y Proposal Z Initial investment $92,000 $92,000 $92,000 Cash flow from operations Year 1 90,000 46,000 92,000 Year 2 2,000 46,000 Year 3 47,500 47,500 Disinvestment 0 0 Life (years) 3 years 3 years 1 year (a) Select the best investment proposal 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 14 percent. • Round accounting rate of return four decimal places. • Round net present value to the nearest whole number. • Use negative signs with your answers, when appropriate. Proposal X Best proposal Proposal Y 2 2 Payback period (years) Accounting rate of return Net present value Proposal Z 1Z 0 X,Y (11,298) X 15,788

Answer 1

1) Pay back period = Net cash inflow - Initial investment

Proposal X = ( 90,000 + 2,000 ) - 92,000 = 2 years

Proposal Y = ( 46,000 + 46,000 ) - 92,000 = 2 years

Proposal Z = 92,000  - 92,000 = 1 year

Best proposal is Z as per pay back period.

2) Accounting rate of return = Annual avg profit / Initial investment

Proposal X - Depreciation = 92,000 / 3 = $ 30,667

Annual avg profit = ( 90000 + 2000 + 47500 ) / 3 = $ 46,500

Avg net cash flow = 46500 - 30667 = $ 15,833

ARR = 15833 / 92000 *100 = 17.21 %

Proposal Y - Depreciation = 92,000 / 3 = $ 30,667

Annual avg profit = ( 46000 + 46000 + 47500 ) / 3 = $ 46,500

Avg net cash flow = 46500 - 30667 = $ 15,833

ARR = 15833 / 92000 *100 = 17.21 %

Proposal Z - Depreciation = 92,000 / 1 = $ 92,000

Annual avg profit = 92,000 / 1 = $ 92,000

Avg net cash flow = 92,000 - 92,000 = 0

ARR = 0/ 92000 *100 = 0 %

Best proposal are X and Y as per Accounting Rate of Return.

3) Net Present Value = Cash Flow / ( 1 + r )ⁿ - Initial investment

Proposal X = 90,000 / ( 1 + 0.14 ) ¹ + 2,000 / ( 1 + 0.14 ) ² + 47,500 / ( 1 + 0.14 ) ³ - 92,000

= $ 78,947 + $ 1,539 + $ 32,062 - 92,000

= $ 50,548

Proposal Y = 46,000 / ( 1 + 0.14 ) ¹ + 46,000 / ( 1 + 0.14 ) ² + 47,500 / ( 1 + 0.14 ) ³ - 92,000

= $ 40,351 + $ 35,395 + $ 32,062 - 92,000

= $ 15,788

Proposal Z = 92,000 / ( 1 + 0.14 ) ¹ - 92,000

= $ 80,702 - 92,000

= - $ 11,298

Best proposal X as per Net present value.