Question

u Write a report (about 200-400 words) for the firm to use giving recommendations/information as follows: Which system they should use on the basis of method PBP or NPV Which system would be best overall taking into account the results from the methods The possible limitations of investment appraisal u (Hint: PVIF10%, 1-5 are 0909, 0.826, 0.751, 0.683, 0.621)

Answer 1

Ans ) Calculation of payback period

Payback period=Total innitial capital investment/Average cash inflow

System A=320000/435000/5=3.7 yers

System b=185000/340000/5=2.7 years

Calculation of NPV

		System A	System B
discounted cash inflows
1 st year	0.909	140895	86355
2 nd year	0.826	78470	24780
3 rd year	0.751	63835	22530
	0.683	51225	61470
	0.621	15525	58995
Total		349950	254130
Less Initial cash Outflow		320000	185000
NPV		29950	69130

Payback period method-The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equal the total initial cash outlays. At tht point in time , the investor has recovered the money invested in the project.It has following advantages and disadvantages

It is easy to calculate

it is easy to understand as it provides a quick estimate of the time needed for the organization to recoup the cash invested.

The length of the payback period can also serve as an estimate of a project risk the longer the payback period tr riskier the project as long term predictions are less reliable.

Limitations

It ignores time value of money; As long as the payback periods for two projects are the same the payback period technique considers them equal as investments, even if one project generates most of its net cash inflow in the early years of the project while the other project generated most of its net cash inflows in the latter years of the payback period.

This technique is its failure to consider an investment's total profitability; it only considers cash flow from the initiation of the project until its payback period and ignores cash flows after the payback period.

NPV-The net present value technique is a discounted cash flow method that considers the time value of money in evaluating capital investment. An investment has cash flow throughout its life, and it is assumed that a dollar of a cash flow in the early years of an investment is worth more than a dollar f cash flow in a later year.

On the basis of above NPV Method should be selected as it considers time value of money it brings all subsequent cash inflow after the initial investment to their present value.However use of the PBP method may cause organization to place reliance on short payback periods ignoring the need to invest in long term projects.

system B should be selected as its payback period is less and NPV is also higher compared to System A