Question

The directors of a small production company have the opportunity to invest in one of two new projects. Both projects involve the acquisition of new machinery. The figures for the projects are as follows:

Project 1 Project 2 200,000 120,000 Cost (will be incurred immediately) Expected annual profits/losses Year 1 Year 2 Year 3 Estimated scrap value of machinery 58,000 (2,000) 4,000 14,000 36,000 (4,000) 8,000 12,000

The business has an estimated cost of capital of 10%. They use a straight-line method of depreciation for non-current assets to calculate operating profit. The business has sufficient funds to meet the capital expenditure requirements.

You must demonstrate the main methods of project appraisal. Produce a document setting out your findings and the assumptions on which calculations are based. Evaluate each method of project appraisal and make a recommendation to the board as to which project they should invest in.

For each project, calculate:

- accounting rate of return

- payback

- net present value

- internal rate of return

An alternative way of determining depreciation is to use the reducing balance method.

- Use a theoretical rate of depreciation value of 40% to determine the annual net book values of assets costing £200,000 and £120,000 respectively for a four-year period.

- Discuss what allowances should be made for the effects of inflation in project appraisal.

Answer 1

Calculation of ARR:

Particular	Project1	Project1
Cost	-200000	-120000
Annual CF1	58000	36000
Annual CF2	-2000	-4000
Annual CF3	4000	8000
Scrap	14000	12000
Depreciation(SLM)=(cost-scrap)/3	62000	36000
Average Investment=cost+scrap/2	107000	66000
Average CF=(CF1+CF2+CF3)/3	20000	13333.33
ARR(%)=Avg CF/Avg investment*100	18.69	20.20

Calculation of Payback period:

As the cash flow are not getting recovered throughout the life(i.e. 3years) the pay back period is more than 3 years.

Calculation of NPV:

NPV=PV of Cash flows before depreciation-Cost

PV of cash flows:

Year	Project1	Project2	PV factor	PV P1	PV P2
0	-200000	-120000	1	-200000	-120000
1	58000	36000	0.909091	52727.27	32727.27
2	-2000	-4000	0.826446	-1652.89	-3305.79
3	18000	20000	0.751315	13523.67	15026.3
NPV				-135402	-75552.2

Note: pv factor=1/(1+r)^{^n}

where r= rate i.e.10% and n= year

Calculation of IRR:

As the investment is not getting recovered throughout the life, no internal rate rate of return shall equate the cash flows to the cost.