1] | ARR = Average NI/Initial investment = 1200000/7000000 = | 17.14% | |||
2] | The company can purchase the new equipment as the ARR is | ||||
greater than the expected rate of return of 12%. | |||||
3] | ARR has the disadvantages: | ||||
*It is based on accounting profits not cash flows. Hence, the | |||||
analysis is not realistic and can depend on the assumptions | |||||
made in preparing financial results. | |||||
*It does not consider time value of money | |||||
*It does not consider risk | |||||
*It does not give the addtion to shareholders' wealth if the | |||||
investment is made. | |||||
4] | Payback period is the time taken for the cash flows to recoup | ||||
the initial investment. As the cash flows are uneven, the | |||||
cumulative cash flows are to be worked out to find the | |||||
payback period. | |||||
Year | Cash flows | Cumulative cash flows | |||
0 | $ (7,000,000) | $ (7,000,000) | |||
1 | $ 2,800,000 | $ (4,200,000) | |||
2 | $ 2,450,000 | $ (1,750,000) | |||
3 | $ 2,695,000 | $ 945,000 | |||
4 | $ 1,300,000 | $ 2,245,000 | |||
Payback period = 2+1750000/2695000 = | 2.65 | Years | |||
5] | As the payback period of the project is more than the acceptable maximum, the prorject should | ||||
not be accepted. | |||||
6] | The payback method has the following advantages: | ||||
*It is based on cash flows | |||||
*It considers risk as it favors investments with shorter paybacks | |||||
*It is easy to understand and workout. | |||||
7] | The NPV is worked out in the table below: | ||||
Year | Cash flows | PVIF at 12% | PV at 12% | ||
0 | $ (7,000,000) | 1.00000 | $ (7,000,000) | ||
1 | $ 2,800,000 | 0.89286 | $ 2,500,000 | ||
2 | $ 2,450,000 | 0.79719 | $ 1,953,125 | ||
3 | $ 2,695,000 | 0.71178 | $ 1,918,248 | ||
4 | $ 1,300,000 | 0.63552 | $ 826,174 | ||
NPV | $ 197,546 | ||||
8] | As the NPV is positive, the project can be accepted. | ||||
Positive NPV indicates the net addition to shareholders' wealth in present value terms, if the project is | |||||
implemented. | |||||
9] | NPV was chosen because of the following advantages of the method: | ||||
*It considers the time value of money | |||||
*It can consider risk by adjusting the discount rate or the cash flows themseleves | |||||
*It considers only cash flows | |||||
*It considers the cash flows for the entire life of the opportunity | |||||
*It gives the net addition to shareholders' wealth if the project is accepted. Addition/maximization of shareholders' | |||||
wealth is the goal of financial management | |||||
*It can rank projects |
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