Question

Ranking Investment Proposals: 

Payback Period, Accounting Rate of Return, and Net Present Value 

Presented is information pertaining to the cash flows of three mutually exclusive investment proposals: 

Proposal X Proposal Y Proposal Z Initial investment $69,000 $69,000 $69,000 Cash flow from operations Year 1 60,000 34,500 69,000 Year 2 9,000 34,500 Year 3 33,500 33,500 Disinvestment 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 10 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. 

Best proposal Payback period (years) Accounting rate of return Net present value Proposal X 2 4.95 x 1 * Proposal Y 27 4.95 x 1* Proposal z 1 Z OZ 1 * X 

(b) Factors explaining the differences in rankings include all of the following except: 

The net present value method considers the cost of capital while the payback method does not discount future cash flows. 

While the accounting rate of return explicitly considers the cost of the asset as part of annual depreciation the net present value method considers the cost of the asset as part of the initial investment. 

Net present value considers the timing of cash flows while payback considers only total cash flows. 

The accounting rate of return considers profitability while payback only considers the time required to recover the investment.

Answer 1

Solution Computation of Payback period for each proposal Step-1: Compute the cumulative cash flows for all the three proposals Proposal Z Year Cash flows Proposal x L Cumulative Cash flows cash flows ($ 69,000) ($69,000) $60,000 ($9,000) | $9,000 $0 $33,500 $33,500 Proposal Y Cumulative Cash flows cash flows ($ 69,000) ($69,000) $34,500 ($34,500) $34,500 $0 $33,500 $33,500 Cumulative cash flows ($ 69,000) ($69,000) $69,000 1 2 SO 3 $0 Step-2: Compute the Payback period for all three proposals Proposal X Payback period = 2 Years Proposal Y Payback period = 2 Years Proposal z Payback period = 1 Year Computation of Accounting Rate of Return for each proposal Step-1: Compute the Annual Depreciation under all the three proposals Proposal z $69,000 Initial investment Life (Years) Annual Depreciation Proposal X $69,000 3 $23,000 Proposal Y $69,000 3 $23,000 $69,000 Step-2: Compute the Accouning rate of return under all the three proposals Proposal X Year Proposal X Less: Cash flows Depreciation $60,000 $23,000 $9,000 $23,000 $33,500 $23,000 Annual net profit $37,000 ($14,000) $10,500 $33,500 3 Average Net profits = $33,500 / 3 = $11,167 Average investment = ($69,000 + $0)/2 = $34,500 Accounting Rate of return = $11,167/$34,500 = 0.3237

Proposal Y Year Proposal Y Less: Cash flows Depreciation $34,500 $23,000 $34,500 $23,000 $33,500 $23,000 Annual net profit $11,500 $11,500 $10,500 $33,500 2 3 Average Net profits = $33,500 / 3 = $11,167 Average investment = ($69,000 + $0)/2 = $34,500 Accounting Rate of return = $11,167/$34,500 = 0.3237 Proposal Z Annual net Year Proposal Y Less: Cash flows Depreciation $69,000 $69,000 Clation profit 1 Average Net profits = $0/1 = $0 Average investment = ($69,000 + $0)/2 = $34,500 Accounting Rate of return = $0/$34,500 = Computation of Net Present Value for each proposal Year Present Value Factor @ 10% Proposal Present Cash flows Value of Cash flows ($69,000)| ($69,000)| $60,000 $54,545 $9,000 $7,438 $33,500 $25,169 $18,152 Proposal Y Present Cash flows Value of Cash flows ($69,000)| ($69,000)| $34,500 $31,364 $34,500 $28,513 $33,500 $25,169 $16,045 Proposal Z Present Cash flows Value of Cash flows ($69,000) ($69,000) $69,000 $62,727 $0 $0 0.90909 0.82645 0.75131 NPV = $o $0 ($6,273) Best Proposal x Proposal Y| Proposal 2 Proposal 1 Payback period (Years) Accounting Rate of Return Net Present Value 0.3237 $18,152 0.3237 $16,045 ($6,273) X & Y X Required (b) Factors explaining the differences in ranking include all the following except: Net present value considers the timing of cash flows while payback considers only total cash flows.