200 000 100 200 000 1 80 000 2 70 000 3 65 000 06086

200 000 100 200 000 1 80 000 2 70 000 3 65 000 06086

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200 000 1.00 200 000 1 +80 000 0.8475 +67 800 2 +70 000 0.7182 +50 274 3 +65 000 0.6086 +39 559 4 +60 000 0.5158 +30 948 5 +65 000 0.4371 +28 411 ––––––– +16 992 ––––––– Project B Year 0 230 000 1.00 230 000 1 +100 000 0.8475 +84 750 2 +70 000 0.7182 +50 274 3 +50 000 0.6086 +30 430 4 +50 000 0.5158 +25 790 5 +65 000 0.4371 +28 411 ––––––– 10 345 ––––––– Project C Year 0 180 000 1.00 180 000 1 +55 000 0.8475 +46 613 2 +65 000 0.7182 +46 683 3 +95 000 0.6086 +57 817 4 +108 000 0.5158 +55 706 ––––––– +26 819 ––––––– (d) The NPV method of evaluation is superior to the other methods, and the project with the largest NPV ought to be selected: project C. It should be noted that project C is also preferred to A and B when the payback and accounting rate of return methods are used. (e) Other factors which should be considered are qualitative factors such as the impact on existing sales, the effect on employees and the effect on the CAPITAL INVESTMENT DECISIONS: APPRAISAL METHODS 121
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environment from each of the three projects. In addition the risk and reliability of the cash flows for each project should be considered. (a) Cash flow Year 1 2 3 4 5 (£) (£) (£) (£) (£) Saving in fleet costs 250 000 275 000 302 500 332 750 366 025 Less driver’s costs 33 000 35 000 36 000 38 000 40 000 Repairs and maintenance 8 000 13 000 15 000 16 000 18 000 Other costs 10 000 15 000 20 000 16 000 22 000 –––––– –––––– –––––– –––––– –––––– 51 000 63 000 71 000 70 000 80 000 Net savings 199 000 212 000 231 500 262 750 286 025 Depreciation of £120 000 per annum (£750 000 less £150 000 scrap value depreciated over 5 years) has been deducted from other costs since it is not a cash expense. (b) (i) Payback = 3 + (£750 000 £642 500) / £262 750 years = 3.41 years (ii) Accounting rate of return = average profit (£118 255) average investment (£450 000) = 26.3% Average profit = savings over 5 years depreciation 5 years = (£1 191 275 £600 000) / 5 years = £118 255 per year Average investment = 1 2 initial outlay + 1 2 scrap value = 1 2 (£750 00) + 1 2 (£150 000) = £450 000 (iii) Net present value Cost Discount factor (£) (£) Year 0 (750 000) 1 Saving 199 000 0.893 177 707 2 Saving 212 000 0.797 168 964 3 Saving 231 500 0.712 164 828 4 Saving 262 750 0.636 167 109 5 Saving 286 025 0.567 162 176 5 Sale of proceeds 150 000 0.567 85 050 ––––––– Net present value 175 834 ––––––– (c) The answer should draw attention to the fact that the transport fleet investment has a higher NPV but a longer payback and lower accounting rate of return than the alternative. The decision should be based on the NPV rule and it is recommended that the company invests in the new transport fleet. The answer should also explain the superiority of the NPV technique over the accounting rate Solution IM 13.3 122 CAPITAL INVESTMENT DECISIONS: APPRAISAL METHODS
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of return and payback methods (see ‘The concept of NPV’, ‘Payback method’ and ‘Accounting rate of return’ in Chapter 13). Task 1: (a) Year Cash flow Discount factor Present value (£) (£) 1 18 000 0.926 16 668 2 29 000 0.857 24 853 3 31 000 0.794 24 614 –––––– 66 135 Less investment outlay 55 000 –––––– 11 135 –––––– (b) Payback occurs during the third year. Assuming even cash flows throughout the year the payback period is: 2 years + (£55 0 £ 0 3 0 1 0 £ 0 4 0 7 000) = Approximately 2.3 years Task 2: (a) The proposal should be accepted because it has a positive net present value.
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