Introduction

The attempted solution below are in response to the written assignment for unit 6 focusing on determining the

relevant cash flows, depreciation, payback period, net present value, IRR and ARR.

1. DETERMINATION OF RELEVANT CASH FLOWS

Determination of relevant cash flows Option 1

Details Years
0 1 2 3 4 5 6 7
Cost of the
machine (65,000)
Revenues 0 75,000 100,000 125,000 150,000 150,000 150,000
Less: Costs
Maintenance 2,700 2,700 2,700 2,700 2,781 2,781
costs 2,700
Materials 10,000 10,000 10,000 10,000 10,000 10,000
Costs 15,000
Labor Costs 72,100
70,000 74,263 76,491 78,786 81,149 83,584
Depreciation
9,286 9,286 9,286 9,286 9,286 9,286 9,286
Total Costs
96,986 94,086 96,249 98,477 100,772 103,216 105,651
Net cash flows
(96,986) (19,086) 3,751 26,523 49,228 46,784 44,349

Determination of relevant cash flows OPTION 2

Details Years
0 1 2 3 4 5 6 7
Cost of the
machine (85,000)
Revenues 0 80,000 95,000 130,000 140,000 150,000 160,000
Less : Costs
Maintenance 3,500 3,500 3,500 3,500 3,605 3,605
costs 3,500
Materials Costs 15,000 15,000 15,000 15,000 15,000 15,000
20,000
Labor Costs 60000 61,800
63,654 65,564 67,531 69,556 71,643
Depreciation 10,286 10,286 10,286 10,286 10,286 10,286 10,286
Total costs 93,786 90,586 92,440 94,350 96,317 98,447 100,534
Net cash flows
(93,786) (10,586) 2,560 35,650 43,683 51,553 59,466
Add: Salvage 13,000

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 Value
Total Cash flows
(93,786) (10,586) 2,560 35,650 43,683 51,553 72,466

Working 1. Depreciation

OPTION2: DEPRECIATION OPTION 1: DEPRECIATION

Depreciation = Cost - Salvage Value / Useful Life Depreciation = Cost - Salvage Value / Useful Life
= 85,000-13,000 / 7years = 65,000-0 /7 years
2. 9,286

COMPUTATION OF NPV, IRR AND PAYBACK

PERIOD FOR OPTION 1 AND OPTION 2 AND RECOMMENDATIONS ON WHAT OPTION IS

VIABLE.

2.1 Payback Period

Pay Back Period OPTION 1 Pay Back Period OPTION 2

Years Net cash Cumulativ Year Net Cash flows Cumulative
flows e Cash s Cash flows
flows
0 0 (65,000) (65,000)
(85,000) (85,000)
1 1 (161,986)
(93,786) (178,786) (96,986)
2 2 (19,086 (181,072)
(10,586) (189,372) )
3 3 3,75 (177,321)
2,560 (186,812) 1
4 4 26,523 (150,798)
35,650 (151,162)
5 5 49,228 (101,570)
43,683 (107,478)
6 6 46,78 (54,786)
51,553 (55,926) 4
7 7 44,34 (10,436)
72,466 16,540 9
The Payback period is after 7 years Payback Period = 6 years and 9 months
Payback Period is defined as the time it takes the cash inflows from a capital investment project to equal the cash

outflows. It’s usually expressed in years. When deciding between two or more competing projects, the usual

decision is to accept the one with the shortest payback period. Payback method is used as a first screening method.

Therefore, for the case of this Company project Option 2 should be selected since it has the shortest payback period

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of 7 years 9 months as compared to Option 1 whose Payback period is after the project’s useful life of 7 years. This

means the project will not be able to recover the investments during its implementation. However, The Company

cannot base its decision on the payback period alone as it does not consider the time value of money. The cash flows

are not discounted. It also ignores the timing of the cash flows within the payback period, cash flows after the end

of payback period, and the total project return.

2.2 The Net Present Value Method (NPV)

Net Present Value (NPV) OPTION 1 Net Present Value (NPV) OPTION 2
Years Net PV PV cash Years Net cash PV PV cash
cash factors flows flows factors flows
flows 8% 8%
0 1 (65,000) 0 1
(65,000) (85,000) (85,000)
1 0.926 (89,799) 1 0.926
(96,986) (93,786) (86,836)
2 0.857 (16,362) 2 0.857 (9,075)
(19,086) (10,586)
3 0.794 2,978 3 0.794
3,751 2,560 2,032
4 0.735 19,494 4 0.735
26,523 35,650 26,203
5 0.681 33,505 5 0.681
49,228 43,683 29,731
6 0.630 29,483 6 0.630
46,784 51,553 32,488
7 0.584 25,878 7 0.584
44,349 72,466 42,284
(59,824)
(48,173)
NPV = (59,824) NPV = (48,173)
Net

Present Value (NPV) is the value obtained by

discounting all cash outflows and inflows of a capital investment project by a chosen discount rate (target rate of

return) or cost of capital. The NPV method compares all present value of all the cash inflows from an investment

with the present value of all the cash outflows from the same investment, considers time value of money that a sum

of money received now is worth more than the same amount of money received in the future, considers all cash

flows in the investment unlike the payback period which only considers cash flows before the end of the payback

period. However, it’s a more sophisticated technique that may not be easily understood by especially non-financial

managers.

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A positive NPV means that the cash inflows from a capital investment will yield a return in excess of the cost of

capital and so the project should be undertaken if the cost of capital is the organization’s target rate of return. A

negative NPV means that the cash inflows from a capital investment will yield a return below the cost of capital and

so the project should not be undertaken if the cost of capital is the organization’s target rate of return. Therefore,

both options are not viable.

2.3 Internal rate of return method

Is used to calculate the exact discounted cash flow from yield or rate of return that a project is expected to achieve.

IRR is also the rate of return at which NPV is zero. If the expected rate of return or IRR exceeds the target rate of

return, the project is worth undertaking (ignoring the risk and uncertainty factors). It’s fairly easy to understand and

interpreted by non-financial managers. However, its complex to compute and thus it requires the use of an expert, it

ignores the relative size of investments and in case of non-conventional cash flow patterns and the IRR method can

yield multiple IRRs.

NPV=t=0∑n/(1+r) tCFt
Where:CFt=net after-tax cash inflow-outflows duringa single period tr=internal rate of return tha
t could be earned inalternative investmentst=time period cash flow is receivedn=number of indi
vidual cash flows

In the above case, all option’s IRR is below zero meaning that the IRR is below the Required rate of return of 8%
and the projects are not viable.

2.4 Average Rate of Return

ARR OPTION 2 ARR OPTION 1

Average accounting profit Average accounting profit

Net cash flows Net cash flows
1 (93,786) 1 (96,986)
2 (10,586) 2 (19,086)
3 2,560 3 3,751
4 35,650 4 26,523
5 43,683 5 49,228
6 51,553 6 46,784
7 72,466
7 44,349
TOTAL 101,540 TOTAL 54,564

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 ARR = 101,540/ 7 = 54564/ 7
= 14507 7,795
14507/85000 X 100 = 7795/65000 X 100
17% 12%
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of
the project's lifetime. Average investment may be calculated as the sum of the beginning and ending book value of
the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
Like payback period, this method of investment appraisal is easy to calculate and it recognizes the profitability
factor of investment. However, it ignores time value of money. Suppose if we use ARR to compare two projects
having equal initial investments. The project which has higher annual income in the latter years of its useful life may
rank higher than the one having higher annual income in the beginning years, even if the present value of the income
generated by the latter project is higher. It can be calculated in different ways. Thus, there is problem of consistency
and it uses accounting income rather than cash flow information. Thus, it is not suitable for projects which having
high maintenance costs because their viability also depends upon timely cash inflows.

Average Accounting Profit

ARR = 
Average Investment or Initial Outlay

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