Tutorial 6

Chengruizhi Ma
a) Payback Period
• The payback period refers to the amount of time it takes to recover the cost of an investment.
Simply put, the payback period is the length of time an investment reaches a breakeven point.

• Project A: Initial investment= 500,000

• In the first two years, the 420,000 has been recovered

• The remaining 80,000 investment is recovered in Year 3, we have to estimate the time when
company receives this 80,000 in Year 3.

• We simply use 80,000/250,000 = 0.32 Years

• The payback period is around 2.32 years

 a)Payback period
• Project B:
• The initial investment is 800,000.
• The 780,000 of investment has been recovered in the first three years.
• The remaining 20,000 will be recovered in Year 4, we have to estimate
the time when company receives this money in Year 4
• 20,000/450,000 = 0.04 Years
• The payback period is around 3.04 Years
b)ARR
• ARR= average profit/initial investment
• Project A:
• Profit= (200,000+220,000+250,000+280,000)- 500,000= 450,000
• Average profit= 450,000/4= 112,500
• ARR= 112,500/500,000= 22.5%
• Project B:
• Profit= (250,000+180,000+350,000+450,000)-800,000= 430,000
• Average profit= 430,000/4=107,500
• ARR= 107,500/800,000= 13.44%
b) ARR Average method
• ARR= average accounting profit/average investment
• Project A:
• Average accounting profit= 112,500
• Average investment= 500,000+0/2=250,000
• ARR= 112,500/250,000= 45%
• Project B:
• Average accounting profit= 107,500
• Average investment: 800,000+0/2=400,000
• ARR= 107,500/400,000= 26.88%
c) NPV

• The formulas:

• The initial investment+ Present Value of all future cash flows

• PV of future cash flows= future cash flow*Discount factor (found in the table)
c) NPV
• Project A:
• (500,000)+200,000*0.926+220,000*0.857+250,000*0.794+280,000*0
.735
• =278,040
• Project B:
• (800,000)+250,000*0.926+180,000*0.857+350,000*0.794+450,000*0
.735
• =194,410
d)Which project you recommend

• Project A

• It has shorter payback period

• It has higher ARR and NPV

 e) Payback Period
• Advantages:
• Shorter term forecasts
• The calculation process is quicker than and simple than any other
appraisal techniques
• This is a very easily understood concept
• Disadvantages:
• Ignores the time value of money: The most serious disadvantage of the
payback method is that it does not consider the time value of money.
• Neglects cash flows received after payback period
• Identical payback period
e) ARR
• Advantages:
• This method recognizes the concept of net earnings i.e. earnings after tax and
depreciation. This is a vital factor in the appraisal of a investment proposal.
• This method gives a clear picture of the profitability of a project.
• Disadvantages:
• This method ignores time factor. The primary weakness of the average return
method of selecting alternative uses of funds is that the time value.
• It does not taken into the consideration of cash inflows which are more
important than the accounting profits.
• There are two methods to calculate the ARR: different firms may use different
approaches
 e) NPV
• Advantages:
• 1. A project with a positive NPV increases the wealth of the company’s, thus maximise the
shareholders wealth.
• 2. Takes into account the time value of money and therefore the opportunity cost of capital.
• 3. Unlike the payback period, the NPV takes into account events throughout their life of the
project.
• Disadvantages:

• 1. Determination of the correct discount rate/factor can be difficult.

• 2. Non-financial managers may have difficulty understanding the concept.
• 3. NPV assumes cash flows occur at the beginning or end of the year, in reality, it is not
always the case.