Question

3. Consider Table 2. Victoria Way Inc. is considering investing in Projects 1 and 2. The initial cost of Project l is €8,000 and E3,000 for Project 2. Each project lasts four years. Straight-line depreciation method is used. The minimum accounting rate of return is 10%. The discount rate is 10% for Project 1 and 20% for Project 2, and the depreciation rate is 25% for each project. NWC is "Net Working Capital". PROJECT 2 0 1,5001,5001,5001,500 16,000 16,000 16,00016,000 8,5008,5008,5008,500 7,500 7,5007,5007,500 5,000 5,000 5,000 5,000 2,000 2,0002,0002,000 Cost of Sales 0 1,0501,0501,0501,050 Depreciation Income Tax Net Income 3 -100-2,500500 (a) Consider Table 2. Calculate the cash flows for each project over the lifetime of each project. (b) Consider Table 2. Calculate the net present value for each project and rank the projects (c) Consider Table 2. Calculate the accounting rate of return for each project and rank the projects (d) Consider Table 2. Calculate the internal rate of return for each project and rank the projects (e) Assume for now that the firm can invest in a single project only. Based on your calculations performed in parts (b)- 2 (d) of this question, which project would you recommend Victoria Way Inc. to invest in and why?

Answer 1

(a)

In order to calculate cash flows, the net incomes for both projects need to be adjusted for two things: depreciation (non cash expense) and working capital changes. An increase in working capital is reduced from net income whereas a decrease is added.

(Why is working capital adjusted?) Working capital is defined as current assets minus current liabilities. A change in current assets or liabilities implies that money has been accounted for in the income statement but cash flow hasn't yet happened. For example, sales are of two types, cash sales and credit sales. In order to calculate cash flow, credit sales need to be subtracted from income statement because this cash has not yet been received. And to find out the amount of credit sales in a period, you have to look at the increase in accounts receivables which is a current assets account. So, an increase in current assets is reduced while calculating cash flow. Similarly other adjustments are made for current liabilities as well.

Cash flow calculation:

Cash flow in the above excel is calculated simply by adding depreciation and change in NWC to Net income.

(b)

Net present value: It is the sum of all cash flows in a project when discounted using the appropriate discount rate. (cash outflows are subtracted and cash inflows are added)

Present values are calculated as:

$P_{v}=\frac{Cash Flow}{(1+discount rate)^{period}}$

So for example, for period 1, Project 1; cash flow is calculated as:

$P_{v}=\frac{2,300}{(1+0.1)^{1}}=2090.909$

And, finally NPV is calculated by just summing all the above calculated present value cash flows (initial investment is subtracted, hence the negative sign).

(c)

Accounting rate of return is simply the average profit earned over the life of the project as a percentage of the initial investment.

$Accounting\: rate\: of\: return=\frac{Average\: profit}{Net \: initial\: investment}$

(d)

Internal rate of return is that rate at which the Net present value of a series of cash flows becomes zero. It can be calculated in excel using goal seek function.

In the above excel, present value of cash flows is calculated as explained in part (b). After that NPV are calculated by summing these present values. Now, we use goal seek to set Net Present value cell to 0 by changing the IRR. This will give you the rate of return at which NPV is zero.

(e)

Project 1 gives a higher internal rate of return and also it also has a positive Net present value. So, this project should be preferred.