Question

3. The Bar The Banana Company is considering a project of buying a machine at $4,300. The machine, with an economic life of three-year, can generate a year end cash flow of $1,200 in year one and two respectively, as well as $3,000 in year three. Assume that the required rate of return is 12% per year. Determine the Discounted Payback (in fractional year) and Profitability Index of the project. Should the project be taken assuming the preset cut-off discounted payback year is 3 years? Would your decision be affected if you get a positive Average Accounting Return? (20 marks)

Answer 1

Year	Cash flow	Present value formula	Present value	Cumulative Present value
0	-4300	-4,300.00	-4,300.00	-4,300.00
1	1200	=1200/(1+12%)^1	1,071.43	-3,228.57
2	1200	=1200/(1+12%)^2	956.63	-2,271.94
3	3000	=3000/(1+12%)^3	2,135.34	-136.60
		NPV	-136.60
Present value of project = 1071.43+956.63+2135.34
Present value of project = 4163.4
Profitability index = PV of future cash flows / Initial investment
Profitability index = 4163.4 / 4300
Profitability index = 0.97
Cumulative cash flow show that in year 3 there is $ 136 remains which means discounted payback period is more than 3 years. The profitability index is 0.97 which is lower than 1. So, If cut-off discount payback period is 3 years we can not undertake this project also as profitability index below 1 project can not be undertaken
Yes our decision would have affected If we get positive returns