Question

Project A Project & CHINA initial investment £15m 25% less than uk Revenue £6m per annual 10% less than uk operating cost £1. 2m per annual 50% less than ute Residual Value £um £um Project length bys Syrs 0 Calculate Payback and Average return for each project and make a recommendation to the board on which project to pick What impact would a 35% increase in the investment cast make in your decision ?

Answer 1

1) Pay Back Period is the length of time required for an investment to recover its initial outlay in terms of profits or savings.

2) The average rate of return is the average annual amount of cash flow generated over the life of an investment. This rate is calculated by aggregating all expected cash flows and dividing by the number of years that the investment is expected to last.

Part A
Statement showing calculation of Pay Back Period
		All amount is GBP '000s
	Project A	Project B
Initial Investment	15000	11250
Annual Revenue	6000	5400
Less: Annual Operating Cost	1200	600
Annual Net Operating Income	4800	4800
Add: Annual Depreciation	2200	1450
Annual Cash Operating Income	7000	6250
Pay Back Period (in years)	2.14	1.80
Average Rate of Return	47%	56%
Conclusion - Project B has a shorter Pay Back Period and higher ARR,
therefore a better choice over Project A, all other factors remaning unchanged
Working Notes:
A.Initial Investment	15000	11250
B.Residual Value	4000	4000
C.Net Depreciable Value (A-B)	11000	7250
D.Project Length	5	5
Depreciation per annum
in SLM (C / D)	2200	1450
Payback period = Investment required for the project/Net annual cash inflow
The net operating income is not equal to net cash operating income
because it has been obtained after taking into account the depreciation – a non-cash expense.
Part B
Assuming a 35% increase in project cost
A.Initial Investment	20250	15187.5
B.Residual Value	4000	4000
C.Net Depreciable Value (A-B)	16250	11187.5
D.Project Length	5	5
Depreciation per annum
in SLM (C / D)	3250	2237.5
Initial Investment	20250	15187.5
Annual Revenue	6000	5400
Less: Annual Operating Cost	1200	600
Annual Net Operating Income	4800	4800
Add: Annual Depreciation	3250	2237.5
Annual Cash Operating Income	8050	7037.5
Pay Back Period (in years)	2.52	2.16
Average Rate of Return	40%	46%
Conclusion - Project B has a shorter Pay Back Period and higher ARR,
therefore a better choice over Project A, all other factors remaning unchanged