Question

Deciding between three projects A company owned exclusively by residents in the Queensland coastal community of Noosa are offered three projects for which the cash flows are as follows in thousands of dollars. The directors work on 12 per cent as their RRR. Assume all cash flows occur at the end of the relevant years. There are no salvage values factored into the expected cash flows, and no salvage values are expected. Project A B C Year 0 -400 - 300 -320 Year 1 200 80 400 Year 2 160 80 20 Year 3 200 140 20 Year 4 120 160 20 Year 5 40 160 200 Required a. Calculate the four investment appraisal measures for each project. b. Rank the projects and advise the directors which projects, if any, to accept. Give your reasons.

Answer 1

ANSWER

a).

There are many investment appraisal measures. Since, the measures are not mentioned specifically, the four most commonly used ones, NPV, IRR, payback period and ARR (accounting rate of return)

Formula	Year (n)	0	1	2	3	4	5
	Project A cash flows (CFA)	-400	200	160	200	120	40
Using NPV function	NPV	147.44
Using IRR function	IRR	28.83%
Sum of all CFA's/life	Annual profit (AP)	64.00
-CFA0/2	Average investment (AI)	200
AP/AI	ARR	32.00%
CCFn-1 + CFAn	Cumulative Cash Flow (CCF)	-400	-200	-40	160	280	320
(-CCF2/CFA3) + 2	Payback period (in years)				2.20
Formula	Year (n)	0	1	2	3	4	5
	Project B cash flows (CFB)	-300	80	80	140	160	160
Using NPV function	NPV	127.32
Using IRR function	IRR	25.68%
Sum of all CFB's/life	Annual profit (AP)	64.00
-CFB0/2	Average investment (AI)	150
AP/AI	ARR	42.67%
CCFn-1 + CFBn	Cumulative Cash Flow (CCF)	-300	-220	-140	0	160	320
(-CCF2/CFB3) + 2	Payback period (in years)				3.00
Formula	Year (n)	0	1	2	3	4	5
	Project C cash flows (CFC)	-320	400	20	20	20	280
Using NPV function	NPV	238.91
Using IRR function	IRR	50.69%
Sum of all CFB's/life	Annual profit (AP)	84.00
-CFB0/2	Average investment (AI)	160
AP/AI	ARR	52.50%
CCFn-1 + CFBn	Cumulative Cash Flow (CCF)	-320	80	100	120	140	420
(-CCF0/CFC1)	Payback period (in years)		0.80

b).

Analyzing the four investment appraisal methods for the three projects, we can see that the best project is project C as it has the highest NPV and the highest IRR. Usually, ARR and payback methods are not used for ranking projects as they do not take the time value of money into consideration. Even among, NPV and IRR, preference is given to NPV as it has the assumption that the cash flows are reinvested at the cost of capital rate which is a conservative assumption and better than the IRR assumption that reinvestments happen at the IRR rate.

So, based on NPV, the rankings will be:

1 - Project C

2 - Project A

3 - Project B

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