Question

3. End of year 0 New factory (15.0) 4.5 4.5 6.5 6.5 10% discount factors: Year 1: 0.91 Year 2:0.83 Year 3: 0.75 Year 4: 0.68 (a) Using data in Appendix A, calculate for the factory project: (i) The Average Rate of Return (ARR) [4] (ii) The Discounted Payback period. [4] (b) Comment briefly on the likely accuracy of the net cash flow data in Appendix A. [4]

Answer 1

a)

i) The Total net csh inflow after four years = (4.5+ 4.5 +6.5+ 6.5 )= 22

Cash outflow at year 0 = 15

Total profit = 22 - 15 =7

Profit per year = 7/4 = 1.75

Average rate of return (ARR) = (Profit per year/ initial capital outflow) *100

= (1.75 / 15 )* 100

= 11.67 %

ii)

Year	Cash Flow(CF)	Pv Factor(Pv)	CF*Pv	Cumulative CF
0	-15	1	-15.00	-15.00
1	4.5	0.91	4.10	-10.90
2	4.5	0.83	3.74	-7.16
3	6.5	0.75	4.88	-2.28
4	6.5	0.68	4.42	2.14

From the table we can see the discounted payback is between 3 & 4 years

Hence , discounted payback = 3 + 2.28/4.42= 3.51584 years or 3 years and ( 0.51584*12= ) 6.19 months

b)

Net cash flow is the total cash inflow minus the initial cash outflow of the project.

Here the cash flows are forecasted . The cash flows could be forecasted using market research about fellow competitors or other industry averages. However we can see that the cash inflows of year 1 & 2 are same and year 3 & 4 are also same. So it is assumed that there will be no significant growth in revenue in the 2nd year fron the 1st year and also in the 4th year from the 3rd year.

So it looks like the estimated cash inflows are not that much reliable as certain factors may not have been considered like opening of a new line of business, changes in operating costs or certain other factors. Normally the growth is assumed to be higher in the first few years and then it grows at a constant rate after the initial period. However the growth remaining constant in the 2nd and 4th year must be due to some overlooking of forecasted data.