Bongo Ltd. is considering the selection of one of two mutually exclusive project
ID: 2420097 • Letter: B
Question
Bongo Ltd. is considering the selection of one of two mutually exclusive projects. Both would involve purchasing machinery with an estimated useful life of 5 years.
Project 1 would generate annual cash flows (receipts less payments) of £200,000; the machinery would cost £556,000 with a scrap value of £56,000.
Project 2 would generate cash flows of £500,000 per annum; the machinery would cost £1,616,000 with a scrap value of £301,000.
Bongo uses straight-line depreciation. Its cost of capital is 15% per annum.
Assume that all cash flows arise on the anniversaries of the initial outlay, that there are no price changes over the project lives, and that accepting either project will have no impact on working capital requirements.
Assess the choice using the following methods by completing the calculations shown below:
ARR
NPV
IRR
Payback period
Calculate the missing answers:
ARR workings (Project 1)
These profits are the same each year in this question.
Annual depreciation (Cost – SV) / 5
Average NBV of investments
Be sure to demonstrate your workings.
Project 1 Project 2 ARR (see workings) 33% ??? NPV (£’000) ??? 210 IRR 25% ??? Payback Period (yrs) ??? 3.2Explanation / Answer
(All amounts in £ thousands) ARR workings (Project 1) ARR workings (Project 2) Cash flows 200 500 Less: depreciation (see below) 100 263 Accounting profits 100 237 These profits are the same each year in this question. Annual depreciation (Cost – SV) / 5 (556,000 – 56,000) / 5 100 ( 1,616,000-301,000) / 5 263 Average NBV of investments (556 + 56) /2 306 (1616+301)/2 958.5 ARR 33% 27% Be sure to demonstrate your workings. NPV for Project A With a cash profit per year of $ 500 thousand for five years, against an initial outlay of $ 1,616 thousand, the NPV for Project 2 works out to $ 165,398.40 With a cash profit per year of $ 200 thousand for five years, against an initial outlay of $ 556 thousand, the NPV for Project 1 works out to $ 120,557.71 Based on the cost of capital of 15%, the individual IRRs for the two projects will be Project 1 24.71% Project 2 19.48% The payback period for the two projects is the time frame within which the cost of the project is recovered Hence, for Project 1, the payback period will be 2.78 years or 2.8 years rounded off For Project 2, the payback period will be 3.232 years or 3.2 years rounded off