Bongo Ltd. is considering the selection of one of two mutually exclusive project
ID: 2421070 • 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
1) To calculate the accounting rate of return: -
Project 1
ARR = average returns / average investement
ARR= (1,056,000 / 5) / (556,000/5)
ARR = 211,200/111,200
ARR = 189.92%
Project 2:
ARR for project 2 = Average returns / average investment
ARR for project 2 = $2,801,000/5 / $1,616,000/5
ARR for project 2 = 700250/323200
ARR for project 2 = 216.66%
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To find the net present value of Project 1:-
Present value of cash flows for project 1 = $ 311,200/1.151 + $ 311,200/1.152 + $ 311,200/1.153 + $ 311,200/1.154 + $ 367,200/1.155
Present value of cash flows for project 1 = 1071032.564
NPV of project 1 = -$556,000 + $ 1,071,032.564
NPV of project 1 = 515,033
Present value of cash flows for project 2 = $ 823,200/1.151 + $ 823,200/1.152 + $ 823,200/1.153 + $ 823,200/1.154 + 1,124,200/1.155
Present value of cash flows for project 2 = 2909144.274
NPV for project 2 = - $ -1,616,000 + $ 2909144.274
NPV for project 2 = $ 1,293,144
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To find the Internal rate of return: Project 1
Annuity of project 1= $1,056,000/5
Annuity of project 1= $ 211,200
Payback period = 556,000/$ 211,200
Payback period = 2.63
From the present value of annuity table ,the rate of return value corresponding to 2.63 = 26%
By Trial and error method
IRR = 25% + 206/11559
IRR for project 1 = 25.01 %
To find IRR for project 2 :
Annuity = 2,801,000/5
Annuity = $ 560,200
Payback period = 2.88 years
From the present value of annuity table ,the rate of return value corresponding to 2.88 years = 22%
IRR = 20% + 271 / 37,231
IRR for project 2 = 20%
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To find the payback period
Payback period for project 1 = 2 + (556,000 - 400,000)/ 200,000
Payback period for project 1 = 2.78 years
Payback period for project 2 = 3 + ( $1,616,000 - $ 1,500,000)/500,000
Payback period for project 2 = 3.232 years.
Year cash flows 0 -556,000 1 200,000 2 200,000 3 200,000 4 200,000 5 256,000 Total 1,056,000