Bongo Ltd. is considering the selection of one of two mutually exclusive project
ID: 2454915 • 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
Explanation / Answer
NPV
Calculation of IRR for project 2
IRR is the discount rate at whicvh NPV is zero
Using Interpolation we get,
Payback period for project 1
= Initial cash outlay / cash flow per year (as cash flow per year is constant)
= 556000 / 200000
= 2.5 years
For most of the cases project 1 shows the better result except NPV criteria , for which project 2 is better.
However, as the projects are mutually exclusive, the choice of the project should be based on the NPV criteria, and based on that Project 2 should be chosen as it has a higher NPV than that of project 1.
ARR = Average Accounting profit / Avearge investment project 1 project 2 (a) Cost of the machine 556000 1616000 (b) Salvage Value 56000 301000 (c) Depreciable Value - (a - b) 500000 1315000 (d) Useful life in years 5 5 (e) Deprciation per year - c/d 100000 263000 (f) Average investment - (a+b) / 2 306000 958500 (g) Cash flows per year 200000 500000 (h) Depreciation per year 100000 263000 (i)Average Accounting profit per year - (g-h) 100000 237000 ARR - (i / f) x 100 % 33% 25%