Presented is information pertaining to the cash flows of three mutually exclusiv

Question

Presented is information pertaining to the cash flows of three mutually exclusive investment proposals:

(1) Select the best investment proposal using the payback period, the accounting rate of return on initial investment, and the net present value criteria. Assume that the organization's cost of capital is 12 percent.

Round accounting rate of return four decimal places. Round net present value to the nearest whole number. Use negative signs with your answers, when appropriate.

Proposal A Proposal B Proposal C Initial investment $ 45,000 $ 45,000 $ 45,000 Cash flow from operations Year 1 40,000 22,500 45,000 Year 2 5,000 22,500 Year 3 22,500 22,500 Disinvestment 0 0 0 Life (years) 3 years 3 years 1 year

Explanation / Answer

Proposal A Cash flow PVF @ 12% PV of Cash flow Cumulative Cash flow Initial Investment         -45,000 1         -45,000 Cash flow : Year 1          40,000               0.89          35,714             35,714 Year 2             5,000               0.80             3,986             39,700 Year 3          22,500               0.71          16,015             55,715          22,500          10,715 Payback period = 2 + (45000-39700/16015) Payback period = 2 + 0.33 = 2.33 years ARR = Average accounting profit / Average investmet ARR = ((35714+3986+16015)/3) / 45000 = 41.27% NPV = -45000+35714+3986+16015 = 10715 Proposal B Cash flow PVF @ 12% PV of Cash flow Cumulative Cash flow Initial Investment         -45,000 1         -45,000 Cash flow : Year 1          22,500               0.89          20,089             20,089 Year 2          22,500               0.80          17,937             38,026 Year 3          22,500               0.71          16,015             54,041          22,500             9,041 Payback period = 2 + (45000-38026/16015) Payback period = 2 + 0.44 = 2.44 years ARR = Average accounting profit / Average investmet ARR = ((20089+17937+16015)/3) / 45000 = 40.03% NPV = -45000+20089+17937+16015 = 9041 Proposal C Cash flow PVF @ 12% PV of Cash flow Cumulative Cash flow Initial Investment         -45,000 1         -45,000 Cash flow : Year 1          45,000               0.89          40,179             40,179 Year 2                    -                 0.80                    -               40,179 Year 3                    -                 0.71                    -               40,179                    -             -4,821 Payback period = No payback period ARR = Average accounting profit / Average investmet ARR = 40179 / 45000 = 89.29% NPV = -45000+40179 = -4821

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