PROBLEM 1
A company is considering the following investment projects:
Cash Flows)
Projects
Co
C₁
C₂
C3
A
- 10,000
+ 10,000
B
- 10,000
+ 17,500
+ 7,500
C
- 10,000
+ 12,000
+ 4,000
+ 12,000
D
- 10,000
+ 10,000
+ 3,000
+ 13,000
(@Rank the project according to each of the following methods: () Payback, (ii) ARR, (ii) IRR and (iv) NPV; assuming discount rates of 10 and 30 per cent.
(Assuming the projects are independent, which one should be accepted? If the projects are mutually exclusive, which project is the best?
Answers
Answer:
ii) ARR
Explanation:
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Payback period method:
Project A: 1 year (10,000 / 10,000)
Project B: 1.57 years (10,000 / 17,500 + 7,500)
Project C: 2 years (10,000 / 12,000 + 4,000)
Project D: 1.86 years (10,000 / 10,000 + 3,000 + 13,000)
(ii) Accounting rate of return (ARR) method:
ARR = Average annual income / Initial investment x 100%
Project A: 0% (-10,000 / 1 x 100%)
Project B: 75% ((17,500 + 7,500) / 2 / 10,000 x 100%)
Project C: 60% ((12,000 + 4,000) / 2 / 10,000 x 100%)
Project D: 63.33% ((10,000 + 3,000 + 13,000) / 3 / 10,000 x 100%)
(iii) Internal rate of return (IRR) method:
Using a financial calculator or spreadsheet, the IRR for each project is calculated as follows:
Project A: 0%
Project B: 39.2%
Project C: 27.1%
Project D: 29.3%
(iv) Net present value (NPV) method:
NPV = Sum of present values of cash flows - Initial investment
Using a discount rate of 10%:
Project A: 0 (-10,000 + 10,000 / 1.1^1)
Project B: 3,821.9 (-10,000 + 17,500 / 1.1^1 + 7,500 / 1.1^2)
Project C: 3,020.7 (-10,000 + 12,000 / 1.1^1 + 4,000 / 1.1^2 + 12,000 / 1.1^3)
Project D: 3,395.5 (-10,000 + 10,000 / 1.1^1 + 3,000 / 1.1^2 + 13,000 / 1.1^3)
Using a discount rate of 30%:
Project A: 0 (-10,000 + 10,000 / 1.3^1)
Project B: 2,873.0 (-10,000 + 17,500 / 1.3^1 + 7,500 / 1.3^2)
Project C: 1,822.9 (-10,000 + 12,000 / 1.3^1 + 4,000 / 1.3^2 + 12,000 / 1.3^3)
Project D: 1,942.8 (-10,000 + 10,000 / 1.3^1 + 3,000 / 1.3^2 + 13,000 / 1.3^3)
Based on the ranking of each method:-
Payback period: A > D > B > C
ARR: B > D > C > A
IRR: B > D > C > A
NPV (10%): B > D > C > A
NPV (30%): B > C > D > A
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