Question

Manchestera ltd is considering the selection of one of a pair of mutually exclusive capital investement projects. Both would involve the purchase of machinery with a life of five years. Manchestera uses the straight-line method for calculating depreciation and its cost of capital is 15% per year.

Project 1 would generate annual net cash inflows of £400,000; the machinery would cost £1,112,000 and have scrap value of £112.000.

Project 2 would generate annual net cash inflows of £1,000,000; the machinery would cost £3,232,000 and have scrap value of £602,000.

In-class activity:

For each project, calculate:

1. Accounting rate of return (using the initial investment)
2. The payback period
3. Net present value

Answer 1

The exercise involves calculating three investment metrics for two mutually exclusive projects for Manchestera Ltd: the Accounting Rate of Return (ARR), Payback Period, and Net Present Value (NPV), considering the cost of capital at 15% per year.

Calculation of Project Investment Metrics

To compare the two mutually exclusive capital investment projects for Manchestera Ltd, we will calculate three key metrics for each project: Accounting Rate of Return (ARR), Payback Period, and Net Present Value (NPV).

Project 1

1. Accounting Rate of Return (ARR) is calculated using the formula: ARR = (Average Annual Profit) / Initial Investment. The average annual profit is the sum of annual net cash inflows minus annual depreciation.
2. The initial investment is the cost of machinery minus the scrap value.
3. Payback Period is the time it takes for the project to recoup its initial investment through cash inflows. It is calculated by dividing the initial investment by annual net cash inflows.
4. Net Present Value (NPV) assesses the profitability of a project by calculating the present value of its cash inflows discounted at a certain rate (the cost of capital) and subtracting the initial investment.

Project 2

1. ARR for Project 2 follows the same formula as Project 1, with the respective values for that project.
2. The Payback Period will also follow the same method of calculation as Project 1.
3. NPV for Project 2 is calculated similarly, using the specific cash inflows and cost details for Project 2.

To accurately compare the two projects, calculations for each metric must be carried out.

This will enable Manchestera Ltd to make an informed decision based on their specific cost of capital and the projected outcomes of each project.