An Accounting and investment techniques project

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'A means of assessing whether an investment project is worthwhile or not' http://www.bized.co.uk Investment appraisal is all about assessing those income streams against the cost of investment' http://www.bized.co.uk

Therefore, it had value to the business entity because it enables Company to decide on various projects. i.e it enables company to make Accept or Reject decision.

'It enables the company to examine the viability or otherwise of a project' (Adeniyi A. Adeniji, 2004 p.415)

QUESTION B:

(i) To calculate the Pay back period for Project A:

YEAR DISCOUNTING CUMMULATIVE

CASH FLOW CASH FLOW

1 22 22

2 31 53

3 43 96

4 52 148

5 71 219

Therefore since we have different cash flows for each year the Pay Back Period will be:

3years + 29 = 3.1years

52

SALAU, GANIYU OLANREWAJU L0814FKFK0210

(ii)To calculate the Payback period for Project B:

YEAR DISCOUNTING CUMMULATIVE

CASH FLOW CASH FLOW

1 43 43

2 43 86

3 43 129

4 43 172

5 43 ` 215

Since all the cash flows are the same throughout the years it is preferable to use the Annuity method of calculating NPV

= 2+ 39 = 2. 1years

43

Project B should be accepted because it is below the targeted period set by the company for the payback period.

QUESTION C:

The following are the criticism of the pay back period:

It does not always give a reliable decision since it ignores the time value of money

'Payback period ignores cash flows immediately after the payback period' (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

'The approach ignores the wealth maximization objective of the organisation's (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

'The approach ignores the effect of inflation on the actual cash flow' (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

'Unable to distinguish between projects with same payback period' (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

QUESTION D:

To calculate the NPV of Project A

YEAR NET CASH FLOWS DISCOUNT RATE PRESENT VALUE

12%

1 22 0.893 19.646

2 31 0.797 24.707

3 43 0.712 30.616

4 52 0.636 33.072

5 71 0.567 40.257

NET PRESENT VALUE AT 12% 23.298

To calculate the Net Present Value of Project B

YEAR NET CASH FLOWS DISCOUNT RATE PRESENT VALUE

12%

1 43 0.893

2 43 1.668

3 43 2.361

4 43 2.974

5 43 3.517

Net Present Value at 12% = 43,000* 3.605-125,000

= 155,015-125,000

Therefore the Net Present Value at 12% = 30,015

Project B should be accepted based on the fact it has the highest NPV and therefore is the

best option.

QUESTION E:

'The Net Present Value is the value obtained by discounting all cash outflows and inflows of

a capital investment project by a chosen target rate of return or cost of capital'. (Adeniyi A.

Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 424)

'It therefore compares the present value of all cash inflows from an investment with the

present value of all the cash outflows from an investment' (Adeniyi A. Adeniji (2004),

Management Accounting, ThirdEdition,Nigeria Page 425)

'If the NPV is positive, it means that the cash inflows from a capital investment will yield a

return in excess of the cost of capital, and so the project should be undertaken if the cost of

capital is the organisation's target rate Of return'. (Adeniyi A. Adeniji (2004), Management

Accounting, Third Edition, Nigeria, Page 426)

'If the Net Present Value is negative it means that the cash flows from a capital investment

will yield a return below the cost of capital, and so the project should not be undertaken if the

cost of capital is the organisation's target rate of return' (Adeniyi A. Adeniji (2004),

Management Accounting, Third Edition, Nigeria, Page 426)

'If the NPV is exactly zero, the cash inflows from a capital investment will yield a return

which is exactly the same as the cost of capital, and so if the cost of capital is the

organisation's target rate of return, the project will be only just worth undertaken'. (Adeniyi

A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 426)

QUESTION F:

If the cost of capital increases the Net present value decreases and moves or tends towards a negative value.

If the cost of capital decreases the Net present value increases and moves or tends towards a positive value.

QUESTION G:

YEAR ` NET CASH FLOWS DISCOUNT PRESENT VALUE

RATE AT 17%

1 22 0.855 18.810

2 31 0.731 22.661

3 43 0.624 26.832

4 52 0.534 27.768

5 71 0.456 32.376

128.447

Less Initial Investment 125.000

Net Present Value 3.447

YEAR ` NET CASH FLOWS DISCOUNT PRESENT VALUE

RATE AT 20%

1 22 0.833 18.326

2 31 0.694 21.514

3 43 0.579 24.897

4 52 0.482 25.064

5 71 0.402 28.542

118.343

Less Initial investment 125.000

(6.657)

Therefore, the closer our Net present values are to zero, the closer our estimate will be to the true internal rate of return.

We shall now use the two Net present value calculated earlier to estimate the internal rate of return.

Net present value at 17% for project A = 3.447, at 20% for project A = (6.657)

The formula to apply is:

Rate of return = A + [ P * (B-A)]

P+N (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

Where A is the lower rate with a positive Net present value

B is the higher rate with a negative Net present value

P is the amount of positive Net present value

N is the amount of the Negative Net present value

Internal Rate of return = 17%+ [ 3.447 * (20-17)] %

3.447+6.657

= 17% + 3.447 * 3%

10.104

= 17% + 1.023

= 18.023%

PROJECT B:

YEAR ` NET CASH FLOWS DISCOUNT PRESENT VALUE

RATE AT 17%

1 43 0.854

2 43 0.731

3 43 0.624

4 43 0.533

5 43 0.456

3.199

At 17% = 43.000 * 3.199 - 125.000

= 137.557 - 125.000

= 12.557

Since we have a positive Net present value at 17% let us try at 20% =

YEAR ` NET CASH FLOWS DISCOUNT PRESENT VALUE

RATE AT 20%

1 43 0.833

2 43 0.694

3 43 0.579

4 43 0.482

5 43 0.402

2.991

At 20% = 43.000 * 2.991 - 125.000

= 128.613 - 125.000

= 3.613

Since we are a little closer to a Negative value let us try 25%

YEAR ` NET CASH FLOWS DISCOUNT PRESENT VALUE

RATE AT 25%

1 43 0.800

2 43 0.640

3 43 0.512

4 43 0.409

5 43 0.328

2.689

At 25% = 43.000 * 2.689 - 125.000

= 115.6528-125.000

= (9.3472)

We shall now use the two Net present value calculated earlier to estimate the internal rate of return.

Net present value at for project B = 3.613 at 20%, at 25% = (9.3472)

The formula to apply is:

Rate of return = A + [ P * (B-A)]

P+N (Adeniyi A. Adeniji (2004), Management Accounting, Third Edition, Nigeria, Page 423)

Where A is the lower rate with a positive Net present value

B is the higher rate with a negative Net present value

P is the amount of positive Net present value

N is the amount of the Negative Net present value

Internal Rate of return = 20%+ [ 3.613 * (25-20)] %

3.613+9.347

= 20% + 3.613 * 5%

12.960

= 20% + 0.0139

= 20.013%

Therefore, since the Internal rate of return investment rules states that where the internal rate of return exceeds the cost of capital we should accept the project, so project B with greater percentage of internal rate of return than project A should be accepted.

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