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Mason Co. is evaluating two alternative investment proposals. Below are data for each proposal: The following information was taken from present value tables: All revenue and expenses other than depreciation will be received and paid in cash. The company uses a discount rate of 12% in evaluating all capital investments. Compute the following for each proposal (round payback period to the nearest tenth of a year and round return on average investment to the nearest tenth of a percent): (f) Based on your analysis, which proposal appears to be the best investment?
Expert Answer
a)Annual net cash flow:
Annual net cash flow for Proposal A=(Net Income) +Depreciation (non cash expense)
Depreciation =(Initial investment-Salvage value)/useful life
Depreciation=(84000-4000)/5=$16,000
Annual net cash flow for Proposal A=(8200+16000)=$24,200
Annual net cash flow for Proposal B=(Net Income) +Depreciation (non cash expense)
Depreciation =(Initial investment-Salvage value)/useful life
Depreciation=(96000-0)/6=$16,000
Annual net cash flow of Proposal B=(8000+16000)=$24,000
b)Pay back period
Pay back period is the period when the initial investment is recovered
Payback period of proposal A=84000/24200=3.47 years
Payback period of proposal b=96000/24000=4 years
c)Average Investment:
Average investment=(Initial investment +Scrap value)/2
Average investment Proposal A=(84000+4000)/2=$44,000
Average investment Proposal B=(96000+0)/2=$48,000
d)Return on average investment:
Return on average investment =Net annual income/Average investment
Return on average investment of Proposal A=8200/44000=0.1864=18.64%
Return on average investment of Proposal B=8000/48000=0.1667=16.67%
e)Net Present value:
Net Present value(NPV) of Proposal A;
Present Value (PV) of Salvage value=4000*0.567=$2,268
PV of annual net cash flow=24200*3.605=$87,241
Net Present value(NPV) of Proposal A=2268+87241-84000=$5,509
Net Present value(NPV) of Proposal B;
Present Value (PV) of Salvage value=0
PV of annual net cash flow=24000*4.111=$98,664
Net Present value(NPV) of Proposal B=0+98664-96000=$2,664
| Proposal A | Proposal B | ||
| a) | Annual net cash flow | $24,200 | $24,000 |
| b) | Pay back period in years | 3.47 | 4.00 |
| c) | Average Investment | $44,000 | $48,000 |
| d) | Return on average investment | 18.64% | 16.67% |
| e) | Net Present Value(NPV) | $5,509 | $2,664 |
(f) Based on the above analysis Proposal A appears to be best , because:
- Higher NPV
- Lower investment
- Higher return on average investment
- Lower pay back period
