Finаnсiаl Маnаgеmеnt аnd СоntrоlPart AAdvice the management of Thomson LtdPay Back Period (PBP)The method measures the span of time necessary to recoupr the amount of money invested in a project. The PBP is determined by adding up the cash inflows from year one until the sum cash inflow is equal to the amount invested. Pay back period = Initial investment Annual cash flow income = 300,000 80,000 =3 years 9 monthsA PBP of less than 4 years indicates that the project will pay itself at the end of its lifespan.
Therefore the project should be adopted. Net Present Value (NPV)This method is a discounted cash flow to capital budgeting whereby all expected future cash flows/incomes are discounted to their present values using a minimum desired. NPV is the excess of the present value of cash inflows generated by the project over the amount invested in the project, expressed by PV-I=NPV, where PV is the Present Value and I is the Investment Net present Value (NPV) = Annual cash inflows x Present value annuity factorPV = 80,000 x 3.1699 = 253,592NPV=PV-I= 253,592 -300,000=(46,408)The NPV is negative; hence the project should be rejected. Project is accepted if the PV of future cash flows exceeds the amount invested giving a positive net present value. Accounting Rate of Return (ARR) ARR measures the profitability of a project from the conventional accounting point of view.
ARR is found by dividing the after tax profit/income by average investment. Average investment is equivalent to a half of the original investment. If depreciated constantly ARR is found by dividing the total of investment book value after depreciation by the life of the project. ARR = Average Income x 100Average InvestmentAverage Income = Total revenues expected + amount realized after disposal of asset= (80,000 x 4) + 60,000)= 380,000Average Investment = 300,000 + (10/100 x 300,000)=330,000ARR = 380,000 x 100330,000=115.15 %The results using this method indicate an average rate of return above 100%, therefore the project should be undertaken. Internal Rate of Return (IRR)IRR method takes into account the discount rate taking into account the adjustment in time at a discount rate of 15%YearPV factorCash inflowPV of project1.0000(380,000)380,0000.870080,00069,6000.75680,00060,4800.65880,00052,6400.57280,00045,760228,480Discounted cash inflow = 228,480 + (60,000 x 0.572) = 268,800Discounted Investment = 330,000 x 1.0000 = 330,000IRR = Discounted average incomeDiscounted average investment=268,800/330,000 x 100=81.45%The results here indicate an internal rate of return of less than 100%; therefore the project should be rejected. Critically comment on the results you obtained in (a) above referring to the pros and cons of each evaluation method. Despite the fact that the PBP handles investment risk effectively and costs less in terms of time and may not involve sophisticated techniques, it has the disadvantage of not recognizing the time value of money.
The method does not take into account the interest rate of 10% regarding the cost of capital and the amounts to be realized after disposal.
PBP also ignores cash flows arising after the PBP and any accountant knows that it is the cash flows after PBP which determines the profitability of an investment. A project should be accepted in this approach if its NPV is positive and rejected if it is negative. In case of ranking projects, the NPV method gives the highest ranking to a project with the highest Net present value.
The method however fails to take into account the cash inflows realized from disposing the machine which is 20% of the initial cost of capital. Failure to do this leads to an inaccurate evaluation of the viability of the project since it may change the balance.