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The following information relates to two capital expenditure projects
The following information relates to two capital expenditure projects. Because of capital rationing, only one project can be accepted. Project A R800 000 5 years R40 000 Project B R920 000 5 years R60 000 Initial cost Expected life Expected scrap value Expected net cash inflows: End of year 1 2 3 4 5 R 320 000 280 000 260 000 240 000 220 000 R 400 000 280 000 200 000 200 000 200 000 Sebalina EXAMINER MODERATOR Page 5 of 7 Faculty of Management Sciences Department - Business Support Studies: Project Management Central University of Technology, Free State The company estimates its cost of capital is 12%. Depreciation is calculated using the straight-line method. Required 3.1 Calculate the payback period for project B. (Answer expressed in years and months) (10 marks) 3.2 Calculate the accounting rate of return for project A (Answer expressed to 2 decimal places) (3 marks)
Expert Solution
Answer 3.1)-
CALCULATION OF PAYBACK PERIOD OF PROJECT B-
| Year | CASH INFLOW BEFORE DEPRECIATION (A) | DEPRECIATION (B) | NET CASH INFLOW (A + B) | CUMULATIVE CASH INFLOW |
| 1 | 400000 | 172000 | 572000 | 572000 |
| 2 | 280000 | 172000 | 452000 | 1024000 |
| 3 | 200000 | 172000 | 372000 | 1396000 |
| 4 | 200000 | 172000 | 372000 | 1768000 |
| 5 | 200000 | 172000 | 372000 | 2140000 |
?Depreciation- (Initial cost - scrape value ) ÷ expected life
= (920000 - 60000)÷ 5 = 172000
??Pay back period = 1 + (920000 - 572000 ÷ 452000)
= 1 + 0.76 = 1.76 years
Pay back period for project B is 1.76 years.
Answer 3.2)-
CALCULATION OF ACCOUNTING RATE OF RETURN (ARR) FOR PROJECT A-
| YEARS | 1 | 2 | 3 | 4 | 5 | TOTAL |
| Cash inflow before depreciation | 320000 | 280000 | 260000 | 240000 | 220000 | 1320000 |
| Less- depreciation | 152000 | 152000 | 152000 | 152000 | 152000 | 760000 |
| Net cash inflow | 168000 | 128000 | 108000 | 88000 | 68000 | 560000 |
? Depreciation- (Initial cost - scrape value) ÷ expected life
= (800000 - 40000)÷5 = 152000
??Accounting rate of return = average income ÷ [1/2 ( initail investment + scrape value )]
= 112000 ÷ [1/2 ( 800000+ 40000)] ×100
=112000 ÷ 1/2(840000) ×100
=112000 ÷ 420000 × 100
=0.2667 ×100
= 26.67%
Accounting rate of return for project A is 26.67%.
? AVERAGE INCOME = Total net cash flow ÷ 5
= 560000 ÷ 5 = 112000
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