Kongo & Sons is considering two mutually exclusive projects. Both need a initial cash outlay of Rs. 10,000 each, and have a life of five years. Company's required rate of return is 10 percent and pays tax ait a 50 per cent rate. The projects are gong to be depreciated on a straight line basis. The before taxes cash flows expected to be generated by the projects are as follows :
| Year | 1 | 2 | 3 | 4 | 5 |
| Project P (Rs.) Project Q (Rs.) | 4,000 6,000 | 4,000 3,000 | 4,000 2,000 | 4,000 5,000 | 4,000 5,000 |
Calculate for each project : 1) the payback (2) the average rate of return (3) the net present value and profitability index, and (4) the internal rate of return. Which project should be accepted and why?
1) PAYBACK PERIOD
Payback period is the period with in which the cumulative cas in flow is equal to
cumulative cash out flow
On the project. The payback period for the two projects are computed below:
| Year | For the year | Cumulative | For the year | Cumulative |
| 1 2 3 4 5 | 4000 4000 4000 4000 4000 | 4000 8000 12000 16000 20000 | 6000 3000 2000 5000 5000 | 6000 9000 11000 16000 21000 |
Initial cash out flow for both the project is each rs 10,000/-
Both the projects attain payback in 3rd year.
Assuming that cash inflow during the year arises uniforml,the exact payback period is
worked out below.
Payback period for project
= 2+( 10,000-8000)74000 = 2 ½ year paybak period for project a
=2+( 10,000-9000)72000 = 2 ½ year Thus payback period for both the projects is same; 2 '/2 year
2) AVERAGE RATE OF RETURN(ARR)
ARR is defined as annualised net income earned (i.e net profit after tax) on the average
funds invested
In the project.
ARR = average annual profit after tax/average investment in the project * 100
* Average investment in the project:
The follwing two approaches are adopted to calculated .the average investment.
a) Initial cash outlay:
| b) |
In the first approach, initial cash outflow (investment) is taken as average investment.
* Average investment after depreciation:* • ;
* Average investment after depreciation:* • ;
since, annual depreiation is charge as expense while computing annual net profit, the book value of the asset decreses over time. If the firm follows straight the method of depreciation and we also assume that solvage value after the endof the life of the project is zero; the average investent will be
!/2 * initial investment
| Year | Project p | Project q |
| 1 2 3 4 5 | 4000 4000 4000 4000 4000 | 6000 3000 2000 5000 5000 |
| Total | 20,000 | 21000 |
| 21,000/5 |
Average annual cash in flow 20000/5
| 42000 50% 2100 |
4000
tax rate 50%
average annual cash inflow after tax 2000
average annual cash inflow after tax 2000
hence project q is better
*When project are mutually exclusive*
It is given that the two projects are mutually exclusive. This means that selection of one
project, puts bar on selection of other project in addition to the project selected.
Based on ARR criterian project q should be selected.
3) NET PRESENT VALUE METHOD :
For the computing net present value a discounting rate of 10% is assumed taking the rate as given required rate of return
| Project—p |
project---q
| Year | Discounting factor @ 10% | Cash flow | Present . value | Cash flow | Present value |
| 1 2 3 4 5 | 0.90909 0.82645 0.75131 0.68301 0.62092 | 4000 4000 4000 4000 4000 | 3,636 3,305.8 3005.2 2732 2483.7 | 6000 3000 2000 5000 5000 | 5,454 ' 2479.4 1502.6 3415 3104.6 |
| Total | | | 15,162.7 | | 15,955.6 |
| 10,000 5955.6 |
| 10,000 51627' |
| Less : initial out lay Net present value |
| i |
Based on net present value method project q is selected. The project beings mutually exclusive,selection of project p.
PROFITABILITY INDEX:
=Present value of cash inflows/present value of cash outflow
for project p =15162.7/10,000-1.516
for project q -15955.6/10,000=1.596
hence project q will be selected
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