Investment Appraisal Measures and Capital Allocation Decisions

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PART A
The requisite computations are shown below.
1) ARR Computation (Project 2)
Annual cash flows =£ 500,000
Annual depreciation = (1616000-301000)/5 = £263,000
Hence, annual accounting profits = Cash flow – Depreciation = 500,000 -263,000 = £237,000
Average book value = (Initial cost + Scrap value)/2 = (1616000 + 301000)/2 =£958,500
Hence, ARR for project 2 = (237000/958500)*100 = 25%
2) NPV Computation (Project 1)
Net cash inflow in year 0 = -£556,000
Net cash inflow in year 1 = £200,000
Net cash inflow in year 2 = £200,000
Net cash inflow in year 3 = £200,000
Net cash inflow in year 4 = £200,000
Net cash inflow in year 5 = £200,000 + £56,000 = £256,000
Cost of capital = 15% p.a.
Hence, NPV (Project 1) (£ 000’s) = -556 + (200/1.15) + (200/1.152) + (200/1.153) +
(200/1.154) + (256/1.155) = 142
3) IRR Computation (Project 2)
Net cash inflow in year 0 = -£1,616,000
Net cash inflow in year 1 = £500,000

Net cash inflow in year 2 = £500,000
Net cash inflow in year 3 = £500,000
Net cash inflow in year 4 = £500,000
Net cash inflow in year 5 = £500,000 + £301,000 = £801,000
IRR is defined as the discount rate for which NPV is zero. Let the IRR be X%.
Hence, 0 = -1616 + (500/(1+X)) + (500/(1+X)2) + (500/(1+X)3) + (500/(1+X)4) +
(801/(1+X)5)
Solving the above, we get X = 20%
Therefore, the IRR for project 2 is 20%.
4) Payback Period (Project 1)
Initial investment = £ 556,000
Cash inflows during the first two years = £200,000 + £200,000 = £400,000
Remaining investment to be recovered = £ 556,000 - £400,000 = £156,000
Time required in the third year to recover the remaining investment = (156000/200000)= 0.8
Hence, payback period for project 1 is 2.8 years
Based on the above computations, the completed table is shown below.
PARTICULARS Project 1 Project 2
ARR 33% 25%
NPV(£’000) 142 210
IRR 25 20
Payback period (years) 2.8 3.2
Based on NPV, Project 2 should be selected. Based on the other parameters, Project 1 should
be selected (Berk et. al.,2016)