BHM201 Net Present Value and Accounting Rate of Return: Project Evaluation Assessment 1 Answer
Answer
ASSESSMENT 1: PART D
Project evaluation – Net Present Value (NPV) & Accounting Rate of Return (ARR)
Answer:
- i) Accounting Rate of Return for both the Café and gym projects
ARR is the measure of return with respect to the initial investment cost. It is calculated as the percentage of average annual profit to initial investment.
| Increased profit | ||
| Year | Café | Gym |
| 1 | $64,000 | $25,000 |
| 2 | $49,000 | $35,000 |
| 3 | $34,000 | $55,400 |
| 4 | $19,000 | $72,400 |
| 5 | $19,000 | $50,000 |
| Average Annual profit | $37,000 | $47,560 |
| Initial Investment | $350,000 | $350,000 |
| ARR | 10.57% | 13.59% |
ii) Net Present Value (NPV) for both the Café and gym projects
| café | Gym | ||||
| Year | PV Factor @ 12% | Net cash flows | PV of cash flows | Net cash flows | PV of cash flows |
| 1 | 0.89286 | $101,000 | $90,179 | $47,000 | $41,964 |
| 2 | 0.79719 | $91,000 | $72,545 | $61,000 | $48,629 |
| 3 | 0.71178 | $71,000 | $50,536 | $73,000 | $51,960 |
| 4 | 0.63552 | $63,000 | $40,038 | $93,000 | $59,103 |
| 5 | 0.56743 | $45,000 | $25,534 | $120,000 | $68,091 |
| 5 (salvage value) | 0.56743 | $125,000 | $70,928 | $150,000 | $85,114 |
| Total cash inflows | $496,000 | $349,760 | $544,000 | $354,862 | |
| Initial Investment | 1.0000 | $350,000 | $350,000 | $350,000 | $350,000 |
| NPV (PV of inflows - PV of investment) | -$240 | $4,862 | |||
- b. Using your results for the NPV project evaluation method, apply the decision rule to suggest which project makes more financial sense.
Answer:
The NPV evaluation method uses the present value of cash flows to evaluate the investment. The NPV is = Present value of cash inflows – PV of cash outflows
The project is profitable and should be accepted if the NPV is more than Zero. This shows that the project will add to the net worth of the organization. At NPV zero the project will result in break-even point with no profit and loss. At NPV less than Zero the project will reduce the net worth of the organization and hence should not be accepted (CFI-NPV, 2020).
From the above table it is seen that NPV of café is -$240 and NPV of Gym, is $4,862. Since the NPV of Gym is positive and NPV of café is less than Zero, Investment in Gym is profitable should be acceptable.
- c. Outline two (2) weaknesses of using the Accounting Rate of Return (ARR) for determining which project to invest in.
Answer:
Weaknesses of using ARR are:
- The method ignores the time value of money in evaluating the investments. Time value of money plays a very important role in investment profit because a dollar earned today is more worth than dollar earned tomorrow. Therefore the method might prefer the project having higher returns at the end of the life cycle where as in actual the real value of the profits will be less (CFI-ARR, 2020).
- The method considers the accounting profit and ignores the cash flows. The accounting profits are affected by various factors like the different accounting policies, management practices and thus makes comparisons difficult. Therefore this method not an ideal metric for comparisons between the projects which have different durations and fluctuating cash flows (CFI-ARR, 2020).
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