Chapter 25, Problem 2BPSB

To determine

Introduction:

Net Cash Flows:

The difference between the cash inflows and outflows of the company over a period of time refers to net cash flows.

Payback Period:

The time required to cover the cost of investment refers to payback period. The company prefers shorter payback period that has less risks compared to longer payback period.

Requirement-1:

To compute:

The annual expected net cash flows of Project A and Project B of Aikman Company that indicates the financial stability of the company.

Answer to Problem 2BPSB

Solution:

Net cash flows for Project A: $\$99,900$

Net cash flows for Project B: $\$105,900$

Explanation of Solution

The annual expected cash flows is computed by using the below formula:

$NetCashFlow=Netincome+DepreciationExpense$

Therefore the annual net cash flow of each project is calculated as below:

Project A:

Net income: $\$39,900$

Depreciation Expense: $\$60,000$

Net Cash Flow $=\$39,900+\$60,000=\$99,900$

Depreciation for Project A:

Given,

Cost of Machinery/Investment: $\$240,000$

Useful life of an Asset: $4years$

Annual Depreciation= $\$240,000=\$0/4=\$60,000$

Project B:

Net income: $\$25,900$

Depreciation Expense: $\$80,000$

Net Cash Flow $=\$25,900+\$80,000=\$105,900$

Depreciation for Project B:

Given,

Cost of Machinery/Investment: $\$240,000$

Useful life of an Asset: $3years$

Annual Depreciation= $\$240,000=\$0/3=\$80,000$

Depreciation expense is calculated by using the formula:

$\begin{array}{l}AnnualDepreciation=MachineryCost-SalvageValue/UsefullifeofAssets\hfill \\ \hfill \end{array}$

Conclusion

Hence the net cash flow for Project A is $99,900 and Project B is $105,900. Project B has the higher net cash flows compared to Project A that indicates Project B is financially sound than Project B. However Project A also has equally good cash flows.

To determine

Requirement-2:

To determine:

The payback period of Project A and Project B of Aikman Company to determine the investment risk of projects.

Answer to Problem 2BPSB

Solution:

Payback period of Project A: 2.4 years

Payback period of Project B: 2.3 years

Explanation of Solution

The payback period is derived using the formula:

$\begin{array}{l}Paybackperiod=CostofInvestment/NetCashFlow\hfill \\ \hfill \end{array}$

Calculation of Payback Period for Project A:

Given,

Cost of Investment: $\$240,000$

Net Cash Flow (As calculated): $\$99,900$

Payback period $=\$240,000/\$99,900=2.4years$

Calculation of Payback Period for Project B:

Given,

Cost of Investment: $\$240,000$

Net Cash Flow (As calculated): $\$105,900$

Payback period $=\$240,000/\$105,900=2.3years$

Conclusion

The shortest payback period has less risk and longer payback period has high risk. Hence from the computation of payback period of both the projects, Project B has shorter period compared to Project A. However there is no much difference in the payback periods of both the projects that indicates both has less risk of investment.

To determine

Requirement-3:

To compute:

The accounting rate of return of Aikman Company for Project A and Project B to decide whether the company has to proceed with which project investment.

Answer to Problem 2BPSB

Solution:

The accounting rate of return for Project A is 33.3%

The accounting rate of return for Project B is 21.6%

Explanation of Solution

Explanation:

The accounting rate of return is calculated using the formula:

$\begin{array}{l}Accountingrateofreturn=AverageNetProfitorincome/AverageInvestment*100\hfill \\ \hfill \end{array}$

$\begin{array}{l}Averageinvestmentofasset=CostofInvestment/2\hfill \\ \hfill \end{array}$

Project A:

Given,

Net income: $\$39,900$

Average investment: $\$240,000/2=\$120,000$

Accounting rate of return= $39,900/$120,000*100=33.3%

Project B:

Given,

Net income: $\$25,900$

Average investment: $\$240,000/2=\$120,000$

Accounting rate of return= $\$25,900/\$120,000*100=21.58\%$

Conclusion

From the computation of accounting rate of return Project A has higher accounting rate of return compared to Project B. Hence the company can proceed with investment in Project A.

To determine

Requirement-4:

To determine:

The net present value of Project A and Project B using the discounted rate at 8% for the Aikman Company to analyse the profitability of a projected project.

Answer to Problem 2BPSB

Solution:

The net present value at discounted rate of 8% of Project A is $\$90,879$.

The net present value at discounted rate of 8% of Project B is $\$32,915$.

Explanation of Solution

The present value of net cash flows at discounted rate is calculated by using the formula:

$Netcashflows*Presentvalueof\$1at8\%annuity-AmountInvested$

Project A:

Net cash flow as calculated for Project A is $99,900

Cost of investment is $240,000

Present value of 1 at 8% Annuity for 4 years is 3.3121 (Taken from the Annuity table)

The below table shows the calculation of net present value for Project A:

Project B:

Net cash flow as calculated for Project A is $105,900

Cost of investment is $240,000

Present value of 1 at 8% Annuity for 3 years is 2.5771(Taken from the Annuity table)

The below table shows the calculation of net present value for Project B:

Conclusion

From the computation of net present value of cash flows, Project A has the higher present value of $90,879 compared to Project B that indicates Project A is highly profitable.

To determine

Requirement-5:

To discuss:

The project that would be recommended to the management and the explanation for the recommendation.

Answer to Problem 2BPSB

Solution:

Project A is recommended to the management.

Explanation of Solution

Project A has higher present value of cash flows of $90,879 and accounting rate of return

of 33.3% when compared to Project B.

Conclusion

Hence comparing the net present value and accounting rate of return of both the projects, the Project A is highly profitable to proceed with.