Problem1. Oakland Plc is considering a major investment project. The initial outlay of $900,000 will, in following years, be followed by positive cash flows, as given below. (These take place on anniversary dates).
Year 1 2 3 4 5
Cash flow ($) 50,000 120,000 350,000 80,000 800,000
After the end of the fifth year, this business activity will cease and no more cash flows will be generated.
The initial $900,000 investment in plant and machinery is to be depreciated over the five year life of the project using the straight-line value method. These assets will have no value after Year 5.
The management judge that the cash inflows given above are also an accurate estimation of the profit before depreciation for each of the years. They also think that the appropriate discount rate to use for the firm’s projects is 10% per annum.
The board of directors is used to evaluating project proposals on the basis of a pay-back rule which needs that all investments achieve payback in four years.
As the newly appointed executive responsible for project evaluation, you have been asked to assess this project using a number of different techniques and to advise the board on the advantages and disadvantages of each. Do this in the following series.
Required:
Question1. Evaluate pay-back period.
Question2. Evaluate discounted pay-back period.
Question3. Evaluate accounting rate of return.
Question4. Evaluate internal rate of return.
Question5. Evaluate net present value.
Question6. Compare the relative theoretical and practical demerits and merits of pay-back period, accounting rate of return and internal rate of return.