Sarkozy Ltd is considering the selection of one of a pair of mutually exclusive investment projects. Both would involve purchase of machinery with a life of five years.
Project 1 would generate annual cash flows (receipts less payments) of $200,000; the machinery would cost $556,000 and have a scrap value of $56,000.
Project 2 would generate annual cash flows of $500,000; the machinery would cost $1,616,000 and have a scrap value of $301,000.
Sarkozy Ltd uses the straight line method for providing depreciation. Its cost of capital is 15% pa. Assume that annual cash flows arise on the anniversaries of the initial outlay, that there will be no price changes over the project lives and that acceptance of one of the projects will not alter the required amount of working capital.
You are required to:
(a) Calculate for each project:
(i) The accounting rate of return (ratio, over project life, of average accounting profit to average book value of investment);
(ii) The net present value;
(iii) The internal rate of return (DCF yield) to nearest 1%; and
(iv) The payback period.
(b) State which project you would select for acceptance, if either, giving reasons for your choice of criterion to guide the decision.