Congratulations You have just become the new head of your de

Congratulations! You have just become the new head of your department. Upon arriving to move into your new office, you find a memo on your desk. You have your first assignment. You have been asked to develop a proposal for a new piece of equipment that your superiors believe will make your area much more efficient and effective. There are three possible alternatives that you are to consider.

Having had an amazing Managerial Accounting class in your MBA program, you know exactly what to do. You will compare these three alternative purchases using the following and develop a table to compare them, highlighting the strongest in each measure. Then you will write a memo to the CFO with your recommendation, your rationale, a table showing the results, and an appendix that shows each computation in full detail.

a. Payback period

b. Net present value

c. Accouting rate of return

d. Internal rate of return (using average annual cash flows)

You are excited about this opportunity and cannot wait to get started, because you know that you will make a polished presentation and make a great impression!

Use a discount rate of 12%.

	Alternative A	Alternative B	Alternative C
Cost	$1,000,000	$1,250,000	$2,000,000
Setup Costs	$0	$50,000	$50,000
Training costs	$10,000	$25,000	$35,000
Annual maintence costs	$10,000	$15,000	$16,000
Anticipated annual savings	$125,000	$190,000	$225,000
Annual labor savings	$25,000	$0	$40,000
Expected useful life in years	8	9	7
Overhaul costs in year 4	$45,000	$50,000	$35,000

Solution

Step-1: Calculation of payback period:

Particulars

Alternative-A (in $)

Alternative-B (in $)

Alternative-C (in $)

Initial Investment

Cost

10,00,000

12,50,000

20,00,000

Setup Cost

0

50,000

50,000

Training cost

10,000

25,000

35,000

Total Initial Investment

10,10,000

13,25,000

20,85,000

Net Annual Cash Inflows

Annual savings

1,25,000

1,90,000

2,25,000

Annual Labor Savingd

25,000

0

40,000

Total savings (A)

1,50,000

1,90,000

2,65,000

Annual maintenance cost (B)

10,000

15,000

16,000

Net Annual Cash Inflows (A)-(B)

1,40,000

1,75,000

2,49,000

Payback Period

=Net investment/Annual Cash flow

7.21

7.57

8.37

Ranking

1

2

3

Step-2: Calculation of Net Present value

Particulars

Alternative-A (in $)

Alternative-B (in $)

Alternative-C (in $)

Initial Cash Outflow (Step-1)

10,10,000

13,25,000

20,85,000

Overahall expesnes in 4^th year

45,000

50,000

35,000

PVF @ 12%

0.636

0.636

0.636

PV of ovehall expenses

28,620

31,800

22,260

PV of total cash outflows

10,38,620

13,56,000

21,07,260

PV of Net cash Inflows

Net Annual Cash Inflows (Step-1) (A)

1,40,000

1,75,000

2,49,000

No of Years

8

8

7

PVAF @12% (B)

4.967

4.967

4.564

PV of cash in flows (A)*(B)

6,95,380

8,69,225

11,36,436

Net Present value=PV of cash inflows-PV of cash outflows

(3,43,240)

(4,86,775)

(9,70,824)

Ranking

1

2

3

Step-3: Calculation of Accounting rate of return:

Particulars

Alternative-A (in $)

Alternative-B (in $)

Alternative-C (in $)

Average Annual Profit:

Annual Cash Inflows

1,40,000

1,75,000

2,49,000

No of Years

8

9

7

Total Inflow over period

11,20,000

15,75,000

17,43,000

Less: Overhaul cost

45,000

50,000

35,000

Less: Depreciation

(No salvage value)

10,10,000

13,25,000

20,85,000

Total Profit/(loss) of project

65,000

2,00,000

(3,77,000)

Useful life

8

9

7

Average Annual Profit

8125

22,222

Nil

Average Investment

Initial Investment

10,10,000

13,25,000

20,85,000

At the end salvage value

0

0

0

Average Investment=(initial investment+ At the end salvage value)/2

5,05,000

6,62,500

10,42,500

Accounting rate of return=Average Annual Profit/Average investment

1.6%

3.35%

O%

Ranking

2

1

3

Step-4: Internal Rate of Return:

Particulars

Alternative-A (in $)

Alternative-B (in $)

Alternative-C (in $)

NPV @ 10%

Initial Outflows

10,10,000

13,25,000

20,85,000

Overhall expense at the end of 4^th year

45,000

50,000

35,000

PVF @10%

.683

0.683

0.683

PV of Overhall expense

30,735

34,150

23,905

Total Initial outflows

10,40,735

13,59,150

21,08,905

Net annual cash flows

1,40,000

1,75,000

2,49,000

Annuity factor@10%

5.3349

5.7590

4.8684

Annuity cashflows

7,46,886

1007825

12,12231

NPV @10%

(293849)

(351325)

(8,96,674)

NPV @12%

(3,43,240)

(4,86,775)

(9,70,824)

IRR=10%+NPV1*(R2-R1)/(NPV1-NPV2)

10.93%

10.83%

10.96%

Ranking

2

3

1

Step-5: Analysis Table (Ranking Table)

Particular

Alternative-A

Alternative-B

Alternative-C

Payback Period

1

2

3

NPV

1

2

3

Accounting rate of return

2

1

3

Internal Rate of return

2

3

1

Particulars	Alternative-A (in $)	Alternative-B (in $)	Alternative-C (in $)
Initial Investment
Cost	10,00,000	12,50,000	20,00,000
Setup Cost	0	50,000	50,000
Training cost	10,000	25,000	35,000
Total Initial Investment	10,10,000	13,25,000	20,85,000
Net Annual Cash Inflows
Annual savings	1,25,000	1,90,000	2,25,000
Annual Labor Savingd	25,000	0	40,000
Total savings (A)	1,50,000	1,90,000	2,65,000
Annual maintenance cost (B)	10,000	15,000	16,000
Net Annual Cash Inflows (A)-(B)	1,40,000	1,75,000	2,49,000
Payback Period =Net investment/Annual Cash flow	7.21	7.57	8.37
Ranking	1	2	3