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Calculating the Capital Budgeting Parameters

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Sea Cable Industries is a company involved in the manufacture of marine cables. The company is planning a move into land lines to exploit new telecommunications opportunities. This will involve the acquisition of new equipment. Two machines have been identified and the returns involved in purchasing each are as follow:

Machine 1 Machine 2
Rand Rand
Cost (Immediate outlay) 200 000 120 000
Expected annual net Profit/Loss
Year 1 60 000 33 000
Year 2 (2000) (12 000)
Year 3 8000 12000
Year 3 Estimated residual value 14000 12000

The company has an estimated cost of capital of 10% and utilizes the straight line method of depreciation. Sea Cable Industries minimum accounting rate of return is 18% and the maximum payback period is 2 years and 4 months. You should assume that the two machines are mutually exclusive.

Required:
1 Calculate the accounting rate of return for each machine, assess its acceptability and indicate which machine is better using the accounting rate of return.
2 Calculate the payback period for each machine, assess its acceptability and indicate which machine is better using the payback period.
3 Calculate the net present value (NPV) of each machine, assess its acceptability and indicate which machine is better using NPV.
4 Calculate the internal rate of return (IRR) of each machine, assess its acceptability and indicate which machine is better using IRR.
5 Which method of investment appraisal is most appropriate and give reasons.

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Solution Summary

Accounting rate of return, payback period, NPV and IRR are some of the measures which help in decision making. Solution describes the steps to calculate these measures for given machines and chooses the best machine.

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Calculating the various capital budgeting parameters

Bongo Ltd. is considering the selection of one of two mutually exclusive projects. Both would involve purchasing machinery with an estimated useful life of 5 years.

Project 1 would generate annual cash flows (receipts less payments) of £200,000; the machinery would cost £556,000 with a scrap value of £56,000.

Project 2 would generate cash flows of £500,000 per annum; the machinery would cost £1,616,000 with a scrap value of £301,000.

Bongo uses straight-line depreciation. Its cost of capital is 15% per annum.

Assume that all cash flows arise on the anniversaries of the initial outlay, that there are no price changes over the project lives, and that accepting either project will have no impact on working capital requirements.
Assess the choice using the following methods by completing the calculations shown below:
- ARR
- NPV
- IRR
- Payback period

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