can the problem be show in excel, as i learn better that way via spreadsheet put

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can the problem be show in excel, as i learn better that way via spreadsheet

pute the payback, the AKR, the , the IRR, ai the protitability index of this investment. 2. Recommend whether the company should invest in this project. 26-31A Using payback, ARR, NPV, IRR, and profitability index to make Learning Objectives 2, 4 capital investment decisions Hill Company operates a chain of sandwich shops. The company is considering two possible expansion plans, Plan A would open eight smaller shops at a cost of $8,700,000. Expected annual net cash inflows are $1,550,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Hill Company would open three larger shops at a cost of $8,340,000. This plan is expected to generate net cash inflows of $990,000 per year for 10 years, the estimated useful life of the properties. Estimated residual value for Plan B is $1,200,000. Hill Company uses straight-line depreciation and requires an annual return of 10%. 1. Plan A 1.09 profitability index, Plan B $(1,793,250) NPV Requirements 1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans. 2. What arethe strenths and wlness of these capital budgeting method 3. Which expansion plan should Hill Company choose? Why? 4. Estimate Plan A's IRR. How does the IRR compare with the company's required rate of return?

Explanation / Answer

Payback period method=Initial Investment/Annual Cash inflow

Plan A Payback period=$8700000/$1550000=5.61yrs.

Plan B Payback period=$8340000-$1200000/$990000=7.21 yrs.

ARR method= Net profit after depreciation and tax/ Investment

Plan A :Net profit after depreciation and tax=cash inflow-depreciation

$1550000-$870000=$680000

Depreciation = Initial investment/working life= $8700000/10=$870000

So ARR=$680000/$8700000*100=7.81%

Plan B ARR

Net profit after depreciation and tax=cash inflow-depreciation

$990000-$714000=$276000

Depreciation= initial investment- salvage value/working life

$8340000-$1200000/10=$714000

ARR=$276000/$7140000*100=3.86%

NPV method

NPV= present value of cash inflows -present value of cash outflows

Plan A

Present value of cash inflows =$1550000*6.145=$9524750(6.145 Is present value of NPV at end of 10 yrs @10%)

less:Present value of cash outflow= $ 8700000

$ 824750

Plan B

Present value of cash inflows=$990000*6.145=$6083550+present value of $1200000 at the end of 10yrs.($1200000*.3855) i.e.$462600=$6546150

present value of cash outflow=$8340000

NPV (1793850)

Profitability index= Present value of cash inflow/present value of cash outflow

Plan A: 9524750/8700000=1.094

Plan B: $6546150/$8340000=.757

2.Strength and weaknesses of Payback period method:

Strenghths:1. It's an easy way to compare several projects and then to take the project that has the shortest payback time.

2. It is simple and easy to understand.

Weaknesses: 1.Ignores the time value of money

2. Neglects cash flows received after payback period:

3. Ignores a project's profitability

4. Does not consider a project's return on investment

Strengths of ARR:

1. It is very easy to calculate and simple to understand like pay back period. It considers the total profits or savings over the entire period of economic life of the project.

2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.

3. This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature.

4. This method gives a clear picture of the profitability of a project.

5. This method alone considers the accounting concept of profit for calculating rate of return. Moreover, the accounting profit can be readily calculated from the accounting records.

6. This method satisfies the interest of the owners since they are much interested in return on investment.

7. This method is useful to measure current performance of the firm.

Weaknesses of ARR:

1. The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions.

2. This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored.

3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the management.

4. This method does not consider the external factors which are also affecting the profitability of the project.

5. It does not taken into the consideration of cash inflows which are more important than the accounting profits.

Strengths of NPV method:

1. NPV gives important to the time value of money.

2.In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.

3. Profitability and risk of the projects are given high priority.

4. NPV helps in maximizing the firm's value.
Weaknesses of NPV method:

1. NPV is difficult to use.

2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not equal.

3. It is difficult to calculate the appropriate discount rate.

4. NPV may not give correct decision when the projects are of unequal life.
Strengths of profitability index method:

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

3. PI makes the right in the case of different amount of cash outlay of different project.

4. PI ascertains the exact rate of return of the project.

Weaknesses of Profitability Index method:

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life.

3. Company must adopt for plan A as it is favourable according to all methods of capital budgeting.

4. IRR=12.25%

Irr Factor= Net initial investment/Annual cash inflows

8700000/1550000=5.612

This discount factor is located from PV of annuity of $1 in arrears table

this value lies between 12 and 13%

formula of calculating IRR= lower rate+ NPV at lower rate/ NPV at lower rate-NPV at higher rate( Higher rate-lower rate)

12%+8757500/8757500-8410300(13%-12%)

12+.25=12.25%

NPV at 12%=1550000*5.65=8757500 (for 5.65 refer pv table of annuity)

NPV at 13%= 1550000*5.426=8410300 ( refer pv annuity table)

Irr is more that 10%

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