The fun Foods corporation must decide on what new product lines to introduce nex

Question

The fun Foods corporation must decide on what new product lines to introduce next year .After tax cash flows are listed below along with initial investments .The firm%u2019s cost of capital is 12% and its target accounting rate of return is 20%.Assume straight %u2013line depreciations and an asset life of five years .The corporate tax rate is 35%.All projects are independent.

Projects

Investment

Year1

Year2

Year 3

Year 4

Year 5

A

$5,000

$800

$1,000

$350

$1,250

$3,000

B

$7,500

$1,250

$3,000

$2,500

$5,000

$5,000

C

$4,000

$600

$1,200

$1,200

$2,400

$3,000

a)      Calculate the accounting rate of return on the project. Which projects are acceptable according to this criterion?(Note Assume net income is equal to after %u2013tax cash flow less depreciation)

b)      Calculate the payback period. All projects with a payback of fewer than four years are acceptable. Which are acceptable according to this criterion?

       c) Calculate the projects NPV s .Which are acceptable according to this criterion

       d) Calculate the Projects IRRs .Which are acceptable according to this criterion

       e) Which projects should be chosen

Projects

Investment

Year1

Year2

Year 3

Year 4

Year 5

A

$5,000

$800

$1,000

$350

$1,250

$3,000

B

$7,500

$1,250

$3,000

$2,500

$5,000

$5,000

C

$4,000

$600

$1,200

$1,200

$2,400

$3,000

Explanation / Answer

Hi,

Please find the answer as follows:

Part A:

Accunting Rate of Return

A = (800 + 1000 + 350 + 1250 + 3000 - 1000*5)/5/5000/2 = 11.20%

B = (1250 + 3000 + 2500 + 5000 + 5000 + 5*1500)/5/7500/2 = 49.33%

C = (600 + 1200 + 1200 + 2400 + 3000 - 5*800)/5/4000/2 = 44%

Project B and C should be accepted.

Part B:

Payback Period

A

Total Investment to be recovered = 5000

Payback Period = 4 + (5000 - 800 - 1000 - 350 - 1250)/3000 = 4.53 Years

B

Total Investment to be recovered = 7500

Payback Period = 3 + (7500 - 1250 - 3000 - 2500)/5000 = 3.15 Years

C

Total Investment to be recovered = 4000

Payback Period = 3 + (4000 - 600 - 1200 - 1200)/2400 = 3.42 Years

Project B and C should be accepted.

NPV

A = - 5000 + 800/(1+.12)^1 + 1000/(1+.12)^2 + 350/(1+.12)^3 + 1250/(1+.12)^4 + 3000/(1+.12)^5 = -742.72

B = - 7500 + 1250/(1+.12)^1 + 3000/(1+.12)^2 + 2500/(1+.12)^3 + 5000/(1+.12)^4 + 5000/(1+.12)^5 = 3801.83

C = - 4000 + 600/(1+.12)^1 + 1200/(1+.12)^2 + 1200/(1+.12)^3 + 2400/(1+.12)^4 + 3000/(1+.12)^5 = 1574.007 or 1574.01

Project B and C should be accepted.

IRR

A =

NPV = 0 = - 5000 + 800/(1+r)^1 + 1000/(1+r)^2 + 350/(1+r)^3 + 1250/(1+r)^4 + 3000/(1+.r)^5

Solving for r we get IRR as = 7%

B =

NPV = 0 = - 7500 +1250/(1+r)^1 + 3000/(1+r)^2 + 2500/(1+.r)^3 + 5000/(1+r)^4 + 5000/(1+r)^5

Solving for r we get IRR as = 27%

C=

NPV = 0 = - 4000 + 600/(1+r)^1 + 1200/(1+r)^2 + 1200/(1+r)^3 + 2400/(1+r)^4 + 3000/(1+r)^5

Solving for r we get IRR as = 23.37%

Project B and C should be accepted.

Thanks.

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