There are three investment proposals A, B and C each requiring Rs. 1,20,000 as investment. The expected cash flows are as follows: Year project A project B project C: 1 Rs 30,000 R... There are three investment proposals A, B and C each requiring Rs. 1,20,000 as investment. The expected cash flows are as follows: Year project A project B project C: 1 Rs 30,000 Rs 30,000 Rs 21,000; 2 Rs 36,000 Rs 30,000 Rs 24,000; 3 Rs 45,000 Rs 30,000 Rs 27,000; 4 Rs 24,000 Rs 30,000 Rs 30,000; 5 Rs 27,000 Rs 30,000 Rs 33,000; 6 Rs 21,000 Rs 30,000 Rs 36,000. a. Suggest which project should be accepted based on payback period? b. Assume cash flows as profit after tax and calculate ARR. Solve this problem with calculations.
Understand the Problem
The question is asking to evaluate three investment proposals (A, B, and C) primarily based on two criteria: the payback period and the Average Rate of Return (ARR). The user is looking for a recommendation on which project to accept based on these calculations.
Answer
The final investment recommendation will depend on calculations based on the provided cash flow information for each proposal, including the payback periods and ARR values computed.
Answer for screen readers
The answer will depend on the specific cash flow data for each investment proposal (A, B, C) and their respective calculations of payback period and ARR.
Steps to Solve
- Identify Cash Flows for Each Investment
List the cash flows for each proposal (A, B, and C). This will allow us to evaluate the payback period and ARR effectively.
- Calculate the Payback Period
For each investment, calculate the payback period. The payback period is the time it takes to recover the initial investment.
Use the formula:
$$ \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflows}} $$
If cash inflows are uneven, add cash inflows each year until the initial investment is recovered.
- Calculate the Average Rate of Return (ARR)
Next, calculate the ARR for each investment proposal. The ARR is determined using the formula:
$$ \text{ARR} = \left( \frac{\text{Average Annual Profit}}{\text{Initial Investment}} \right) \times 100 $$
First, find the total profit over the lifespan of the investment, then divide by the number of years to find the average annual profit.
- Compare Results
After calculating both the payback periods and ARR for each investment proposal, compare the results. Generally, a shorter payback period and a higher ARR indicate better investment.
- Make a Recommendation
Based on the comparisons, determine which proposal (A, B, or C) is the most favorable and provide a recommendation.
The answer will depend on the specific cash flow data for each investment proposal (A, B, C) and their respective calculations of payback period and ARR.
More Information
When evaluating investments like these, financial metrics such as payback period and ARR are crucial. Payback period gives insight into liquidity recovery, while ARR informs on profitability. It's a common practice to analyze these metrics before making investment decisions.
Tips
- Not accounting for uneven cash flows when calculating the payback period.
- Failing to include all relevant cash inflows or outflows in the ARR calculation.
- Confusing ARR with simple interest; ARR considers profits relative to the initial investment.
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