Problem 1: Stadler is a motivated young executive who has recently been hired to the position of financial director of Paradis plc, a small listed company. Stadler regards this appointment as a temporary one, enabling him, to gain experience before moving to a larger organisation. His intention is to leave Paradis plc in three years’ time, with its share price standing high. As a result, he is particularly concerned that the reported profits of Paradis plc must be as high as possible in his third and final year with the company.
Paradis plc has recently increased $350,000 from a rights issue, and the directors are considering three ways of using these funds. Three projects (A, B, and C) are being considered, each involving the immediate purchase of equipment costing $350,000. One project only can be undertaken and the equipment for each project will have a useful life equivalent to that of the project, with no scrap value. Stadler favours project C because it is anticipated to show the highest accounting profit in the third year. However, he does not wish to reveal his real reasons for favouring project C and so in his report to the chairman, he suggests project C because it shows the highest internal rate of return. The following summary is taken from his report:
Year Project A Project B Project C
0 (350,000) (350,000) (350,000)
1 100,000 40,000 200,000
2 110,000 100,000 150,000
3 104,000 210,000 240,000
4 112,000 260,000 40,000
5 138,000 160,000 -
6 160,000 - -
7 180,000 - -
8 - - -
Internal rate of return for the three projects are A at 27.5%; B at 26.4% and C at 33.0%.
The chairman of the company is accustomed to projects being appraised in terms of payback and accounting rate of return, and he is consequently suspicious of the use of internal rate of return as a method of project selection. Accordingly, the chairman has asked for an independent report on choice of project. The company’s cost of capital is 20% and a policy of straight – line depreciation is used to prepare off the cost of equipment in financial statements.
problem1. Evaluate the payback period for each project.
problem2. Evaluate the accounting rate of return for each project.
problem3. Evaluate the net present value for each project.
problem4. Prepare a report for the chairman with supporting computations indicating which project should be preferred by the ordinary shareholders of Paradis plc. Your report must critically compare and contrast the salient features of Payback, ARR, IRR and NPV as alternative investment appraisal techniques.