Idwala Carbonates group of companies located in Port Shepstone in the South Coast (KwaZulu-Natal) is considering which of two mutually exclusive projects to accept, each with a five-year life.
These projects are aimed at increasing the production capacity for limestone to boost the supply of this material to Eskom's Kusile Power Station in Mpumalanga.
Project A requires an initial expenditure of R2 300 000 and is forecast to generate annual cash flows before depreciation of R800 000.
The equipment purchased at time zero has an estimated residual value after five years of R300 000. Project B costs R660 000 for equipment at the start. This has a residual value of R60 000 after five years. Cash inflows before depreciation of R250 000 per annum are anticipated.
The company has a straight-line depreciation policy and a cost of capital of 15 per cent (relevant for projects of this risk class).
You can assume that the cash flows are also equal to the profits before depreciation.
Calculate:
3.1. An accounting rate of return. (6)
3.2. The net present value. (6)
3.3. What are the disadvantages of using ARR. (5)