1. Managing Finance and Budgets
Lecture 7
Activities & Solutions

2. Accounting Rate of Return – Further Example
PROJECT ONE PROJECT TWO
Investment £300, £ 500,000
Cashflow Dep’n Net Profit Cashflow Dep’n Net Profit
Year 1: , , , , , ,000
Year 2: , , , , , ,000
Year 3: , , , , , ,000
Year 4: , , , , , ,000
Year 5: , , , , , ,000
Totals: , , , , , ,000
ARR = Average profit/Average investment
= (210,000/5)/ (300,000/2) = 28% (480,000/5)/(500,000)/2 = 38.4%
In this case, the depreciation has been included as part of the Net Profit calculation

3. Activity One
A company is considering investing in either of two new machines which will help to increase its production. The first machine will cost £240,000, and the company estimates that it will have a working life of 5 years. The second machine will cost £360,000 and have a working life of 6 years. The net positive cash-flows as a result of cost savings from the new machine are shown below. Calculate the payback period and Accounting Rate of returns for each of the machines.
Machine 1: Net Cash-flows: £ 90,000/yr for first 3 years
£ 50,000/yr for remaining 2 years
Machine 2: Net Cash-flows: £100,000 Year 1
£110,000 Years 2
£120,000 Years 3 and 4
£ 90,000 Years 5 and 6

4. Activity One –Solution Part 1
Machine 1:
Cost £240K Life 5 years
Net Cash-flows: £ 90K /yr for first 3 years
£ 50K /yr for remaining 2 years
ARR
Average Profit = [ (3 x 90000) + (2 x 50000) ]  5 =
Average Investment = ( )  5 =
ARR = 26000/48000 = 54.2% PP
In the first two years, Total Cash flow = £180000,
so the PP will occur sometime in year three
Proportion of year three = ( )/90000 = 8 months
PP = 2 years and 8 months

5. Activity One –Solution Part 2
Machine 2:
Cost £360K Life 6 years
Net Cash-flows: £100K, £110K, £120K, £120K, £90K, £90K
ARR
Average Profit = [ ( x x2) ]  =
Average Investment = ( )  6 =
ARR = 45000/60000 = 75% PP
In the first three years, Total Cash flow = £330000,
so the PP will occur sometime in year four
Proportion of year four = ( )/ = 3 months
PP = 3 years and 3 months

6. Activity One -Summary Machine 1: ARR = 45.8% PP = 2 years 8 months
Analysis:
If we opt for the Machine 1, it will cost less, and we will recoup our initial expenditure 7 months sooner. However the second machine promises greater return on our investment in the long run.
Decision:
If the company can secure the finances (e.g. long term loan over 4 years ), then Machine 2 represents a much better investment. If finances are a problem, then we may have to settle for Machine 1.

7. Activity Two
For the scenario described in Activity One, calculate a Net Present Value for each of the two machines, using a Discount Rate of 10% and a Discount Rate of 20%. The Discount Factors at the two rates are shown below:
10% 20%
Year
Year
Year
Year
Year
Year

8. Activity Two – Solution (1)
MACHINE ONE MACHINE TWO
Discount Discount
Cashflow Factor DCF Cashflow Factor DCF
Inv’mnt , , , ,000-
Year 1: , , , ,900
Year 2: , , , ,860
Year 3: , , , ,120
Year 4: , , , ,960
Year 5: , , , ,890
Year 6: , ,850
Totals: , ,580
The above figures use a Discount Rate of 10%

9. Activity Two – Solution (2)
MACHINE ONE MACHINE TWO
Discount Discount
Cashflow Factor DCF Cashflow Factor DCF
Inv’mnt , , , ,000-
Year 1: , , , ,300
Year 2: , , , ,340
Year 3: , , , ,480
Year 4: , , , ,840
Year 5: , , , ,180
Year 6: , ,150
Totals: , ,710
The above figures use a Discount Rate of 20%

10. Activity Two – Solution Summary
DF = 10% DF = 20%
NPV of Machine 1 £48,940 -£6,260
NPV of Machine 2 £100, £6,710
Analysis:
If the value of money is decreasing at 10% per annum (low risk, low inflation, low interest), then Machine 2 is a much better proposition, earning over £50K more.
However, if the value of money is decreasing at 20% per annum (high risk, high inflation, high interest) then Machine 1 is a slightly better proposition, as its loss is somewhat less. However, the value of purchasing any machine under these circumstances is questionable.