Question

A company is considering an investment proposal to install new milling controls. The project will cost Ksh. 500,000. The facility has a life expectancy of 5 years and no salvage value. The company’s tax rate is 30%. The firm uses straight line depreciation. The estimated cash flows before tax (CBT) from the proposed investment proposal are as follows:

Year

Ksh (CFBT)

1 100,000

2 110,000

3 140,000

4 150,000

5 250,000

Compute the following:

i) Payback period, ii) Average rate of return,

iii) Internal rate of return,

iv) Net present value at 10% discount rate,

v) Discounted payback period vi) Profitability index at 10% discount rate, Comment on the results computed as above.

Answer 1

Pay-back period is

= 3 years +$50,000-45,750 \over 16,750$

=3 years + $4,250 \over 16,750$

=3 years +0.25

= 3.25 years

Step 2 (ii) Calculation of Average rate of return-

=$average net profit \over average investment$

=$16,750 \over 25,000$

=67%

Step 3 (iii) Calculation of NPV at 10% discount rate-

Step 4 (iv) Profitability Index @10%-

PI = $PV of cash inflows \over PV of cashflows$ = $62,417.195 \over 50,000$ = 1.248

Therefore,

i) the Payback period is 3.25 years.

ii) Average rate of return is 67%.

iii) NPV is 12,417.20

iv) PI is 1.248