Example 3 Congo Ltd is considering the selection of one of a pair of mutually exclusive investment projects.

Both would involve purchase of machinery with a life of five years Project 1 would generate annual cash flows (receipts less payments) of 200,000; the machinery would cost 556,000 and have a scrap value of 56,000. Project 2 would generate annual cash flows of 500,000; the machinery would cost 1,616,000 and have a scrap value of 301,000. Congo uses the straight-line method for providing depreciation. Its cost of capital is 15 per cent per annum. Assume that annual cash flows arise on the anniversaries of the initial outlay, that there will be no price changes over the project lives and that acceptance of one of the projects will not alter the required amount of working capital. Requirements (i) Calculate for each project (a) the accounting rate of return (i.e. the percentage of the average accounting profit to the average book value of investment) to the nearest 1%. (b) the net present value (c) the internal rate of return (Yield or Economic return) to the nearest 1%, and (d) the payback period to one decimal place. Ignore taxation. (ii) WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly explain which one of the discounted cash flow techniques used in part (i) of this question should be used by the management of Congo Ltd, in deciding whether Project 1 or Project 2 should be undertaken. Solution to ex 3

(ii) Investment Decision

This example illustrates the conflict which will often be found between the two discounted cash flow appraisal techniques in a ranking decision. Under the net present value criterion, project 2 is preferred because it has a higher net present value when the project cash flows are discounted at the cost of capital. On the other hand project 1 has the higher internal rate of return. To decide which method of ranking is correct it is necessary to consider the assumed objective of the firm, which is to maximise the wealth of the providers of finance. Both projects earn more than the required rate of return but project 2 generates larger cash surpluses in excess of the required amounts than project 1, as can be seen from the net present value calculations. It is these cash surpluses which improve the wealth of the owners of the firm. IRR provides a relative (as opposed to an absolute) result, and may give incorrect decision advice if mutually exclusive projects are of different size (as in this instance) or have unequal lives. IRR makes an inconsistent assumption about the rate at which cash surpluses can be reinvested; it assumes they are reinvested at whatever the IRR happens to be. The companys cost of capital is a more appropriate reinvestment rate i.e. the assumption underlying NPV. Accordingly PROJECT 2 IS PREFERRED TO PROJECT 1 and this can be justified by the following argument: Project 1 is relatively more profitable than project 2, but it is smaller. The two projects are mutually exclusive, which means that only one of them can be accepted. It is better for the owners of the company to receive the large cash surpluses from a large adequately profitable project than to receive the smaller cash surpluses from a small very profitable project. Taken to extremes, a return of ten per cent on 1,000 is better than a return of one thousand per cent on a penny.