a) NPV is considered superior to the payback method and the accounting rate of return

because it takes account of the time value of money.

b) To compute the NPV it is necessary to convert the profits into cash flows by adding back
depreciation of 25 000 per annum in respect of the asset purchased at the end of year 3 for
75 000. The NPV calculation is as follows:

Year factor Cash flow Discount factors NPV

3 (75,000) 0.675 (50,625)
4 35 000 0.592 20,720
5 28 000 0.519 14,532
6 27 000 0.465 12,555
(2,818)

ii)
Year Discount Project T NPV Project T NPV
factors Cash flow Cash flow
1 0.877 27,000 23 679 40,000 (iii) 35,080
2 0.769 30,000 23 070 45,000 34,605
3 0.675 32,000 21 600 45,000(iv) 30 375
4 0.592 44,000 26 048
5 0.519 40,000(ii) 20,760
115,157 100 060
Investment 70,000 60,000
outlay
NPV 45,157 40,060

Payback:
T: 2 years + (70 000 - 57 000)/32 000 = 2.41 years
R: 1 year + (60 000 - 40 000)/45 000 = 1.44 years
The decision should be to invest in Project T because it has the higher NPV.

Working:
Yearly profits plus (70 000 -10 000)/5 years depreciation= 12,000
ii)18 000 profits + 12 000 depreciation _+10 000 sale proceeds =40,000
iii) Profits plus 60 000/3 years depreciation= 20,000
iv) 75 000 investment outlay - 50 000 =Annual profit (25 000).
Cash flow = 25 000 +20 000 depreciation = 45,000

c) The discount rate can be derived from observations of the returns shareholders require in
financial markets. Where a project is to be financed fully by borrowing, the cost of
borrowing could be used as a basis for determining the discount rate.