Ranking Investment Proposals: Payback Period, Accounting Rate of Return, and Net Present Value

Presented is information pertaining to the cash flows of three mutually exclusive investment proposals:

	Proposal A	Proposal B	Proposal C
Initial investment	$ 45,000	$ 45,000	$ 45,000
Cash flow from operations
Year 1	40,000	22,500	45,000
Year 2	5,000	22,500
Year 3	22,500	22,500
Disinvestment	0	0	0
Life (years)	3 years	3 years	1 year

(a) Select the best investment proposal using the payback period, the accounting rate of return on initial investment, and the net present value criteria. Assume that the organization's cost of capital is 12 percent.

Round accounting rate of return four decimal places. Round net present value to the nearest whole number. Use negative signs with your answers, when appropriate.

	Proposal A	Proposal B	Proposal C	Best proposal
Payback period (years)	Answer	Answer	Answer	AnswerBCA,BAA,CB,C
Accounting rate of return	Answer	Answer	Answer	AnswerCA,CABA,BB,C
Net present value	$Answer	$Answer	$Answer	AnswerAA,CB,CBCA,B

(b) Factors explaining the differences in rankings include all of the following except:

The accounting rate of return considers profitability while payback only considers the time required to recover the investment.

While the accounting rate of return explicitly considers the cost of the asset as part of annual depreciation the net present value method considers the cost of the asset as part of the initial investment.

Net present value considers the timing of cash flows while payback considers only total cash flows.

The net present value method considers the cost of capital while the payback method does not discount future cash flows.