Question
The Flinders Island Airways Pty Ltd is planning a project which is expected to last for six years. During that time, the project is expected
The Flinders Island Airways Pty Ltd is planning a project which is expected to last for six years. During that time, the project is expected to generate net cash inflows of $75,000 per annum.
The project will require the purchase of a machine for $280,000. This new machine is expected to have a salvage value of $10,000 at the end of six years. In addition to its annual operating costs, the machine will require an overhaul costing $50,000 at the end of the fourth year. The company presently has a minimum desired rate of return of 12 per cent. Based on this information, the accountant prepared the following analysis:
Annual net cash inflow $75,000
Less: Annual depreciation $45,000
Annual average cost of overhaul $8,333 $53,333
Average annual net profit $21,667
Return on investment: $21,667 / $280,000 = 7.7%
Therefore, the accountant recommends that the project be rejected, as it does not meet the companys minimum desired rate of return.
Required
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What criticism(s) would you make of the accountants evaluation of the project?
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Use cash flow analysis to determine whether or not the project should be accepted.
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Is the internal rate of return (IRR) greater or less than 12 per cent?
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