The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project’s Discounted Payback and Profitability Index assuming end of year cash flows. Should the project be taken? If the Average Accounting Return was positive, how would this affect your decision? (Present Value = FV× [1÷ (1+i)n])
Present value of cash-flows = -$4,300 at time 0 years
Present value of cash-flow of year-1 and year-2 with $1,200 = $2028.06
Sum of the present values of cash-flows at the end of year 2 = -$2,271.94
Present value of cash-flow of $3,000 of year 3 = $2,135.34
Sum of present values of the cash-flows at the end of year 3 = -$136.60
Discounted payback in this case cannot be calculated as NPV < 0 but in such case NPV = -$136.60
The PI = ∑CFATt/Initial Investment = 4163.40/4300 = 0.97 approx
So, I think both measures NPV and the profitability index have indicated the rejection in this case and even positive accounting rate of return cannot change the decision. As;
Payback = 2.63 years approx.
IRR = 10.41% as it is lower than 12% so reject the project.
Project also rejected as NPV = -$136.60