Reference no: EM132641413

You are a Senior Analyst at Eagles LLP, a major advisory and professional services firm. One of your clients is Touchdown Trips Inc., a company that provides luxury package tours to watch sports events in North America. Touchdown Trips Inc. uses a luxury private jet aeroplane to carry clients to their destination. The company is planning to invest in a new luxury jet. Two possible investment options have been identified: the Gulfstream G650ER (option A) and the Boeing BBJ Max 7 (option B). Each option has an expected life of five years, after which the selected aeroplane will be replaced by a new luxury private jet aeroplane. Sufficient funding is available to finance only one of the options.

                             Option A                         Option B

                             USD ($000 USD ($000)

Initial cost (year 0)  51,000                     76,500

Scrap value (year 5)   40,110                    60,120

                          Forecast net                  cash inflows

Year 1                  3,200                             3,900

Year 2                   3,300                             3,600

Year 3                  3,100                             3,300

Year 4                   3,000                             3,100

Year 5                     2,900                            2,600

Assume that all cash flows occur at the end of the respective year.

Touchdown Trips Inc. has a cost of capital of 12 per cent. Touchdown Trips Inc. have requested that the payback period and accounting rate of return techniques be used to support this capital investment decision. The company's approach to investment appraisal was discussed at a recent meeting of Eagles LLP's senior executive team. Bill Brady, Senior Partner at Eagles LLP is keen for the managers of Touchdown Trips Inc. to understand the characteristics of capital investment decisions:

Bill has commented:

• We need to ensure that the managers at Touchdown Trips Inc. understand the characteristics of capital investment decisions. This might lead them to accept the use of capital investment appraisal techniques other than payback and accounting rate of return.

• Xiaolin Peng, Head of Asset Management at Eagles LLP, has highlighted that the internal rate of return technique may be suitable in this case. Xiaolin has commented: Internal rate of return is the rate of return that an investment project yields, taking account of the fact that cash may be flowing in and out of the project at various points in its life. If we explain the advantages and disadvantages of internal rate of return to the managers at Touchdown Trips Inc., this might encourage them to accept the use of this technique.

Required:

Question (a) Calculate the payback period for both option A and option B.

Question (b) Calculate the accounting rate of return for both option A and option B. Assume that the only difference between cash flow and profit is the depreciation charge.

Question (c) Critically evaluate the accounting rate of return technique.

Question (d) Advise the senior executive team on the comments made by Bill Brady and Xiaolin Peng. Your advice should include an explanation of the characteristics of investment appraisal decisions and the advantages and disadvantages of the internal rate of return technique.