You should attempt to answer this question yourself before looking up the suggested answer, which appears on pages 853- 4. If any part of your answer is incorrect, check back carefully to make sure you understand where you went wrong.

Stadler is an ambitious young executive who has recently been appointed to the position of financial director of Paradis pic, a small listed company. Stadler regards this appointment as a temporary one, enabling him to gain experience before moving to a larger organization. His intention is to leave Paradis pic in three years time, with its share price standing high. As a consequence, he is particularly concerned that the reported profits of Paradis pic should be as high as possible in his third and final year with the company.

Paradis pic has recently raised £350000 from a rights issue, and the directors are considering three ways of using these funds. Three projects (A, B and C) are being considered, each involving the immediate purchase of equipment costing £350 000. One project only can be undertaken, and the equipment for each project will have a useful life equal to that of the project, with no scrap value. Stadler favours project C because it is expected to show the highest accounting profit in the third year. However, he does not wish to reveal his real reasons for favouring project C, and so, in his report to the chairman, he recommends project C because it shows the highest internal rate of return. The following summary is taken from his report:

The chairman of the company is accustomed to projects being appraised in terms of payback and accounting rate of return, and he is consequently suspicious of the use of internal rate of return as a method of project selection. Accordingly, the chairman has asked for an independent report oo the choice of project.
The company's cost of capital is 20% and a policy of straight-line depreciation is used to write off the cost of equipment in the financial statements.
Requirements:

(a) Calculate the payback period for each project. (3 marks)

(b) Calculate the accounting rate of return for each project. (5 marks)

(c) Prepare a report for the chairman with supporting calculations indicating which project should be preferred by the ordinary shareholders of Paradis pic. (12 marks)

(d) Discuss the assumptions about the reactions of the stock market that are implicit in Stadler's choice of project C. (5 marks)
Note: Ignore taxation.

Net cash flows (2000) Years Project 0 ABC -350 -350 -350 -88 1 2 100 110 40 100 200 150 240 2188 3 4 104 112 138 608 5 210 260 160 - 40 6811 160 - | | | 180 781 Internal rate of return (%) 27.5 26.4 33.0