Question

A friend of yours is analyzing an investment in a small peach orchard. He has estimated that the orchard will require an initial expenditure of $25,000 to prepare the soil, buy and plant the trees, and install new irrigation equipment. The trees won’t produce for the first 2 years, and will produce at only 1/2 and 3/4 of full production in years 3 and 4, respectively. Your friend estimates his net income will be negative in the first couple of years as he continues to spend time and money on the orchard with no production, but expects his net income to become positive in year three and eventually reach $6,000 per year. Your friend expects to have the trees until the end of the 15th year (after harvest), at which time he will remove them at a cost of $5000. To summarize, your friend estimates his net income each year will be as follows:

Year 0: -$25,000

Year 1: -$10,000

Year 2: -$5,000

Year 3: $1,000

Year 4: $2,500

Year 5: $6,000

Years 6 through 14: $6,000 per year.

Year 15: You tell me…harvest happens, but then trees have to be removed…what is the net income for year 15?

1.What is the Simple Rate of Return of the investment? Please enter your answer as a percent without the percentage sign.

2. Does the SRR indicate this project would be accepted by an investor?

3. In what period (Year) does this investment "break even?" You can think of this as the Payback Period of this investment, but you can't use the formula in this case because the returns are not constant for all years. Instead you can just compute the year the returns finally pay off the initial investment and any losses.

4.Your friend knows how to compute the total net return, and is talking to you because he wants a slightly more “complete” analysis; he heard about something called the Net Present Value (NPV), and wants you to help. After some discussion, your friend tells you he wants to analyze the investment using a 7% discount rate. What is the Present Value of the $25,000 initial investment?

5. What is the NPV of the project?

Answer 1

Year 15 cash flow = Net income - Cost of removal = 6000 - 5000 = 1000

1. Simple Return = (Total sum of all Cash flows)/Initial Cost = (-10000 -5000 + 1000 +2500 +6000*10 +1000)/25000 = 198%

2. No the SRR won't indicate rather the NPV decides it for the investor.

3. Break-even is the time when the initial outlay i.e. 25000 will be recovered

Year	Cash Flow	Net Cash Flow
1	-10000	-35000
2	-5000	-40000
3	1000	-39000
4	2500	-36500
5	6000	-30500
6	6000	-24500
7	6000	-18500
8	6000	-12500
9	6000	-6500
10	6000	-500

In year 11 there will be 6000 in 12 months so for 500 it will take 1 month

The break-even will be 10 years 1 month.

4. Present Value of initial investment = -25000

5. NPV = -25000 + (-10000/1.07) + (-5000/1.07^2) + (1000/1.07^3) + (2500/1.07^4) + (6000/1.07^5) + (6000/1.07^6) + (6000/1.07^7) + (6000/1.07^8) + (6000/1.07^9) + (6000/1.07^10) + (6000/1.07^11) + (6000/1.07^12) + (6000/1.07^13) + (6000/1.07^14) + (1000/1.07^15)

NPV = -3249.968