Question

Aaron Heath is seeking part-time employment while he attends school. He is considering purchasing technical equipment that will enable him to start a small training services company that will offer tutorial services over the Internet. Aaron expects demand for the service to grow rapidly in the first two years of operation as customers learn about the availability of the Internet assistance. Thereafter, he expects demand to stabilize. The following table presents the expected cash flows.

Year of
Operation	Cash Inflow			Cash Outflow
2019	$	13,300		$	8,700
2020		20,200			11,000
2021		22,800			13,000
2022		22,800			13,000

In addition to these cash flows, Aaron expects to pay $21,400 for the equipment. He also expects to pay $3,500 for a major overhaul and updating of the equipment at the end of the second year of operation. The equipment is expected to have a $1,100 salvage value and a four year useful life. Aaron desires to earn a rate of return of 10 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

1. Calculate the net present value of the investment opportunity. (Negative amount should be indicated by a minus sign. Round intermediate calculations and final answer to 2 decimal places.)

2. Indicate whether the investment opportunity is expected to earn a return that is above or below the desired rate of return and whether it should be accepted.

a. Net present valueb ____________________

b. Will the return be above or below the cost of capital? Above

Should the investment opportunity be accepted? Accepted

Answer 1

Answer:

(a) Calculation of the net present value of the investment opportunity:

Particulars	Period	PV Factor@10%	Amount	Present Value
Cash Inflow:
Cash inflow in 2019	1 yr	0.90909	$13,300	$12,090.90
Cash inflow in 2020	2 yr	0.82645	$20,200	$16,694.29
Cash inflow in 2021	2 yr	0.75131	$22,800	$17,129.87
Cash inflow in 2022	4 yr	0.68301	$22,800	$15,572.63
Salvage value of equipment	4 yr	0.68301	$1,100	$751.31
Total Cash Inflow (a)				$62,239.00
Cash Outflow:
Cost of equipment	0	1	$21,400	$21,400
Cash outflow in the year 2019	1 yr	0.90909	$8,700	$7,909.08
Cash outflow in the year 2020	2 yr	0.82645	$11,000	$9,090.95
Cash outflow in the year 2021	3 yr	0.75131	$13,000	$9,767.03
Cash outflow in the year 2022	4 yr	0.68301	$13,000	$8,879.13
Cost of overhaul & updation	2 yr	0.82645	$3,500	$2,892.58
Total Cash Outflow (b)				$59,938.77
Net Present Value (a-b)				$2,300.23

(b) The return is above the cost of capital as the investment will be able to generate a positive net value of $2,300.23.

Therefore, investment opportunities should be accepted.