Question

Wallowa Company is considering a long term investment project called ZIP. ZIP will require an investment of $120,000. it will have a useful life of 4 years and no residual value. Wallowa uses the straight-line method to compute depreciation expense. Annual cash inflows would increase by $60,000, and annual cash outflows would increase by $20,000. The company's required rate of return is 12%

SHOW YOUR WORK

1. Compute the cash payback period on this project.

2. Calculate the net present value on this project and discuss whether it should be accepted.

3. Compute the profitability index on this project

4. Calculate the internal rate of return on this project and discuss whether it should be accepted.

5. Compute the annual rate of return on this project.

Answer 1

Solution 1:

Initial investment = $120,000

Net annual cash inflows = $60,000 - $20,000 = $40,000

Payback period = Initial investment / Annual cash inflows = $120,000 / $40,000 = 3 years

Solution 2:

Computation of NPV
Particulars	Period	Amount	PV factor at 12%	Present Value
Cash outflows:
Initial investment	0	$120,000.00	1	$120,000
Present Value of Cash outflows (A)				$120,000
Cash Inflows
Annual cash inflows	1-4	$40,000.00	3.03735	$121,494
Present Value of Cash Inflows (B)				$121,494
Net Present Value (NPV) (B-A)				$1,494

As NPV is positive, therefore project should be accepted.

Solution 3:

Profitability index = Present value cash inflows / Present value of cash outflows = $121,494 / $120,000 = 1.01

Solution 4:

For computing IRR lets calculate NPV at 13% discount rate.

Computation of NPV
Particulars	Period	Amount	PV factor at 13%	Present Value
Cash outflows:
Initial investment	0	$120,000.00	1	$120,000
Present Value of Cash outflows (A)				$120,000
Cash Inflows
Annual cash inflows	1-4	$40,000.00	2.97447	$118,979
Present Value of Cash Inflows (B)				$118,979
Net Present Value (NPV) (B-A)				-$1,021

IRR = 12% + (NPV at 12% - NPV at IRR) / (NPV at 12% - NPV at 13%)

= 12% + ($1,494 - 0) / ($1,494 + $1,021) = 12.59%

As IRR is higher than company required rate of return, therefore project should be accepted.

Solution 5:

Annual increase in income = Net annual cash flow - Depreciation = $40,000 - ($120,000/4) = $10,000

Average investment = (Cost + Residual value) /2 = $120000 / 2 = $60,000

Annual rate of return = Average annual income / Average investment = $10,000 / $60,000 = 16.67%