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Problem 2 (Ignore income taxes in this problem.) Miami Medical Center, Inc., is considering a project...

Problem 2

(Ignore income taxes in this problem.) Miami Medical Center, Inc., is considering a project that would have a ten-year life and would require a $1,200,000 investment in equipment. At the end of ten years, the project would terminate, and the equipment would have no salvage value. The project would provide net operating income each year as follows:

Sales

$1,700,000

Variable expenses

$1,200,000

Contribution margin

$500,000

Fixed expenses:

   Fixed out-of-pocket cash expenses

$200,000

   Depreciation

$120,000

Net operating income

$180,000

All of the above items, except for depreciation, represent cash flows. The company's required rate of return is 12%.

Required (please show your work):

a. Compute the project's net present value.

b. Compute the project's internal rate of return to the nearest whole percent.

c. Compute the project's payback period.

d. Compute the project's simple rate of return.

Solutions

Expert Solution

Sales 1,700,000
Variable expenses 1,200,000
Contribution margin     500,000
Fixed expenses:
   Fixed out-of-pocket cash expenses     200,000
   Depreciation     120,000
Net operating income     180,000
Initial Investment     1,200,000
Simple rate of return =180000/1200000 15.00%
Calculation of cash flow
Net Operating income        180,000
Add Depreciation        120,000
Cash profit        300,000
Calculation of cash flows
Year Cashflow Cumulative cash flow
0 (1,200,000) (1,200,000)
1        300,000      (900,000)
2        300,000      (600,000)
3        300,000      (300,000)
4        300,000                  -  
5        300,000       300,000
6        300,000       600,000
7        300,000       900,000
8        300,000    1,200,000
9        300,000    1,500,000
10        300,000    1,800,000
As we can see that the cumulative cash flow is zero at year 4 so we can say that the payback period is 4 years
Calculation of NPV
Year Cashflow PV factor @ 12% Cash flow
0 (1,200,000)           1.000 (1,200,000)
1        300,000           0.893       267,857
2        300,000           0.797       239,158
3        300,000           0.712       213,534
4        300,000           0.636       190,655
5        300,000           0.567       170,228
6        300,000           0.507       151,989
7        300,000           0.452       135,705
8        300,000           0.404       121,165
9        300,000           0.361       108,183
10        300,000           0.322         96,592
NPV       495,067
Calculation of IRR
Year Cashflow PV factor @ 15% Cash flow PV factor @ 20% Cash flow
0 (1,200,000)           1.000 (1,200,000)        1.000 (1,200,000)
1        300,000           0.870       260,870        0.833       250,000
2        300,000           0.756       226,843        0.694       208,333
3        300,000           0.658       197,255        0.579       173,611
4        300,000           0.572       171,526        0.482       144,676
5        300,000           0.497       149,153        0.402       120,563
6        300,000           0.432       129,698        0.335       100,469
7        300,000           0.376       112,781        0.279         83,724
8        300,000           0.327         98,071        0.233         69,770
9        300,000           0.284         85,279        0.194         58,142
10        300,000           0.247         74,155        0.162         48,452
NPV       305,631 NPV         57,742
IRR= =Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV)
=15%+5%*(305631/(305631-57742)
21.16%

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