In: Finance
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.
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% | ||||||||