Question

High Flyers is considering the purchase of two new hot air balloons so that it can expand its desert sunset tours. Various information about the proposed investment follows:

Initial Investment( for 2 balloons)	$500,000
Useful life	5 years
Salvage Value	$150,000
Annual net income generated from additional flights	$60,000
Cost of Capital for High Flyers	11%

Help High Flyers evaluate this project by calculating:

1. Net Present Value( the long way- see p. 355 for example)

2. Net Present Value (using the excel formula NPV)

3. Recalculate NPV with cost of capital @16%

4. Based on your calculation of NPV, what would you estimate your project’s internal rate of return to be?

5. Use excel’s IRR function to determine the IRR. Was your estimate close?

6. Payback Period

7. Simple Rate of Return

8. Assume that High Flyers has the following guidelines for its screening preferences:

- Cost of Capital 11%

- IRR of 12%

- Payback period of 5 years or less

- Simple rate of return – 10%

Based on these guidelines, would this project “make the cut”? Explain.

Answer 1

As per rules I am answering the first 4 sub parts

The cash flows are as follows

Year	Initial investment	Salvage	AnnualNet income	Net cash flows
0	-500000			-500000
1			60000	60000
2			60000	60000
3			60000	60000
4			60000	60000
5		150000	60000	210000

1. NPV= -500000+60000/1.11^1 +60000/1.11^2+ 60000/1.11^3+ 60000/1.11^4+210000/1.11^5

=- $189,228.48

2. NPV as per excel

3.NPV at 16% =  -500000+60000/1.16^1 +60000/1.16^2+ 60000/1.16^3+ 60000/1.16^4+210000/1.16^5

- $232,125.43

4. IRR can be computed using excel IRR function as = IRR(CF0-CF5)

= - 2.81%