In: Accounting
F Question 1: Evaluating investment projects
You are planning to invest $75,000 in new equipment. This
investment will generate net cash flows of $45,000 a year for the
next 2 years. The salvage value after 2 years is zero. The cost of
capital is 25% a year.
a) Compute the net present value
NPV = $
Enter negative numbers with a minus sign, i.e., -100 not ($100) or
(100).
Should you invest? Why?
YES -- the NPV is positive, which indicates that the investment is
profitable
YES -- the NPV is negative, which indicates that the investment
will reduce costs
NO -- the NPV is negative, which indicates that the investment is
unprofitable
b) Compute the payback period.
payback period = years
c) Compute the accounting rate of return (ARR).
To compute ARR, first compute:
annual depreciation=$
annual income=$
average investment=$
ARR = %
d) Which of the three methods in (a)-(c) should you use in real
life?
NPV only
payback method only
ARR only
always use all three methods to reach the best decision
Answer (a) | Net Present Value (NPV) = PV of Cash Inflows - PV of Cash Outflow | ||||||||||
= 45000*PVF(25%, 1 year) + 45000*PVF(25%, 2 Year) - 75000 | |||||||||||
= 45000*0.8 + 45000*0.64 - 75000 | |||||||||||
= 64800 - 75000 | |||||||||||
= $10200 | |||||||||||
YES, we will invest, the NPV is negative, which indicates that the investment will reduce costs | |||||||||||
Answer (b) | Payback Period = | Initial Cash Outflow | |||||||||
Annual Cash Inflow | |||||||||||
= | 75000 | ||||||||||
45000 | |||||||||||
= | 1.67 years | ||||||||||
Answer (c) | Equipment Cost is $75,000 | ||||||||||
Salvage Value after 2 years is $0 | |||||||||||
Annual Depreciation = 75000/2 | |||||||||||
= $37,500 | |||||||||||
Average Investment = | 75000+0 | ||||||||||
2 | |||||||||||
= | $37,500 | ||||||||||
Annual Income = | Annual Cash Inflow - Annual Depreciation | ||||||||||
= | 45000-37500 | ||||||||||
= | $7,500 | ||||||||||
Accounting Rate of Return | = | Annual Income | |||||||||
Average Investment | |||||||||||
= | 7,500 | ||||||||||
37,500 | |||||||||||
= | 20% | ||||||||||
Answer (d) | We should always use NPV technique only in real life | ||||||||||
As The NPV method employs more realistic reinvestment rate assumptions, is a better indicator of | |||||||||||
profitability and shareholder wealth, and mathematically will return the correct accept-or-reject | |||||||||||
decision regardless of whether the project experiences non-normal cash flows or if differences in | |||||||||||
project size or timing of cash flows exist | |||||||||||
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