Question

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 1

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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