Question

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F Question 1: Evaluating investment projects You are planning to invest $75,000 in new equipment. This...

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

Solutions

Expert Solution

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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