Question

You have inherited an acre of freehold and want to earn income by investing in a project to be set up on that land. Assume that your required return is 12 percent and tax rate is 30 percent. Required: a. Identify at least 3 different projects that you can set up on that land. b. Estimate initial investment required for each project identified above. c. Estimate relevant cash flows (income and expenses) and apply relevant formulas to calculate Present Value/ Net Present Value (if any). d. Rank your projects, with 1 being the best project. e. Which project will you choose? Why? Hint: You can only choose one project.

Answer 1

Details of project
Project	1	2	3
Initial Investment	-1000000	-1500000	-1000000
total revenue	200000	400000	500000
total expenses	50000	100000	200000
life of project	7	7	7
annual depreciation	Straight line method	Straight line method	Straight line method
tax rate	30%	30%	30%
required return	12%	12%	12%
project 1
Year	0	1	2	3	4	5	6	7
Initial Investment	-1000000
total revenue		200000	200000	200000	200000	200000	200000	200000
total expense		50000	50000	50000	50000	50000	50000	50000
less depreciation		142857.1429	142857.14	142857.14	142857.1	142857.143	142857.143	142857.1
operating profit		7142.857143	7142.8571	7142.8571	7142.857	7142.85714	7142.85714	7142.857
less taxes-30%		2142.857143	2142.8571	2142.8571	2142.857	2142.85714	2142.85714	2142.857
profit after tax		5000	5000	5000	5000	5000	5000	5000
add depreciation		142857.1429	142857.14	142857.14	142857.1	142857.143	142857.143	142857.1
net operating cash flow	-1000000	147857.1429	147857.14	147857.14	147857.1	147857.143	147857.143	147857.1
present value of cash flow = net operating cash flow/(1+r)^n r =12%	-1000000	132015.3061	117870.81	105241.79	93965.89	83898.1137	74909.0301	66883.06
net present value = sum of present value of cash flow	-325216
project 2
Year	0	1	2	3	4	5	6	7
Initial Investment	-1500000
total revenue		400000	400000	400000	400000	400000	400000	400000
total expense		100000	100000	100000	100000	100000	100000	100000
less depreciation		214285.7143	214285.71	214285.71	214285.7	214285.714	214285.714	214285.7
operating profit		85714.28571	85714.286	85714.286	85714.29	85714.2857	85714.2857	85714.29
less taxes-30%		25714.28571	25714.286	25714.286	25714.29	25714.2857	25714.2857	25714.29
profit after tax		60000	60000	60000	60000	60000	60000	60000
add depreciation		214285.7143	214285.71	214285.71	214285.7	214285.714	214285.714	214285.7
net operating cash flow	-1500000	274285.7143	274285.71	274285.71	274285.7	274285.714	274285.714	274285.7
present value of cash flow = net operating cash flow/(1+r)^n r =12%	-1500000	244897.9592	218658.89	195231.15	174313.5	155637.08	138961.679	124072.9
net present value = sum of present value of cash flow	-248226.8
project 3
Year	0	1	2	3	4	5	6	7
Initial Investment	-1000000
total revenue		500000	400000	400000	400000	400000	400000	400000
total expense		200000	100000	100000	100000	100000	100000	100000
less depreciation		142857.1429	142857.14	142857.14	142857.1	142857.143	142857.143	142857.1
operating profit		157142.8571	157142.86	157142.86	157142.9	157142.857	157142.857	157142.9
less taxes-30%		47142.85714	47142.857	47142.857	47142.86	47142.8571	47142.8571	47142.86
profit after tax		110000	110000	110000	110000	110000	110000	110000
add depreciation		142857.1429	142857.14	142857.14	142857.1	142857.143	142857.143	142857.1
net operating cash flow	-1000000	252857.1429	252857.14	252857.14	252857.1	252857.143	252857.143	252857.1
present value of cash flow = net operating cash flow/(1+r)^n r =12%	-1000000	225765.3061	201576.17	179978.72	160695.3	143477.934	128105.298	114379.7
net present value = sum of present value of cash flow	153978.44
Ranking of project
Project	NPV
1	-325216	3
2	-248226.8	2
3	153978.44	1
Project 3 would be selected as it results in positive NPV