Question

Instructions: You are required to use a financial calculator or spreadsheet (Excel) to solve the following capital budgeting problem (sample questions and solutions are provided for guidance): Kingston Corp. is considering a new machine that requires an initial investment of $520,000 installed, and has a useful life of 8 years. The expected annual after-tax cash flows for the machine are $76,000 during the first 3 years, $87,000 during years 4 through 6 and $92,000 during the last two years.

(i) Develop the timeline (linear representation of the timing of cash flows)

(ii) Calculate the Internal Rate of Return (IRR)

(iii) Calculate the Net Present Value (NPV) at the following required rates of return: (a) 3% (b) 4% (c) 8% (d)9%

(iv) Using IRR and NPV criterion, comment if the project should be accepted or rejected at the following required rates of return: (a) 3% (b) 4% (c) 8% (d) 9%

(v) Plot the Net Present Value profile (NPV on Y axis and rates of return on X-axis).

Answer 1

i) Time line for cash flows:

ii) IRR = 5.87% (using the excel function for cash flows)

iii) The NPV values at diffrent required rate of return are:

a	3%	$67,611.00
b	4%	$42,675.84
c	8%	-$42,771.68
d	9%	-$61,070.48

Workings:

Year	Cash flows	3%	PV of cash flows	4%	PV of cash flows	8%	PV of cash flows	9%	PV of cash flows
0	-$5,20,000	$1	-$5,20,000	$1	-$5,20,000	$1	-$5,20,000	$1	-$5,20,000
1	$76,000	$0.971	$73,786	$0.962	$73,077	$0.926	$70,370	$0.917	$69,725
2	$76,000	$0.943	$71,637	$0.925	$70,266	$0.857	$65,158	$0.842	$63,968
3	$76,000	$0.915	$69,551	$0.889	$67,564	$0.794	$60,331	$0.772	$58,686
4	$87,000	$0.888	$77,298	$0.855	$74,368	$0.735	$63,948	$0.708	$61,633
5	$87,000	$0.863	$75,047	$0.822	$71,508	$0.681	$59,211	$0.650	$56,544
6	$87,000	$0.837	$72,861	$0.790	$68,757	$0.630	$54,825	$0.596	$51,875
7	$92,000	$0.813	$74,804	$0.760	$69,912	$0.583	$53,681	$0.547	$50,327
8	$92,000	$0.789	$72,626	$0.731	$67,223	$0.540	$49,705	$0.502	$46,172
	NPV		$67,611.00		$42,675.84		-$42,771.68		-$61,070.48

iv) Using the NPV and IRR criteria, a project should be accepted if NPV is positive and IRR is more than the rate of return.

a	3%	$67,611.00	Accept
b	4%	$42,675.84	Accept
c	8%	-$42,771.68	Reject
d	9%	-$61,070.48	Reject

v) NPV profile