Question

Balloons By Sunset (BBS) is considering the purchase of two new hot air balloons so that it can expand its desert sunset tours. Various information about the proposed investment follows:  

Initial investment (for two hot air balloons)	$	374,000
Useful life		9	years
Salvage value	$	50,000
Annual net income generated		30,668
BBS’s cost of capital		12	%

Assume straight line depreciation method is used.
  

Required:
Help BBS evaluate this project by calculating each of the following:  

1. Accounting rate of return. (Round your answer to 1 decimal place.)

        

2. Payback period. (Round your answer to 2 decimal places.)

         

3. Net present value (NPV). (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided. Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)

         

4. Recalculate the NPV assuming BBS's cost of capital is 15 percent. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided. Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)

    

Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.   

Project 1: Retooling Manufacturing Facility

This project would require an initial investment of $5,850,000. It would generate $1,045,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,240,000.

Project 2: Purchase Patent for New Product

The patent would cost $4,100,000, which would be fully amortized over five years. Production of this product would generate $922,500 additional annual net income for Hearne.

Project 3: Purchase a New Fleet of Delivery Trucks

Hearne could purchase 25 new delivery trucks at a cost of $215,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $7,000. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $1,209,400 of additional net income per year.


Required:
1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)

       

2. Determine each project's payback period. (Round your answers to 2 decimal places.)

       

3. Using a discount rate of 10 percent, calculate the net present value of each project. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided. Round your intermediate calculations to 4 decimal places and final answers to 2 decimal places.)

       

4. Determine the profitability index of each project and prioritize the projects for Hearne. (Round your intermediate calculations to 2 decimal places. Round your final answers to 4 decimal places.)

    

Answer 1

Solution

Balloons by Sunset (BBS)

1. Calculation of accounting rate of return:

Accounting rate of return = annual net income generated/average investment

Annual net income generated = $30,668

Average investment = (initial value of project + ending value of project)/2

= (374,000 + 50,000)/2 = $212,000

Accounting rate of return = (30,668/212,000) x 100 = 14.47%

Accounting rate of return = 14.47%

2. Calculation of payback period:

Payback period = initial investment/annual cash inflows

Initial investment = $374,000

Annual cash inflows –

Annual net income = 30,668

Add: depreciation = (374,000 – 50,000)/9 = $36,000

Annual cash inflows = 30,668 + 36,000 = $66,668

Payback period = 374,000/66,668 = 5.6 years

Payback period = 5.6 years

3. Calculation of net present value:

Discount rate = 12%

Net present value = present value of cash inflows – present value of cash outflows

Present value of cash outflows = ($374,000) x 1.000 = ($374,000)

Present value of cash inflows = annual cash inflows (uniform) x annuity present value factor at $1 at 12% for 9 years + pv of salvage value

= 66,668 x 5.328 = $355,207

Salvage value = 50,000 x 0.3606 = $18,030

Present value of cash inflows = 355,207 + 18,030 = $373,237

Less: pv of outflows = (374,000)

Net present value = ($763)

The NPV of the project at 12% cost of capital is negative.

4. Calculation of net present value, assuming cost of capital 15%:

Discount rate = 15%

Net present value = present value of cash inflows – present value of cash outflows

Present value of cash outflows = ($374,000) x 1.000 = ($374,000)

Present value of cash inflows = annual cash inflows (uniform) x annuity present value factor at $1 at 15% for 9 years + pv of salvage value

= 66,668 x 4.772 = $318,140

Salvage value = 50,000 x 0.2843 = $14,215

Present value of cash inflows = 318,140 + 14,215 = $332,355

Less: pv of outflows = (374,000)

Net present value = ($41,645)

The NPV of the project at 15% cost of capital is negative.

Hearne Company

1. Calculation of accounting rate of return:

Accounting rate of return = annual net income/average investment

- Project 1    Retooling manufacturing facility

Annual net cash flow = 1,045,000

Average investment = (5,850,000 + 1,240,000)/2 = 3,545,000

ARR = 1,045,000/3,545,000 = 29.50%

- Project 2: Purchase patent for new project

Annual cash inflow = 922,500

Initial investment = 4,100,000

ARR = 922,500/4,100,000 = 22.5%

- Project 3: purchase a new fleet of delivery trucks

Annual cash inflow = 1,209,400

Initial investment = 25 x 215,000 = $5,375,000

Salvage value = 175,000

Average investment = (5,375,000 + 175,000)/2 = $2,775,000

ARR = 1,209,500/2,775,000 = $43.6%

2. Payback period:

Project 1: retooling manufacturing facility

Payback period = initial investment/annual cash inflows

Initial investment = $5,850,000

Annual cash inflows –

Annual net income = 1,045,000

Add: depreciation = (5,850,000 – 1,240,000)/8 = $576,250

Annual cash inflows = 1,045,000 + 576,250 = $1,621,250

Payback period = 5,850,000/1,621,250 = 3.6

Project 2: purchase patent for new product

Payback period = initial investment/annual cash inflows

Initial investment = $4,100,000

Annual cash inflows –

Annual net income = 922,500

Add: amortization = (4,100,000)/5 = $820,000

Annual cash inflows = 922,500 + 820,000 = $1,742,500

Payback period = 4,100,000/1,742,500 = 2.35

Project 3: purchase a new fleet of delivery trucks

Payback period = initial investment/annual cash inflows

Initial investment = $5,375,000

Annual cash inflows –

Annual net income = 1,209,400

Add: depreciation = (5,375,000 – 175,000)/10 = $520,000

Annual cash inflows = 1,209,400 + 520,000 = 1,729,400

Payback period = 5,375,000/1,729,400 = 3.1

3. NPV of each project:

Npv = PV of cash inflows – PV of outflows

Project 1:

Project 1 –

Discount rate – 10%

Period – 8 years

PV of cash inflows = 1,045,000 x (P/A, 10%, 8) = 1,045,000 x 5.335 = 5,575,075

Add: pv of salvage value = 1,240,000 x (P/F, 10%, 8) = 1,240,000 x 0.4665 = 578,460

Less: pv of initial investment = (5,850,000) x 1.000 = ($5,850,000)

Net present value = $303,555

Project 2 –

Discount rate – 10%

Period 5 years

Pv of cash inflows = 922,500 x (P/A, 10%, 5) = 922,500 x 3.791 = $3,497,198

Pv of cash outflows = (4,100,000) x 1.000 = (4,100,000)

Net present value = ($602,802)

Project 3 –

Discount rate -10%

Period – 10

Pv of cash inflows = 1,209,400 x (P/A, 10% ,10) = 1,209,400 x 6.145 = $7,431,763

Pv of salvage value = (25 x 7,000) x (P/F, 10%, 10) = 175,000 x 0.3855 = $67,463

Pv of cash outflows = (25 x 215,000) x 1.000 = ($5,375,000)

Net present value = $2,124,225