In: Accounting
Pedro Spier, the president of Spier Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of five years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $108,000 and for Project B are $33,000. The annual expected cash inflows are $27,766 for Project A and $9,155 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Spier Enterprises’ cost of capital is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) |
Required |
a-1. | Compute the net present value of each project. (Round your intermediate calculations and final answers to 2 decimal places.) |
a-2. | Which project should be adopted based on the net present value approach? |
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b-1. |
Compute the approximate internal rate of return of each project. |
b-2. | Which one should be adopted based on the internal rate of return approach? |
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Answer :
a-1. Net Present value :
NPV = Present value of annual cash flow - Initial Investment
Project A
NPV = [$27,766 x PVAF(6%,5years)] - $108,000
= [$27,766 x 4.212] - $108,000
= $116,950.39 - $108,000
= $8,950.39
Project B
NPV = [$9,155 x PVAF(6%,5years)] - $33,000
= [$9,155 x 4.212] - $33,000
= $38,560.86 - $33,000
= $5,560.86
a.2. Project A should be adopted based on the net present value approach.
b.1. Internal rate of return of each project :
IRR = R1 + [NPV1 x (R2 - R1)] / (NPV1 - NPV2)
Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)
Project A
R1 = Lower discount rate i.e. 6%
R2 = Higher discount rate i.e. 8%
NPV1 = Higher Net Present Value (derived from R1) i.e. $8,950.39
NPV2 = Lower Net Present Value (derived from R2)
= [$27,766 x PVAF(8%,5years)] - $108,000
= [$27,766 x 3.992] - $108,000
= $2,841.87
IRR = 6% + [$8,950.39 x (8 - 6)] / ($8,950.39 - $2,841.87)
= 6% + ($8,950.39 x 2) / $6,108.52
= 6% + 2.93%
= 8.93 % or 9%
Project B
R1 = Lower discount rate i.e. 6%
R2 = Higher discount rate i.e. 8%
NPV1 = Higher Net Present Value (derived from R1) i.e. $5,560.86
NPV2 = Lower Net Present Value (derived from R2)
= [$9,155 x PVAF(8%,5years)] - $33,000
= [$9,155 x 3.992] - $33,000
= $3,546.76
IRR = 6% + [$5,560.86 x (8 - 6)] / ($5,560.86 - $3,546.76)
= 6% + ($5,560.86 x 2) / $2,014.1
= 6% + 5.52%
= 11.52 % or 12%
b.2. Project B should be adopted based on the internal rate of return approach.