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: (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.)

Initial investment (for two hot air balloons)	$	384,000
Useful life		8	years
Salvage value	$	40,000
Annual net income generated		32,640
BBS’s cost of capital		11	%

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 2 decimal places.)
2. Payback period. (Round your answer to 2 decimal places.)
3. Net present value (NPV). (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 14 percent. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)

1. Accounting rate of return %

2. Payback period years

3. Net present value

4. Net present value assuming 14% cost of capital

Answer 1

1. Accounting rate of return (ARR)

ARR= Accounting profit / Average investment

Accounting profit = $32,640

Investment = $384,000

ARR = $32,640/$384,000= 8.5%

2. Payback period

Payback period is the number of years taken to recover the investment amount

Investment: 3,84,000

Returns per annum = $32,640 + $43,000 (depreciation) = $75,640 pa

Payback period = Initial investment / returns per annum

= $384,000 / $75,640= 5.08 years

3. Net present value (NPV)

NPV = Initial investment + Annual returns + Residual value

Initial Investment = $ 384,000

Annual returns = Return per annum * Discounting factor

= $75,640 * 5.146 = $389,252.7

Salvage value = $ 40,000* 0.434 = $17,357.06

NPV = ($384,000) + $389,252.7 + $17,357.06 = $22,610 (Rounded off)

4. NPV with 14% cost of capital:

Initial Investment = $384,000

Annual Returns = $75,740 * 4.639 = $350,883.7

Salvage = $40000 * 0.351 = $14,022.36

NPV = ($384,000) + $350,883.7+ $14,022.36= -$19,094 (Rounded off)

Working notes:

1. PV factor for 11% Cost of capital

Rate (%)	Period	PV Factor
11%	1	0.901
11%	2	0.812
11%	3	0.731
11%	4	0.659
11%	5	0.593
11%	6	0.535
11%	7	0.482
11%	8	0.434
	Total	5.146

2. PV factor for 14% Cost of capital:

Rate	Period	PV Factor
14%	1	0.877
14%	2	0.769
14%	3	0.675
14%	4	0.592
14%	5	0.519
14%	6	0.456
14%	7	0.400
14%	8	0.351
	Total	4.639

3. Depreciation under straight line method:

= ($384,000-$40,000)/8

= $43,000