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)	$	385,000
Useful life		8	years
Salvage value	$	41,000
Annual net income generated		33,110
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.)

Answer 1

(1)-Accounting rate of return

Accounting Rate of return = (Net Income / Initial Investments) x 100

= [$33,110 / $385,000] x 100

= 8.60%

(2)-Payback Period

Straight Line Depreciation Expense = [Initial Investment – Salvage Value] / Useful Life

= [$385,000 - $41,000] / 8 Years

= $44,000 / 8 Years

= $43,000 per year

Annual Cash Flow = Net Income + Depreciation Expenses

= $33,110 + $43,000

= $76,110

Therefore, the Payback Period = Initial Investment / Annual Cash Inflow

= $385,000 / $76,110

= 5.06 Years

(3)-Net present value (NPV) if the cost of capital is 11.00%

Net present value = Present Value of annual cash inflows + Present Value of Salvage Value – Initial Investment

= $76,110(PVIAF 11.00%, 8 Years) + $41,000(PVIF 11.00%, 8 Years) - $385,000

= [($76,110 x 5.14612) + ($41,000 x 0.43393)] - $385,000

= $391,671 + $17,791 - $385,000

= $24,462

(4)-Net present value (NPV) if the cost of capital is 14.00%

Net present value = Present Value of annual cash inflows + Present Value of Salvage Value – Initial Investment

= $76,110(PVIAF 14.00%, 8 Years) + $41,000(PVIF 14.00%, 8 Years) - $385,000

= [($76,110 x 4.63886) + ($41,000 x 0.35056)] - $385,000

= $353,064 + $14,373 - $385,000

= -$17,563 (Negative NPV)

NOTE

-The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)n} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.

-The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)n], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.