Question

Cardinal Company is considering a five-year project that would require a $2,500,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 12%. The project would provide net operating income in each of five years as follows:

Sales			$	2,853,000
Variable expenses				1,200,000
Contribution margin				1,653,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	790,000
Depreciation		500,000
Total fixed expenses				1,290,000
Net operating income			$	363,000

1.If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project's net present value to be higher, lower, or the same?

2. If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project’s simple rate of return to be higher, lower, or the same?

3. Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 50%. What was the project’s actual payback period?

4. Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 50%. What was the project’s actual simple rate of return?

Answer 1

Answer 1

In the case of NPV calculations, we consider Net Cash Flows after tax, which involves adding back depreciation and other non-cash expenses to the net income.

If the equipment has a salvage value at the end of its lifetime, the cash flows after tax in the last year of useful life would increase by the amount og such salvage value, thereby increasing the present value of inflows and thus, the NPV.   

Hence, NPV will be higher if the equipment has a salvage value.

The same can be validated as under:

No salvage value

Cash Flows After Tax for all years = 363,000 + 500,000 = 863,000

With salvage value

Answer 2

Annual rate of return is calculated as a percentage terms of net income to the initial investment.

Equipment having a salvage value has a lower amount of depreciation than equipment without salvage value.

Depreciation (if no salvage value) = 2.5 mn/5 years = 500k per annum

Depreciation (with salvage value) = (2.5 mn - 300k)/5 years = 440k per annum.

Thus, with a lower depreciation, the amount of total expenses will reduce, which in turn will boost the net income, and therefore the annual rate of return.

Hence, ARR will be higher if the equipment has a salvage value.

Answer 3

Calculation of cash flows after tax

Calculation of payback period

Answer 4

Annual rate of return = (Net income/Initial Investment) *100 = (136,500/2,500,000)*100 = 5.46%.

In case of any questions on the above workings, please share the same in the comments section.

All the best!