Question

A friend of yours is analyzing an investment in a small peach orchard. He has estimated that the orchard will require an initial expenditure of $25,000 to prepare the soil, buy and plant the trees, and install new irrigation equipment. The trees won’t produce for the first 2 years, and will produce at only 1/2 and 3/4 of full production in years 3 and 4, respectively. Your friend estimates his net income will be negative in the first couple of years as he continues to spend time and money on the orchard with no production, but expects his net income to become positive in year three and eventually reach $6,000 per year. Your friend expects to have the trees until the end of the 15th year (after harvest), at which time he will remove them at a cost of $5000.

To summarize, your friend estimates his net income each year will be as follows:

Year 0: -$25,000

Year 1: -$10,000

Year 2: -$5,000

Year 3: $1,000

Year 4: $2,500

Year 5: $6,000

Years 6 through 14: $6,000 per year.

Year 15: You tell me…harvest happens, but then trees have to be removed…what is the net income for year 15?

1. How much money would an investor expect to make from this project? (This is just the Total Net Return)?

2. What is the Net Return in Year 15?

3. What is the Simple Rate of Return of the investment? Please enter your answer as a percent without the percentage sign.

4. Does the SRR indicate this project would be accepted by an investor?

5. In what period (Year) does this investment "break even?" You can think of this as the Payback Period of this investment, but you can't use the formula in this case because the returns are not constant for all years. Instead you can just compute the year the returns finally pay off the initial investment and any losses.

6. Your friend knows how to compute the total net return, and is talking to you because he wants a slightly more “complete” analysis; he heard about something called the Net Present Value (NPV), and wants you to help.  After some discussion, your friend tells you he wants to analyze the investment using a 7% discount rate.

What is the Present Value of the $25,000 initial investment? (Hint: is it negative or positive?)

7. What is the present value (PV) of the $10,000 net loss your friend will incur during the first year?

8. What is the NPV of the project?

9. This NPV indicates the project  ________ (would/would not) be accepted by an investor with a 7% discount rate.

Answer 1

1. Total net return = -25000-10000-5000+1000+2500+6000*10+6000-5000=$24500

2. Net Return in year 15 is 6000-5000=$1000

3. Simple rate of return = 24500/45000*100=54.44

4. Yes, as it is positive

5. 45000/6000=7.5 years

6. Net Present value of initial investment is negative.

7. 10000*1/1.07=-9346

8. Net Present Value of the project is difference between Present value of Cash Inflows and present value of cash outflows.

9. First we have to find out NPV of this project as follows

Present Value of Cash Outflows:

Yr-0 =-25000*1 =-25000

Yr-1 = -10000*0.935 = -9350

Yr-2 = -5000*0.873 = -4365

Present Value of Cash Inflows:

Yr-3 =1000*0.816=816

Yr-4=2500*0.763=1097.5

Yr-5=6000*0.713=4278

Yr-6=6000*0.666=3996

Yr-7=6000*0.623=3738

Yr-8=6000*0.582=3492

Yr-9=6000*0.544=3264

Yr-10=6000*0.508=3048

Yr-11=6000*0.475=2850

Yr-12=6000*0.444=2664

Yr-13=6000*0.415=2490

Yr-14=6000*0.388=2328

Yr-15 =1000*0.362=362

Formula to find out Discount rate is = (1+r)^-n

where r=interest rate and n=number of periods

Or Discount rates can be found from Present values Tables

Net Present Value of this project is = -$4291.50

As the NPV is Negative, this project would not be accepted.