Question

A company that manufactures recreational pedal boats has approached Mike Cichanowski to ask if he would be interested in using Current Designs’ rotomold expertise and equipment to produce some of the pedal boat components. Mike is intrigued by the idea and thinks it would be an interesting way of complementing the present product line.
One of Mike’s hesitations about the proposal is that the pedal boats are a different shape than the kayaks that Current Designs produces. As a result, the company would need to buy an additional rotomold oven in order to produce the pedal boat components. This project clearly involves risks, and Mike wants to make sure that the returns justify the risks. In this case, since this is a new venture, Mike thinks that a 15% discount rate is appropriate to use to evaluate the project.
As an intern at Current Designs, Mike has asked you to prepare an initial evaluation of this proposal. To aid in your analysis, he has provided the following information and assumptions.
1.    The new rotomold oven will have a cost of $256,000, a salvage value of $0, and an 8-year useful life. Straightline depreciation will be used.
2.    The projected revenues, costs, and results for each of the eight years of this project are as follows.
Sales                                 $220,000
Less:
          Manufacturing Costs                    $140,000
          Depreciation                                      32,000
          Shipping and Admin. Costs               22,000                194,000
Income Before Income Taxes                                                  26,000
Income Tax Expense                                                             10,800
Net Income                                                                            $15,200
Instructions:
(a)  Compute the annual rate of return (Round to two decimal places)
(b)  Compute the payback period (Round to two decimal places)
(c)  Compute the net present value using a discount rate of 9% (Round to the nearest dollar). Should the proposal be accepted using this discount rate?
(d)  Compute the net present value using a discount rate of 15%. (Round to the nearest dollar) Should the proposal be accepted using this discount rate?

Answer 1

(a) First, we will calculate Annual rate of return by using formula= Net profit/ Initial investment\

Net profit/income= $15,200 (given)

Initial investment= $256,000

By putting values in formula= $15,200/ $256,000*100= 5.94%

(b) Next, we will calculate Pay back period by using formula= Initial investment/ Net annual cash inflow

Initial investment= $256,000

Net annual cash inflow= Net Income+ Depreciation

We take Net Income from the Income statement i.e $15,200 but we need to calculate the amount of depreciation by using formula= Cost-Salvage value/ Useful life of an oven.

= $256,000- $0/ 8 years= $32,000

Now, we can calculate Net annual cash inflow= $15,200 + $32,000= $47,200

Pay back period= $256,000/ $47,200= 5.42 years

(c) Next, we will calculate Net present value by using formula= Total present value- Initial Investment

For this we need to calculate Total present value by using formula= Cash inflow* PV factor at 9%

=$47,200* 0.9174(taken from present value annuity table at 9%)= $43301.28

Net present value= $43301.28-$256,000= ($212,700 or $212,699)*

* Note- Brackets are the indication of negative value.

In the above case, the NPV is negative and it is rejected. It is accepted only in either condition when NPV is positive is Zero or positive.

(d)We will calculate Net present value by using formula= Total present value- Initial Investment

For this we need to calculate Total present value by using formula= Cash inflow* PV factor at 15%

==$47,200*0.8696 (taken from present value annuity table at 15%)= $41045.12

Net present value=$41045.12- $256,000=($214,955 or $ 215,000)

Since the NPV is again negative, this proposal should also be rejected.