In: Accounting
Ursus, Inc., is considering a project that would have a eleven-year life and would require a $1,848,000 investment in equipment. At the end of eleven years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows (Ignore income taxes.):
Sales | $ | 2,100,000 | ||||
Variable expenses | 1,400,000 | |||||
Contribution margin | 700,000 | |||||
Fixed expenses: | ||||||
Fixed out-of-pocket cash expenses | $ | 370,000 | ||||
Depreciation | 168,000 | 538,000 | ||||
Net operating income | $ | 162,000 | ||||
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using the tables provided.
All of the above items, except for depreciation, represent cash flows. The company's required rate of return is 9%.
Required:
a. Compute the project's net present value. (Round your intermediate calculations and final answer to the nearest whole dollar amount.)
b. Compute the project's internal rate of return. (Round your final answer to the nearest whole percent.)
c. Compute the project's payback period. (Round your answer to 2 decimal place.)
d. Compute the project's simple rate of return. (Round your final answer to the nearest whole percent.)
A) Net Present Value
Net Operating Income = 162,000
Add: Annual Depreciation = 168,000
Cash Inflow from Project = 330,000
Present Value of Cash Inflow = Annual Cash Inflow * Present Value Annuity Factor (9%, 11 years)
= 330,000 * 6.80519
= 2,245,713
Net Present Value = Present Value of cash inflows – Present value of cash outflows
= 2,245,713 – 1,848,000
= $ 397,713
Note: As the cash inflows is same throughout the project, therefore annuity table has been used to calculate PV of cash inflows. Result will be same either you discount each year cash flow individually and then sum up all or use annuity table.
B) Internal Rate of Return
Payback Period = 1,848,000/330,000
= 5.6
Now look on Present value annuity table and find out that at what rate for 11 years present value factor is 5.6 or around 5.6. From table, at 13% for 11 years PV is 5.6869 and at 14% for 11 years PV is 5.4527. It means Internal Rate of Return lies between 13 to 14%.
Use the following formula to determine exact IRR
PV at 13% = 330,000 * 5.6869 = 1,876,677
PV at 14% = 330,000 * 5.4527 = 1,799,391
= 13 + {(1,876,677 - 1,848,000) / (1,876,677 – 1,799,391)} * (14 -13)
= 13 + (28,677 / 77,286) * 1
= 13 + 0.37
= 13.37 % or 13 %
C) Payback Period
= Total Initial Investment / Annual Cash Inflows
= 1.848,000 / 330,000
= 5.6 years
D) Simple Rate of Return
= Annual Net Income / Investment
= 162,000 / 1 848,000
= 8.76% or 9%
Note: Throught the calculation present value factors are taken upto 4 decimal places.