Question

Cardinal Company is considering a project that would require a $2,810,000 investment in equipment with a useful life of five years. At the end of five years, the project would terminate and the equipment would be sold for its salvage value of $500,000. The company’s discount rate is 16%. The project would provide net operating income each year as follows:

  

Sales			$	2,847,000
Variable expenses				1,121,000
Contribution margin				1,726,000
Fixed expenses:
Advertising, salaries, and other     fixed out-of-pocket costs	$	782,000
Depreciation		462,000
Total fixed expenses				1,244,000
Net operating income			$	482,000

6.	What is the project profitability index for this project? (Use the appropriate table to determine the discount factor(s) and final answer to 2 decimal places.)

7.	What is the project’s payback period? (Round your answer to 2 decimal places.)

8.	What is the project’s simple rate of return for each of the five years? (Round your answer to 2 decimal places. (i.e 0.1234 should be entered as 12.34.))

12.	If the equipment’s salvage value was $700,000 instead of $500,000, what would be the project’s simple rate of return? (Round your answer to 2 decimal places. (i.e 0.1234 should be entered as 12.34.))

Answer 1

6) Project profitability index is equal to present value of future cash inflows divided by initial investment. Project profitability index is calculated as follows:-

Initial Investment = $2,810,000

Salvage Value at the end of 5 years = $500,000

Annual Cash Flows = Net Operating Income+Depreciation

= $482,000+$462,000 = $944,000

Present Value of Cash Inflows = PV of Annual Cash Inflows+PV of Salvage value

= [Annual Cash Inflows*PVAF(5 yrs, 16%)]+[Salvage Value*PVF(5 yrs, 16%)]

= ($944,000*3.27429)+($500,000*0.47611)

= $3,090,929.76+$238,055 = $3,328,984.76

Project Profitability Index = Present Value of Cash Inflows/Initial Investment

= $3,328,984.76/$2,810,000 = 1.18

7) Project's Payback period = Initial Investment/Annual Cash Inflows

= $2,810,000/$944,000 = 2.98

8) Project's Simple rate of return = Average Annual Net Operating Income/Average Investment

Average Investment = (Book Value at the beg.+Book Value at the end)/2

= ($2,810,000+$500,000)/2 = $1,655,000

Project's Simple rate of return = $482,000/$1,655,000 = 0.2912 or 29.12%

12) Project's Simple rate of return = Average Annual Net Operating Income/Average Investment

Average Investment = (Book Value at the beg.+Book Value at the end)/2

= ($2,810,000+$700,000)/2 = $1,755,000

Project's Simple rate of return = $482,000/$1,755,000 = 0.2746 or 27.46%