Question

Balloons By Sunset (BBS) is considering the purchase of two new hot air balloons so that it can expand its desert sunset tours. Various information about the proposed investment follows: (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided.)

Initial investment (for two hot air balloons)	$	356,000
Useful life		6	years
Salvage value	$	56,000
Annual net income generated		29,904
BBS’s cost of capital		9	%

Assume straight line depreciation method is used.

Required:
Help BBS evaluate this project by calculating each of the following:

1. Accounting rate of return. (Round your answer to 2 decimal places.)
2. Payback period. (Round your answer to 2 decimal places.)
3. Net present value (NPV). (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)
4. Recalculate the NPV assuming BBS's cost of capital is 12 percent. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)

Answer 1

Initial investment (for two hot air balloons)	$	356,000
Useful life		6	years
Salvage value	$	56,000
Annual net income generated		29,904
BBS’s cost of capital		9	%

Assume straight line depreciation method is used

1. Accounting rate of return. = 16.80%

ARR calculates the return, generated from net income of the proposed capital investment.

ARR = Average return during period / Average investment

Where,

Average investment = ( investment at beginning + ending ) / 2

Average return during period = total earning on investment life / useful life

Here the annual net income generated  $ 29904 is the average earning

Average return during period = $ 29904

Average investment = ( 356,000 + 0) / 2 = 178000

ARR = 29904 / 178000 = 0.168   = 16.80%

2. Payback period. = 3.99 years

Here we can calculate the payback simply, initial investment divided by annual cash flow

Payback period = initial investment / Annual cash flow

initial investment = 356000

Annual cash flow = net income + depreciation exp.

      net income = 29904

   

depreciation exp. Under straight line over 6 year life

depreciation exp. =   356000 / 6 = 59333

Annual cash flow = 29904 + 59333 = 89237

Payback period = 356000 / 89237 = 3.99 years

With in 3.99 years we can recoup our initial investment

3. Net present value (NPV).   = $ 77703

For calculating this just convert every cash flow to its present value form

Annual cash flow = net income + depreciation exp

Annual cash flow = 29904 + 59333 = 89237

Terminal cash flow

items	CF	PV factor @ 9%	Present value of CF at discounted @ 9%
Initial investment (0th time)	(356000)	(1 / 1 + 9%)0 = 1	(356000)
Annual operating cash flow( 1 to 6 years	89237 (annuity)	( 1/1 + 9%)6GT =4.4859	400310
Salvage value at terminal year	56000	(1/1+9%)6 =0.5963	33392.8

NPV = Present value of cash flow - initial investment

NPV = 400310 + 33392.8 - 356000

NPV = 433702.8 - 356000 = 77703

4. Recalculate the NPV assuming BBS's cost of capital is 12 percent

NPV @ 12% = $ 39261

items	CF	PV factor @ 9%	Present value of CF at discounted @ 9%
Initial investment (0th time)	(356000)	(1 / 1 + 12%)0 = 1	(356000)
Annual operating cash flow( 1 to 6 years	89237 (annuity)	( 1/1 + 12%)6GT =4.1114	366889.65
Salvage value at terminal year	56000	(1/1+12%)6 =0.50663	28371.28

NPV = Present value of cash flow - initial investment

NPV = 366889.65 + 28371.28  - 356000

NPV = 395261 - 356000   =   39261