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)	$	350,000
Useful life		8	years
Salvage value	$	54,000
Annual net income generated		32,550
BBS’s cost of capital		11	%

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 14 percent. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Round the final answer to nearest whole dollar.)

	1. Accounting rate of return % 2. Payback period years 3. Net present value 4. Net present value assuming 14% cost of capital

Answer 1

Ans. 1	Accounting rate of return = After tax net income / Average investment * 100
	$32,550 / $202,000 * 100
	16.11%
	*Average investment = (Initial investment + Salvage value) / 2
	($350,000 + $54,000) / 2
	$404,000 / 2
	$202,000
Ans. 2	*Depreciation = (Cost of project - Salvage value) / Useful life in years
	($350,000 - $54,000) / 8
	$296,000 / 8
	$37,000
	Net income	$32,550
	Add: Depreciation	$37,000
	Annual cash inflows	$69,550
	Payback period = Initial investment / Annual cash inflows
	$350,000 / $69,550
	5.03	years
Ans. 3	Present value of cash inflow = Annual cash inflows * Present value of an annuity of 1 of 11%
		$69,550 * 5.146
		$357,904	(rounded)
	Present value of cash inflows	$357,904
	Less: Investment	-$350,000
	Net present value	$7,904
	*Calculation of Present value factor @11%.
	Year		PV @ 11%
	1	1 / (1 + 0.11)^1	0.9009
	2	1 / (1 + 0.11)^2	0.8116
	3	1 / (1 + 0.11)^3	0.7312
	4	1 / (1 + 0.11)^4	0.6587
	5	1 / (1 + 0.11)^5	0.593
	6	1 / (1 + 0.11)^6	0.535
	7	1 / (1 + 0.11)^7	0.482
	8	1 / (1 + 0.11)^8	0.434
	Total of Present value of an annuity		5.146
Ans. 4	Present value of cash inflow = Annual cash inflows * Present value of an annuity of 1 of 14%
		$69,550 * 4.639
		$322,642	(rounded)
	Present value of cash inflows	$322,642
	Less: Investment	-$350,000
	Net present value	-$27,358
	*Calculation of Present value factor @14%.
	Year		PV @ 14%
	1	1 / (1 + 0.14)^1	0.8772
	2	1 / (1 + 0.14)^2	0.7695
	3	1 / (1 + 0.14)^3	0.6750
	4	1 / (1 + 0.14)^4	0.5921
	5	1 / (1 + 0.14)^5	0.519
	6	1 / (1 + 0.14)^6	0.456
	7	1 / (1 + 0.14)^7	0.400
	8	1 / (1 + 0.14)^8	0.351
	Total of Present value of an annuity		4.639