Question

Spring 2018

Quiz 9    Name:_____________

Clyde Corp is considering the purchase of a new piece of equipment. The cost savings from the equipment would result in an annual increase in cash flow of $100,000. The equipment will have an initial cost of $600,000 and have an 8 year life. The equipment has no salvage value. The hurdle rate is 8%. Ignore income taxes. (Present Value of Annuity for 8%: 5.7466;
12%:4.9676) -

Answer the following:

a. What is the accounting rate of return?
b. What is the payback period?
c. What is the net present value?
d. What would the net present value be with a 12% hurdle rate?
e. Based on the NPV calculations, in what range would the equipment's internal rate of return fall?

Answer 1

Ans:

a. Accounting rate of return = Average inflows*100 / Initial investment

= $ 1,00,000*100 / $ 6,00,000

= 16.67%

b. Payback period = Initial investment / Inflows per year

= $ 6,00,000 / $ 1,00,000

= 6 years

c. Net present Value = PV of inflows @ 8% for 8 years - Initial investment

= $ 1,00,000*5.7466 - $ 6,00,000

= $ 5,74,660 - $ 6,00,000

= - $25,340

d. Net Present Value = PV of inflows @ 12% for 8 years - Initial investment

= $ 1,00,000*4.9676 - $ 6,00,000

= $ 4,96,760 - $ 6,00,000

= - $ 1,03,240

e. At internal rate of return, NPV is equals to 0. Since with the increase in the rate of return from 8% to 12%, the NPV is decreasing and at 8% also the NPV is negative. So, we can say that internal rate of return will be in the range of less than 8% to 0%

(Extra working : for NPV -$ 25,340 , rate = 8%

for NPV -$103,240, rate = 12%

for NPV $0, rate = 12 - {-103,240*(12-8)/ (-103,240 + 25,340) }  

= 12 - 5.30

= 6.70% )