Question

Division ABC is currently generating an ROI of 12%. It is considering a new project. This requires an investment of $1.4 million and expected to yield net cash inflows of $460,000 per annum for the next four years. There is no salvage value at the end of fourth year.

The company has a cost of capital of 8%. The depreciation method is “straight line’. There are no taxes.

1. Calculate the Internal Rate of Return for the project. Should we accept or reject the project? Explain. (use your financial calculator to calculate IRR, or E)

2. Calculate and comment on the Net Present Value of the project. Should we accept or reject the project? Explain.

3. Calculate and comment on the Return on Investment ( ROI) for the project next 4 years using straight line depreciation method? Explain your findings.

4. Calculate and comment on the Residual Income (RI) for the project next 4 years using straight line depreciation method. Explain your findings.

5. Assume that the division changes managers every year. Is there a way to be fair to each manager using RI and the annuity depreciation method? Explain

Answer 1

	a) IRR
		Year	Cashflows
		0	-$1,400,000
		1	$460,000
		2	$460,000
		3	$460,000
		4	$460,000
		using excel IRR function	11.90%
	b) NPV	Present value annuity factor of 8% for 4 years	3.31212684		1	0.925926
		Present value of annual cashflows	460,000*3.31212684		2	0.857339
			$1,523,578		3	0.793832
		Less: initial investment	-$1,400,000		4	0.73503
		NPV	$123,578			3.312127
	c)	ROI	Net income/Initial investment
		Net income=	Cash inflows- depreciation
			460,000-350,000
			$110,000
		ROI=	110,000/1,400,000
			7.86%
	d)	Residual income	Net Income of the Firm – Cost of capital*initial investment
			110,000-8%*1,400,000
			-$2,000
	e)	The annuity method of depreciation focuses on figuring for a constant rate of return on any asset. To do so, these steps should be followed: Make an estimate of the future cash flows that are associated with an asset. Determine what the internal rate of return will be on those cash flows. Multiply that IRR by the asset's initial book value. Subtract the above result from the cash flow for the current period. The result of step 4 will be the depreciation to charge to expense in the current period.