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Question 3: Capital Budgeting Suggested time: 30 minutes Top Spin company is considering investing in a...

Question 3: Capital Budgeting
Suggested time: 30 minutes
Top Spin company is considering investing in a roof-top solar network to generate its own power. Assume that the expected annual cash inflows from new solar network will be $50,000. A $150,000 net initial investment is required and the network has five-year useful life and 18% required rate of return. Assume that the investment will occur immediately after management approves the project.
a. For making decision on whether to approve or reject the project, compute the Net Present Value (NPV) of this new investment and analyze whether it will be accepted or rejected and why. (10 marks)
b. To determine a rate at which NPV will be zero, compute Internal Rate of Return and analyze the result. (10 marks)
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Answer #1

1. Calculation of NPV -

Computation of NPV
Initial Cost $150,000
Useful life of Project 5 years
Annual Cash Inflow $50,000
Salvage Value 0
Required Rate of Return 18%
Item Years Amount of Cash Flow 18 % Factor Present Value of Cash Flow
Annual Cash Inflow 1-5 $50,000 3.127 $156,350
Initial Investment Now ($150,000) 1 ($150,000)
Net Present Value $6,350

Investment Decision -

Yes, the project should be accepted, because the net present value is positive ($6,350). Having a positive net present value means the project promises a rate of return that is higher than the Minimum rate of return (18%) required by management.

Internal Rate of Return is 19.87% for factor 3 (Calculations provided below)

Item Years Amount of Cash Flow *IRR- 19.87 % Factor (3) Present Value of Cash Flow
Annual Cost Saving 1-5 $50,000 3 $150,000
Initial Investment Now ($150,000) 1 ($150,000)
Net Present Value $0
*IRR Factor Initial Investment $150,000 = 3
Annual cash inflow $50,000

IRR Calculations with Trial & Error

IRR= (((Change in Rate(20%-19%)/(PV of Lower Cash Inflow-PV of Higher Cash Inflow))* NPV of Lower Rate (19%)) + Lower Rate (19%)

IRR=(((0.01)/(152900-149550))*2900=0.87% +19= 19.87%

Calculations as per below:

NPV with 19 % (Factor- 3.058)

Item Years Amount of Cash Flow 19 % Factor Present Value of Cash Flow
Annual Cash Inflow 1-5 $50,000 3.058 $152,900
Initial Investment Now ($150,000) 1 ($150,000)
Net Present Value $2,900

NPV with 20 % (Factor- 2.991)

Item Years Amount of Cash Flow 20 % Factor Present Value of Cash Flow
Annual Cash Inflow 1-5 $50,000 2.991 $149,550
Initial Investment Now ($150,000) 1 ($150,000)
Net Present Value ($450)

Analysis-

  If IRR is greater than or equal to the Required Rate of Return, the company would accept the project as a good investment. In Our case it is more than our Required rate of Return of 18%.

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