Question

Aaron Heath is seeking part-time employment while he attends school. He is considering purchasing technical equipment that will enable him to start a small training services company that will offer tutorial services over the Internet. Aaron expects demand for the service to grow rapidly in the first two years of operation as customers learn about the availability of the Internet assistance. Thereafter, he expects demand to stabilize. The following table presents the expected cash flows:

Year of
Operation	Cash Inflow			Cash Outflow
2019	$	12,900		$	9,500
2020		20,000			11,000
2021		22,500			12,800
2022		22,500			12,800

In addition to these cash flows, Aaron expects to pay $21,800 for the equipment. He also expects to pay $3,500 for a major overhaul and updating of the equipment at the end of the second year of operation. The equipment is expected to have a $1,400 salvage value and a four year useful life. Aaron desires to earn a rate of return of 12 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

1. Calculate the net present value of the investment opportunity. (Negative amount should be indicated by a minus sign. Round intermediate calculations and final answer to 2 decimal places.)

2. Indicate whether the investment opportunity is expected to earn a return that is above or below the desired rate of return and whether it should be accepted.

Answer 1

Solution a:

Computation of NPV - Aaron Heath
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Initial investment	$21,800	0	1	$21,800.00
Overhaul cost	$3,500	2	0.79719	$2,790.17
Present Value of Cash Outflows (A)				$24,590.17
Cash Inflows:
Year 1	$3,400	1	0.89286	$3,035.72
Year 2	$9,000	2	0.79719	$7,174.71
Year 3	$9,700	3	0.71178	$6,904.27
Year 4	$9,700	4	0.63552	$6,164.54
Salvage Value	$1,400	4	0.63552	$889.73
Present Value of Cash Inflows (B)				$24,168.97
Net Present Value (B-A)				-$421.19

Solution b:

As NPV is negative, it means  investment opportunity is expected to earn a return that is below the desired rate of return, therefore investment should not be accepted.

Note:

Actual answer may differ due to rounding off differences of PV factors. As PV factor table not provide, we have considered 5 decimal places for PV factors.