Question

Water Planet is considering purchasing a water park in Atlanta, Georgia, for $1,870,000. The new facility will generate annual net cash inflows of $460,000 for eight years.  Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 10% on investments of this nature.

Requirements:

1. Compute the payback period, the ROR, the NPV, the IRR, and the profitability index of this investment.
2. Recommend whether the company should invest in this project.

Payback Period

Rate of Return (ROR)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Recommendation

Answer 1

Solution A:

Payback period = Initial investment / Annual cash inflows = $1,870,000 / $460,000 = 4.07 years

Rate of return = Net income / Initial investment = ($460,000 - $1,870,000/8) / $1,870,000 = 12.1%

Computation of NPV
Particulars	Period	Amount	PV factor at 10%	Present Value
Cash outflows:
Cost of expansion	0	$1,870,000.00	1	$1,870,000
Present Value of Cash outflows (A)				$1,870,000
Cash Inflows
Annual cash inflows	1-8	$460,000.00	5.335	$2,454,068
Present Value of Cash Inflows (B)				$2,454,068
Net Present Value (NPV) (B-A)				$584,068

PV factor at IRR = Initial investment / Annual cash inflows = $1,870,000 / $460,000 = 4.065

Refer factor table, this factor falls nearest to IRR = 18%

Profitability index = NPV / Initial Investment = $584,068 / $1,870,000 = 0.31

Solution 2:

Recommendation : company should invest in this project.