Question

Drake Corporation is reviewing an investment proposal. The initial cost and estimates of the book value of the investment at the end of each year, the net cash flows for each year, and the net income for each year are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its book value. There would be no salvage value at the end of the investment's life. Investment proposal Annual Net Income Annual Cash Flows Initial Cost & Book Value $105,000 70,000 Year 0 $10,000 1 $45,000 40,000 35,000 30,000 25,000 12,000 14,000 16,000 42,000 21,000 7,000 3 18,000 5 Drake Corporation uses 11 % target rate of return for new investment proposals. (a) Cash payback period is: (b-1) Average Investment is (b-2) Annual Rate of Return is: (c) Net Cash Flows: Discount Present Value Year # Amount Factor 11% $ 45,000 1 0.90090 S 2 4 5 Total Present value cash inflows Less: ?? Net Present Value

Answer 1

a. Cash payback period

Year	Cash Flows	Cumulative cash flow
0	-105000	-105000
1	45000	-60000
2	40000	-20000
3	35000	15000
4	30000	45000
5	25000	70000

As seen from above table, cash payback period will lie between year 2 and 3.

Cash payback period = 2 + (20000 / 35000) = 2.57 years

b-1. Average investment = ( Book Value of investment at beginning + Book Value of investment at end ) / 2

= (105000 + 0 ) / 2

= $ 52 500

b-2. Annual rate of return = Average Annual Net Income / Average Investment

Average Annual Net Income = Total Annual Net Income / No of years

= (10000 + 12000 + 14000 + 16000 + 18000) / 5

= 70000 / 5 = $ 14,000

Annual rate of return = 14000 / 52500 = 0.2667 or 26.67%

c. Net Cash Flows

Year	Discount Factor 11%	Cash Flows	Present Value
1	0.901	45000	40541
2	0.812	40000	32465
3	0.731	35000	25592
4	0.659	30000	19762
5	0.593	25000	14836
Total PV cash inflows			133195
Less: Initial Investment			-105000
NPV			28195