Question

E26-11 Drake Corporation is reviewing an investment proposal. The initial cost and esti- mates 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 Initial Cost and Book Value Annual Cash Flows Annual Net Income Year 0 $105,000 70,000 42,000 21,000 7,000 $45,000 40,000 35,000 30,000 25,000 $10,000 12,000 14,000 16,000 18,000 2 4 0 Drake Corporation uses an 11% target rate of return for new investment proposals. Instructions (a) What is the cash payback period for this proposal? (b) What is the annual rate of return for the investment? (c) What is the net present value of the investment? (a) Cash payback period is: (b-1) Average Investment is: (b-2) Annual Rate of Return is: (c) Net Cash Flows:

Answer 1

Solution a:

Computation of cumulative cash flows
Year	Cash Flows	Cumulative cash flows
1	$45,000.00	$45,000.00
2	$40,000.00	$85,000.00
3	$35,000.00	$120,000.00
4	$30,000.00	$150,000.00
5	$25,000.00	$175,000.00

Payback period = 2 years + ($105,000 - $85,000) / $35,000 = 2.57 years

Solution b:

Average investment = (Cost + Salvage value) / 2 = ($105,000 + 0) / 2 = $52,500

Average annual income = ($10,000 + $12,000 + $14,000 + $16,000 + $18,000) / 5 = $14,000

Annual rate of return = Average annual income / Average investment = $14,000 / $52,500 = 26.67%

Solution c:

Computation of NPV - Drake Company
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Initial investment	$105,000.00	0	1	$105,000
Present Value of Cash Outflows (A)				$105,000
Cash Inflows:
Year 1	$45,000.00	1	0.90090	$40,541
Year 2	$40,000.00	2	0.81162	$32,465
Year 3	$35,000.00	3	0.73119	$25,592
Year 4	$30,000.00	4	0.65873	$19,762
Year 5	$25,000.00	5	0.59345	$14,836
Present Value of Cash Inflows (B)				$133,195
Net Present Value (B-A)				$28,195