Question

QUESTION Wordse Pearl insulating Company is considering purchasing a new equipment. It will require an initial investment of $7,000,000. The new project will provide $1.200.000 constant net income each year, over the next four years. The scrap value for new equipment will be $120,000 The expected cash flow for the next 4 years are as follows: Year Cash flow (5) 1 2 3 2,800,000 2,450,000 10% decrease from year2 1,300,000 4 and Submit to send it. Click Save All Antall

Answer 1

1]	ARR = Average NI/Initial investment = 1200000/7000000 =	17.14%
2]	The company can purchase the new equipment as the ARR is
	greater than the expected rate of return of 12%.
3]	ARR has the disadvantages:
	*It is based on accounting profits not cash flows. Hence, the
	analysis is not realistic and can depend on the assumptions
	made in preparing financial results.
	*It does not consider time value of money
	*It does not consider risk
	*It does not give the addtion to shareholders' wealth if the
	investment is made.
4]	Payback period is the time taken for the cash flows to recoup
	the initial investment. As the cash flows are uneven, the
	cumulative cash flows are to be worked out to find the
	payback period.
	Year	Cash flows	Cumulative cash flows
	0	$        (7,000,000)	$      (7,000,000)
	1	$           2,800,000	$      (4,200,000)
	2	$           2,450,000	$      (1,750,000)
	3	$           2,695,000	$            945,000
	4	$           1,300,000	$         2,245,000
	Payback period = 2+1750000/2695000 =	2.65	Years
5]	As the payback period of the project is more than the acceptable maximum, the prorject should
	not be accepted.
6]	The payback method has the following advantages:
	*It is based on cash flows
	*It considers risk as it favors investments with shorter paybacks
	*It is easy to understand and workout.
7]	The NPV is worked out in the table below:
	Year	Cash flows	PVIF at 12%	PV at 12%
	0	$        (7,000,000)	1.00000	$ (7,000,000)
	1	$           2,800,000	0.89286	$    2,500,000
	2	$           2,450,000	0.79719	$    1,953,125
	3	$           2,695,000	0.71178	$    1,918,248
	4	$           1,300,000	0.63552	$        826,174
	NPV			$        197,546
8]	As the NPV is positive, the project can be accepted.
	Positive NPV indicates the net addition to shareholders' wealth in present value terms, if the project is
	implemented.
9]	NPV was chosen because of the following advantages of the method:
	*It considers the time value of money
	*It can consider risk by adjusting the discount rate or the cash flows themseleves
	*It considers only cash flows
	*It considers the cash flows for the entire life of the opportunity
	*It gives the net addition to shareholders' wealth if the project is accepted. Addition/maximization of shareholders'
	wealth is the goal of financial management
	*It can rank projects