Question

All scenarios are independent of all other scenarios. Assume that all cash flows are after-tax cash flows a. Kambry Day is considering investing in one of the following two projects. Either project will require an investment of \$20,000. The expected cash flows for the two projects follow. Assume that each project is depreciable. Year Project A ProjectB 6,000 6,000 2 8,000 8,000 3 10,000 10,000 4 10,000 3,000 10,000 5 3,000 b. Wilma Golding is retiring and has the option to take her retirement as a lump sum of \$450,000 or to receive \$30,000 per year for 20 years. Wilma's required rate o return is 6% c. David Booth is interested in investing in some tools and equipment so that he can do independent drywalling. The cost of the tools and equipment is \$30,000. He estimates that the return from owning his own equipment will be \$9,000 per year. The tools and equipment will last 6 years. d. Patsy Folson is evaluating what appears to be an attractive opportunity. She is currently the owner of a small manufacturing company and has the opportunity to acquire another small company's equipment that would provide production of a part currently purchased externally. She estimates that the savings from internal production will be \$75,000 per year. She estimates that the equipment will last 10 years. The owner is asking \$400,000 for the equipment. Her company's cost of capital is 8% Required: 1. Conceptual Connection: What is the payback period for each of Kambry Day's projects? Round your answers to two decimal places Project A years Project B years
If rapid payback is important, which project should be chosen? Project A 2. Conceptual Connection: Which of Kambry's projects should be chosen based on the ARR? If required, round to the nearest percent. Accounting rate of return (ARR): Project A: ARR Project B: ARR Project A 3. Assuming that Wilma Golding will live for another 20 years, should she take the lump sum or the annuity Wilma should take the lump sum. V 4. Assuming a required rate of return of 8% for David Booth, calculate the NP of the investment. If required, round t the nearest dollar. NPV Should David invest? Yes 5. Calculate the IRR for Patsy Folson's project. Round your answer to the nearest percent. Should Patsy acquire the equipment? Yes

#### Homework Answers

Answer #1

Solution 1) Calculation of Payback period for each of Kambry Day’s Projects

Payback period for Project A

 Year After tax Cash Flows Cumulative After tax Cash Flows 1 6000 6000 2 8000 14000 3 10000 24000 4 10000 34000 5 10000 44000

As the Initial Investment is \$20,000, the Payback period is between 2nd and 3rd Year.

PayBack Period

= Completed Number of Years + (Cash Inflows to be recovered / Cash inflows for the next Year)

= 2 + (20,000 – 14000)/ 10000

= 2.6 Years

Payback Period of Project A is 2.6 Years

Payback period for Project B

 Year After tax Cash Flows Cumulative After tax Cash Flows 1 6000 6000 2 8000 14000 3 10000 24000 4 3000 27000 5 3000 30000

As the Initial Investment is \$20,000, the Payback period is between 2nd and 3rd Year.

PayBack Period

= Completed Number of Years + (Cash Inflows to be recovered / Cash inflows for the next Year)

= 2 + (20,000 – 14000)/ 10000

= 2.6 Years

Payback Period of Project B is 2.6 Years

Both the projects have same payback period.

Solution 2) Calculation of Accounting Rate of Return for Project A

 Year After tax Cash Flows 1 6,000.00 2 8,000.00 3 10,000.00 4 10,000.00 5 10,000.00 Total 44,000.00

Calculation of Accounting Rate of Return

ARR = (Average Annual Profit After tax / Average Investment) x 100

Where, Average Investment = ½(Initial Cost + Installation Expenses – Salvage Value) + Salvage Value

Note: As information about Salvage value is mentioned, we will assume that salvage value after 5years is nil.

Average Investment =1/2(20,000 + 0 – 0) + 0

= \$10,000

Average Annual Profit After tax = \$44,000 / 5 = \$8,800

Therefore, ARR = \$8,800 / \$10,000 x 100

= 88%

ARR of Project A is 88%

Calculation of Accounting Rate of Return for Project B

 Year After tax Cash Flows 1.00 6,000.00 2.00 8,000.00 3.00 10,000.00 4.00 3,000.00 5.00 3,000.00 Total 30,000.00

Calculation of Accounting Rate of Return

ARR = (Average Annual Profit After tax / Average Investment) x 100

Where, Average Investment = ½(Initial Cost + Installation Expenses – Salvage Value) + Salvage Value

Note: As information about Salvage value is mentioned, we will assume that salvage value after 5years is nil.

Average Investment =1/2(20,000 + 0 – 0) + 0

= \$10,000

Average Annual Profit After tax = \$30,000 / 5 = \$6,000

Therefore, ARR = \$6,000 / \$10,000 x 100

= 60%

ARR of Project B is 60%

Based on Accounting Rate of Return, Project A should be selected

Solution 3) Calculation of the Present Value of \$30,000 to be received for 20 year.

Following are the steps to be followed on Microsoft Excel to calculate the Present Value of the payments:

Step 1: Click on "FORMULAS" tab at the top of Microsoft Excel
Step 2: Select the option "Financial"
Step 3: Under "Financial" select the option "PV"
Step 4: Insert Rate = 0.06 Nper = 20 PMT = -30000

PV = \$344,097.64

As the Present value of the lump sum amount is higher, Wilma Golding should take the lump sum amount of \$450,000.

Solution 4) Calculation of Net Present Value of the Investment

 Year After tax Cash Flows Present Value Factor @ 8 % Present Value of After tax Cash Flows 1 9,000.00 0.925926 8,333.33 2 9,000.00 0.857339 7,716.05 3 9,000.00 0.793832 7,144.49 4 9,000.00 0.735030 6,615.27 5 9,000.00 0.680583 6,125.25 6 9,000.00 0.630170 5,671.53 Total Present Value of After tax Cash Flows 41,605.92 Less: Cost of the Equipment 30,000.00 Net Present Value 11,605.92

Therefore, the Net Present Value of the Equipment is \$11,605.92. As the Net Present Value is positive, David Booth should invest in the equipment.

Solution 5) Calculation of Internal Rate of Return

 Year After tax Cash Flows 0 (4,00,000.00) 1 75,000.00 2 75,000.00 3 75,000.00 4 75,000.00 5 75,000.00 6 75,000.00 7 75,000.00 8 75,000.00 9 75,000.00 10 75,000.00

Following are the steps to be followed on Microsoft Excel to calculate the IRR:

Step 1: Click on "FORMULAS" tab at the top of Microsoft Excel
Step 2: Select the option "Financial"
Step 3: Under "Financial" select the option "IRR"
Step 4: Insert Values: (-400000; 75000; 75000; 75000; 75000; 75000; 75000; 75000; 75000; 75000; 75000)

IRR = 13.43%

The Internal Rate of Return of the equipment is 13.43%

As the Internal Rate of Return of the equipment is higher than the required rate of return, Patsy should acquire the equipment.

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