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

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 2^nd and 3^rd 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 2^nd and 3^rd 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.