Question

Cardinal Company is considering a five-year project that would require a $2,975,000 investment in equipment with a useful life of five years and no salvage value. The company's discount rate is 14%. The project would provide net operating income in each of five years as follows: $2,735,000 1,000,000 1,735,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $735,000 595,000 1,330,000 $ 405,000

1. Which item(s) in the income statement shown above will not affect cash flows?

2. What are the project's annual net cash inflows?

3. What is the present value of the project's annual net cash inflows?

4. What is the project's net present value?

5. What is the project profitability index for this project? (Round your answer to the nearest whole per cent.)

7. What is the project's payback period?

8. What is the project's simple rate of return for each of the five years?

9. If the company's discount rate was 16% instead of 14%, would you expect the project's net present value to be higher than, lower than, or the same as your answer to requirement 4? No computations are necessary.

10. If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project's payback period to be higher than, lower than, or the same as your answer to requirement 7? No computations are necessary.

11. If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project's net present value to be higher than, lower than, or the same as your answer to requirement 3? No computations are necessary.

12. If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project's simple rate of return to be higher than, lower than, or the same as your answer to requirement 8? No computations are necessary

Answer 1

1) The depreciation expense of $595,000 is the only non-cash expense.
2)
Annual net cash inflows:
Net operating income	$405,000
Add: Noncash deduction for depreciation	$595,000
Annual net cash inflow	$1,000,000
3)
Present value of the annual net cash inflows = $1,000,000 x PVOA(14%,5)
Present value of the annual net cash inflows = $1,000,000 x 3.433	$3,433,000.000
4)
Year	0	1	2	3	4	5
Purchase of equipment	$     (2,975,000.00)
Sales		$      2,735,000.00	$     2,735,000.00	$      2,735,000.00	$            2,735,000.00	$ 2,735,000.00
Variable Expense		$      1,000,000.00	$     1,000,000.00	$      1,000,000.00	$            1,000,000.00	$ 1,000,000.00
Out-of-pocket costs		$         735,000.00	$        735,000.00	$         735,000.00	$               735,000.00	$    735,000.00
Total cash flows	$     (2,975,000.00)	$      1,000,000.00	$     1,000,000.00	$      1,000,000.00	$            1,000,000.00	$ 1,000,000.00
Discount factor (b) @ 14%	1.000	0.877	0.769	0.675	0.592	0.519
Present value (a)×(b)	$ (2,975,000.0000)	$     877,000.0000	$    769,000.0000	$     675,000.0000	$           592,000.0000	$519,000.0000
Net present value	$      457,000.0000
5)
project profitability index = NPV/Investment Required
Project profitability index = 457,000/2975000	0.1536
6)
IRR (Using excel) = IRR( cashflow year 0  to cashflow year 5	20.24%
project’s internal rate of return =
Factor of IRR =  Investment required/ Annual cash flow	2.9750
The factor computed above, 2.975, is closest to 2.991 along the five-year line in Pv table, the factor for the 20% rate of return. Therefore, to the nearest whole percent, the internal rate of return is 20%.
7)
payback period =  Investment required/ Annual cash flow
Payback period = 29750000/ 10000000	2.98	Years
8)
Simple rate of return = Annual incremental net operating income/Initial investment
Simple rate of return =$405,000/2975000	13.61%
9)
If the discount rate was 16%, instead of 14%, the project’s net present value would be lower because the discount factors would be smaller.
10)
The payback period would be the same because the initial investment was recovered at the end of three years. The salvage value at the end of five years is irrelevant to the payback calculation
11)
The net present value would be higher because a $300,000 salvage value translates into a larger cash inflow in the fifth year. Although the salvage value would need to be translated to its lesser present value, it would still increase the project’s net present value.
12)
The simple rate of return would be higher. The salvage value would lower the annual depreciation expense by $60,000 ($300,000 ÷ 5 years), which in turn would raise the annual net operating income and the simple rate of return.