Q1/ Basics of Capital Investment (Ignore Taxes for this Exercise.)
Kenn Day, manager of Day Laboratory, is investigating the possibility of acquiring
some new test equipment. To acquire the equipment requires an initial outlay of
$300,000. To raise the capital, Kenn will sell stock valued at $200,000 (the stock pays
dividends of $24,000 per year) and borrow $100,000. The loan for $100,000 would
carry an interest rate of 6 percent. Kenn estimates that the new test equipment will
produce a cash inflow of $50,000 per year. Kenn expects the equipment to last for 20
years.
Required
1. Compute the weighted cost of capital.
2. Compute the payback period.
3. Assuming that depreciation is $14,000 per year, compute the accounting rate
of return (on total investment).
4. Compute the NPV of the test equipment.
5. Compute the IRR of the test equipment.
6. Should Kenn buy the equipment?
Solution
1. weighted cost of capital= (2/3 * 0.12) + (1/3 * 0.06)= %10
2. payback period = $300,000/$50,000= 6 year.
3. ARR = ($50,000 -$14,000)/$300,000= %12.
4. From Exhibit 20B-2, the discount factor for an annuity with i at 10 percent and
n at 20 years is 8.514.
NPV = (8.514 * $50,000) - $300,000= $125,700.
5. The discount factor associated with the IRR is 6.00
df = I / CF = $300000 / $50000 = 6
From Exhibit 20B-2, the IRR is between 14 and 16 percent (using the row
corresponding to period 20).
6. Since the NPV is positive and the IRR is greater than Kenn’s cost of capital,
the test equipment is a sound investment. This, of course, assumes that the
cash flow projections are accurate.
Q 2/ Each of the following parts is independent. Assume all cash flows are after-tax
cash flows.
1. Kaylin Hansen has just invested $200,000 in a book and video store. She expects to
receive a cash income of $60,000 per year from the investment. What is the payback
period for Kaylin?
2. Kambry Day has just invested $500,000 in a new biomedical technology. She
expects to receive the following cash flows over the next five years: $125,000,
$175,000, $250,000, $150,000, and $100,000. What is the payback period?
3. Emily Nabors invested in a project that has a payback period of 3 years. The project
brings in $120,000 per year. How much did Emily invest in the project?
4. Joseph Booth invested $250,000 in a project that pays him an even amount per year
for five years. The payback period is 2.5 years. How much cash does Joseph receive
each year?
Solution
1. Payback period = $200,000/$60,000 = 3.33 years
2. Payback period:
$125,000
1.0 year
175,000
1.0 year
200,000
0.8 year
$500,000
2.8 years
3. Investment = annual cash flow × payback period
= $120,000 × 3
= $360,000
4. Annual cash flow = Investment/payback period
= $250,000/2.5
= $100,000 per year
Q3/ Each of the following scenarios is independent. All cash flows are after-tax cash
flows.
Required:
1. Jeffrey Akea has purchased a tractor for $62,500. He expects to receive a net cash
flow of $15,625 per year from the investment. What is the payback period for Don?
2. Roger Webb invested $600,000 in a laundromat. The facility has a 10-year life
expectancy with no expected salvage value. The laundromat will produce a net cash
flow of $180,000 per year. What is the accounting rate of return? Use original
investment for the computation.
3. Aiddy Markus has purchased a business building for $700,000. She expects to
receive the following cash flows over a 10-year period:
Year 1: $87,500
Year 2: $122,500
Years 3–10: $175,000
What is the payback period for Aiddy? What is the accounting rate of return (using
average investment and assuming straight-line depreciation over the 10 years)?
Solution:
1. Payback period = Original investment/Annual cash flow
4
= 62500 / 15625
2. Accounting rate of return = Average income/Original investment
30%
= 180000 / 600000
3. Payback period =87500+122500+175000+175000+140000 = $700000
Payback period = 1 +1 +1 + 1 + 0.8 = 4.8 years
Accounting rate of return = Average income/Average investment
Average investment = (I + S) / 2 = 700000 / 2 = $350000
Cash Flows = 87500 + 122500 + (175000 * 8) = $1610000
Average Cash Flow = 1610000 / 10 = $161000
Average depreciation = 700000 / 10 = $70000
Average income = 161000 – 70000 = $91000
Accounting rate of return = 91000 / 350000 = %26
Q 4/ Each of the following scenarios is independent. All cash flows are after-tax cash
flows.
Required:
1. Tada Corporation is considering the purchase of a computer-aided manufacturing
system. The cash benefits will be $1,000,000 per year. The system costs $6,000,000
and will last eight years. Compute the NPV assuming a discount rate of 10 percent.
Should the company buy the new system?
2. Lehi Henderson has just invested $1,350,000 in a restaurant specializing in Italian
food. He expects to receive $217,350 per year for the next eight years. His cost of
capital is 5.5 percent. Compute the internal rate of return. Did Lehi make a good
decision?
Solution
1.
Year
Cash Flow
Present Value
0
($6000000)
(6000000)
1-8
$1000000
5335000
NPV Analysis
Discount Factor
1.000
5. 335
-
------------(665000)
The company should not buy the system
2. df = I/CF= 6.211
IRR = %6
Lehi make a good decision
Q 5/ The following data pertain to an investment project:
Investment required ........... $34,055
Annual savings .................. $5,000
Life of the project .............. 15 years
The internal rate of return is:
A) 12%
B) 14%
C) 10%
D) 8%
Answer: A
Q 6/ James Company is considering buying a new machine costing $30,000. James
estimates that the machine will save $6,900 per year in cash operating expenses for
the next six years. If the machine has no salvage value at the end of six years and the
discount rate used by James is 8%, then the machine's internal rate of return is closest
to:
A) 8%
B) 10%
C) 12%
D) 14%
Answer: B