Accounting
What the Numbers Mean 9e
Demonstration Problem
Chapter 16 – Exercise 17
Calculate NPV – Compare to IRR
Problem Definition
• Sun Bay Manufacturing, Ltd. Is considering
the investment of $230,000 in a new
machine. The machine will generate cash
flow of $40,000 per year for each year of its
eight-year life and will have a salvage value
of $26,000 at the end of its life. The
company’s cost of capital is 10%.
Problem Requirements
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)
b. What will the internal rate of return on this
investment be relative to the cost of capital?
Explain your answer.
Problem Solution
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)
Set up a model for analyzing the timing of
cash flows and enter all cash flows generated
by this project.
Problem Solution
• Model for analyzing project cash flows:
Solution Steps:
Step 1 – Setup the project
years and cash flow items.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Solution Steps:
Step 1 – Setup the project
years and cash flow items.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
Solution Steps:
Step 1 – Setup the project
years
and cash
years
andflow
cashitems.
flow items.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
Annual cash flow
Solution Steps:
Step 1 – Setup the project
years
and cash
years
andflow
cashitems.
flow items.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
Annual cash flow
Salvage value
Solution Steps:
Step 1 – Setup the project
years
and cash
years
andflow
cashitems.
flow items.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
Annual cash flow
Salvage value
Solution Steps:
Step 2 – Enter all
cash flow amounts.
Problem Solution
• Model for analyzing project cash flows:
Investment
Annual cash flow
Salvage value
Solution Steps:
Step 2 – Enter
investment amount.
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
$(230,000)
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
Solution Steps:
Step 2 – Enter annual
cash flow amount.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Solution Steps:
Step 2 – Enter salvage
value amount.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Solution Steps:
Step 3 – Calculate
the present value of
the cash flows.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
$(230,000)
Solution Steps:
Step 3 – Calculate the
present value of the
cash flows.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
x 5.3349
$(230,000)
Solution Steps:
213,396
Step 3 – Calculate the
present value of the
cash flows.
PV factor – Table 6-5:
8 period row, 10% column
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
x 5.3349 x .4665
$(230,000)
Solution Steps:
213,396
Step 3 – Calculate the
12,129
present value of the
cash flows.
PV factor – Table 6-4:
8 period row, 10% column
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
x 5.3349 x .4665
$(230,000)
Solution Steps:
213,396
Step 4 – Calculate the
12,129
net present value of the
proposed investment.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
x 5.3349 x .4665
$(230,000)
Solution Steps:
213,396
Step 4 – Calculate the
12,129
net present value of the
$ (4,475) Net Present Value
proposed investment.
Problem Solution
• Model for analyzing project cash flows:
Year: 0 – 1 – 2 – 3 – 4 – 5 – 6
Investment
$(230,000)
Annual cash flow
$40,000
Salvage value
$26,000
Present Value:
x 5.3349 x .4665
$(230,000)
Solution:
Since the NPV is
213,396
negative, the investment
12,129
does not earn the 10%
$ (4,475) Net Present Value
cost of capital.
Problem Requirements
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)
b. What will the internal rate of return on
this investment be relative to the cost of
capital? Explain your answer.
Problem Solution
Because the net present value is
negative, the internal rate of return on
this project will be lower than the cost
of capital of 10%.
Accounting
What the Numbers Mean 9e
You should now have a better understanding of
net present value and internal rate of return.
Remember that there is a demonstration problem for
each chapter that is here for your learning benefit.
David H. Marshall
Wayne W. McManus
Daniel F. Viele