Professional Documents
Culture Documents
Given:
Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous area. The
tract contains a mineral deposit that the company believes might be commercially attractive to
mine and sell. An engineering and cost analysis has been made, and it is expected that the
following cash flows would be associated with opening and operating a mine in the area:
*** Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance,
and so forth.
It is estimated that the mineral deposit would be exhausted after five years of mining. At that
point, the working capital would be released for reinvestment elsewhere. The Company's
required rate of return is 14%.
Required: Determine the net present value of the proposed mining project. Should the project be
accepted? Ignore income t Explain.
Accounting Approach:
Timing of Cash 14% PV of
Cash Flow PV Table Cash
Relevant Items: Flows Amounts Factor Flows
Cost of equipment required Now ($850,000) 1.000000
($850,000.00)
Working capital required Now ($100,000) 1.000000
($100,000.00)
Net annual cash receipts End of Ys 1-5 $230,000 3.433081
$789,608.62
Cost of road repairs in three years End of Year 3 ($60,000) 0.674972
($40,498.29)
Salvage value of equipment in 5 years End of Year 5 $200,000 0.519369
$103,873.73
Working capital released End of Year 5 $100,000 0.519369
$51,936.87
Net Present Value ($45,079.07)
No, the project should not be accepted; it has a negative net present value. This means that the
rate of return on the investment is less than the company's required rate of return of 14%
From PV of an Annuity Table, scanning along the row for 14 periods yields 5.468 for an IRR equal to 16%
2. Compute the machine's net present value. Use a discount rate of 16% and the format shown in
Exhibit 14-5. Why do you have a zero net present value?
Amount of 16% Present
Item Year(s) Cash flow Table Factor Value
Initial Investment Now ($136,700) 1.00000 ($136,700)
Net annual cash inflows 1-14 $25,000 5.468 $136,700
Net present value $0
The NPV is equal to zero because the discount rate used (16%) is also the IRR.
3. Suppose that the new machine would increase the company's annual cash flows, net of expenses,
by only $20,000 per year. Under these conditions, compute the internal rate of return to the nearest
whole percent.
From PV of an Annuity Table, scanning along the row for 14 periods yields:
Interpolation
12% 6.628 6.628168
X ?% 6.835 6.835000 (0.206832)
0.01 11% 6.982 6.981865 (0.353697)
X = 0.206832
0.01 0.3536970011
0.353697 (X) = (0.01)(.206832)
0.353697 (X) = 0.00206832
X = 0.00584771
X = 0.584771%
RR equal to 16%
(136,700) (136,700)
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
11.405% 15.998%
0.000 0.000
Demo 13A-1 Net Present Value Analysis Including Income Taxes
Given:
The Crescent Drilling Company owns the drilling rights to several tracts of land on which natural gas has been found. Th
on some of the tracts is somewhat marginal, and the company is unsure whether it would be profitable to extract and sell
these tracts contain. One such tract is tract 410, on which the following information has been gathered:
The natural gas in tract 410 would be exhausted after 10 years of extraction work. The equipment would have a useful lif
it could be sold for only 15% of its original cost when extraction was completed. For tax purposes, the company would d
equipment over 10 years using straight-line depreciation and assuming zero salvage value. The tax rate is
tax discount rate is 10%. The working capital would be released for use elsewhere at the completion of the project.
Required:
1. Compute the NPV of tract 410.
Timing of After
Cash Pre-tax Tax
Normal Acctg. Approach Flows Amounts Effect
Investment in equipment Now ($600,000) None
Working capital required Now ($85,000) None
Net annual cash receipts End of Ys 1-10 $110,000 70%
Tax Savings (Depreciation tax shield) End of Ys 1-10 $60,000 30%
Restoration Expense End of Year 10 ($70,000) 70%
Salvage value of equipment in 10 years End of Year 10 $90,000 None
Tax Outflow from Salvage Gain End of Year 10 $90,000 30%
Working capital released End of Year 10 $85,000 None
Net Present Value
No, the investment project should not be undertaken. The NPV is negative.
$600,000
$85,000
$110,000
$70,000
After-tax
Cash 10% PV of
Flow PV Table Cash
Amounts Factor Flows
($600,000) 1.000000 ($600,000.00)
($85,000) 1.000000 ($85,000.00)
$77,000 6.144567 $473,131.67
$18,000 6.144567 $110,602.21
($49,000) 0.385543 ($18,891.62)
$90,000 0.385543 $34,698.90
($27,000) 0.385543 ($10,409.67)
$85,000 0.385543 $32,771.18
($63,097.34)
Required:
1. What dollar value per year would the intangible benefits have to be worth in order to make
the equipment an acceptable investment? (Ignore income taxes).
If Union Bay Plastics uses a discount rate of 15% to calculate the NPV and the resulting NPV
equals zero, then the investment would be earning a return of exactly 15%; the IRR = 15%.
Therefore:
Annual cash inflows X Table Value (15%, 10 years) from PV of an Annuity Table - Cost = 0
(Annual cash inflows X 5.019) - $750,000 = 0
5.019 (Annual cash inflows) = $750,000
Annual cash inflows = $750,000/5.019 5.019 5.018769
Annual cash inflows = $149,432.16 $149,439.05
Thus the dollar value per year of the intangible benefits must be worth at least:
Given:
Austin Company is investigating four different investment opportunities. Information on the
four projects under study is given below:
Project Number 1 2 3 4
Investment required ($480,000) ($360,000) ($270,000) ($450,000)
Present value of cash inflows (10%) 567,270 433,400 336,140 522,970
Net present value $87,270 $73,400 $66,140 $72,970
Life of Project (in years) 6 12 6 3
Internal Rate of Return 16% 14% 18% 19%
Since the company's required rate of return is 10%, a 10% discount rate has been used in the
NPV calculations above. Limited funds are available for investment, so the company can not
accept all of the available projects.
Required:
1. Compute the project profitability index for each investment project.
Project Number 1 2 3 4
Net present value $87,270 $73,400 $66,140 $72,970
Investment required $480,000 $360,000 $270,000 $450,000
Project profitability index 0.1818125 0.20388889 0.24496296 0.16215556
Present value of cash inflows (10%)/Investment Req. 1.1818125 1.20388889 1.24496296 1.16215556
Which ranking is best depends on the company's opportunities for reinvesting funds
as they are released from a project.
IRR: The internal rate of return method assumes that any released funds are reinvested
at the internal rate of return.
This means that funds released from project #4 would have to be reinvested at a
rate of return of 19%, but another project yielding such a high rate of return might
be difficult to find.
PPI: The project profitability index approach assumes that funds released from a project
are reinvested at a rate of return equal to the discount rate, which in this case is only
10%. On balance, the PPI is generally regarded as the most dependable method of
ranking competing projects.
NPV: The net present value is inferior to the project profitability index as a ranking device
because it does not properly consider the amount of investment.
For example, it ranks project #3 fourth because of its low NPV; yet this project is
the best in terms of the amount of cash inflow generated per dollar invested.
($1,560,000)
(Not in text)
m a project
case is only
king device
Demo 13-5 Payback Period and Simple Rate of Return
Given:
The Heritage Amusement Park would like to construct a new ride called the Sonic Boom, which
the park management feels would be very popular. The ride would cost $450,000 to construct,
and it would have a 10% salvage value at the end of its 15-year useful life. The company
estimates that the following annual costs and revenues would be associated with the ride:
The Sonic Boom has a payback less than the maximum 6-year limit.
The Sonic Boom satisfies the payback criterion.
2. Compute the simple accounting rate of return promised by the new ride. If Heritage Amusement
Park requires a simple rate of return of at least 12%, does the Sonic Boom ride meet this
criterion?
AROR = 14.00%
The Sonic Boom has an AROR greater than the minimum 12% requirement.
The Sonic Boom satisfies the simple accounting rate or return criterion.
What if the required AROR was 16%? Should the investment opportunity be accepted?
($450,000)
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
135000
18.595% IRR
e Amusement
Demo 13-6 Payback Method
Given:
The management of Weimar Inc., a civil engineering design company, is considering
an investment in a high-quality blueprint printer with the following cash flows:
Investment
Cash Cash
Year Outflow Inflow
1 $38,000 $2,000
2 $6,000 $4,000
3 $8,000
4 $9,000
5 $12,000
6 $10,000
7 $8,000
8 $6,000
9 $5,000
10 $5,000
Required:
1. Determine the payback period of the investment.
Investment
Cash Cash Unrecovered
Year Outflow Inflow Investment
1 ($38,000) $2,000 ($36,000)
2 ($6,000) $4,000 ($38,000)
3 $8,000 ($30,000)
4 $9,000 ($21,000)
5 ***** $12,000 ($9,000)
6 ***** $10,000 $1,000
7 $8,000 $9,000
8 $6,000 $15,000
9 $5,000 $20,000
10 $5,000 $25,000
2. Would the payback period be affected if the cash inflow in the last year
was several times larger?
Since the investment is recovered prior to the last year, the amount
of the cash inflow in the last year has no effect on the payback period.
The payback method ignores cash flows after the payback date.
Demo 13-7 Net Present Value Analysis of a Lease or Buy Decision
Given:
Blinko Products wants an airplane for use by its corporate staff. The airplane that the company wishes to acquire, a Z
Purchase alternative.
If the Zephyr II is purchased, then the costs incurred by the company would be as follows:
The plane would be sold after 5 years. Based on current resale values, the company would be able to sell it for ab
the five-year period.
Lease alternative.
If the Zephyr II is leased, then the company would have to make an immediate deposit of $50,000
years, a the end of which time the deposit would be refunded. The lease would require an annual rental payment o
of Year 1). As part of this lease cost, the manufacturer would provide all servicing and repairs, license the plane, a
plane would revert to the manufacturer, as owner.
2. Which alternative would you recommend that the company accept? Why?
The company should accept the leasing alternative. The present value of the cash outflows is less negative under
at the company wishes to acquire, a Zephyr II, can be either purchased or leased
e as follows:
mpany would be able to sell it for about one-half of its original cost at the end of
deposit of $50,000 to cover any damage during use. The lease would run for five
d require an annual rental payment of $200,000 (the first payment is due at the end
cing and repairs, license the plane, and pay all taxes. At the end of five-years, the
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