Question

Cowboy Recording Studio is considering the investment of $134,700 in a new recording equipment. It is estimated that the new equipment will generate additional cash flow of $19,500 per year for each year of its 7-year life and will have a salvage value of $13,000 at the end of its life. Cowboys' financial managers estimate that the firm’s cost of capital is 8%. Use Table 6-4and Table 6-5. (Use appropriate factor(s) from the tables provided. Round the PV factors to 4 decimals.)

Required:

a. Calculate the net present value of the investment. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations.)

b. Calculate the present value ratio of the investment. (Round your answer to 2 decimal places.)

c. What is the internal rate of return of this investment, relative to the cost of capital?

d. Calculate the payback period of the investment. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

Initial Investment = $134,700
Incremental Cash Flows = $19,500
Salvage Value = $13,000
Useful Life = 7 years
Cost of Capital = 8%

Answer a.

Present Value of Cash Inflows = $19,500 * PVA of $1 (8%, 7) + $13,000 * PV of $1 (8%, 7)
Present Value of Cash Inflows = $19,500 * 5.2064 + $13,000 * 0.5835
Present Value of Cash Inflows = $109,110.30

NPV = Present Value of Cash Inflows - Initial Investment
NPV = $109,110.30 - $134,700
NPV = -$25,589.70

Answer b.

Present Value Ratio = Present Value of Cash Inflows / Initial Investment
Present Value Ratio = $109,110.30 / $134,700
Present Value Ratio = 0.81

Answer c.

NPV at cost of capital of 8% is -$25,589.70

So, internal rate of return of this investment is smaller than 8%

Answer d.

Payback Period = Initial Investment / Incremental Cash Flows
Payback Period = $134,700 / $19,500
Payback Period = 6.91 years