Question

(Ignore income taxes in this problem.) Ursus Inc., is considering a project that would have a ten-year life and would require a $1,000,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows:

Sales	$2,000,000
Variable Expenses	$1,400,000
Contribution Margin	$600,000
Fixed Expenses	$400,000
Net Operating Income	$200,000

All of these items, except for depreciation of $92,500 a year, represent cash flows. The depreciation is included in the fixed expenses.  The company's required rate of return is 12%

a. What is the Payback period?_______________

1. should we accept the project based on Payback period? Yes/No _________

2. Why? __________

b. What is the Net Present Value?_____________

1. should we accept the project based on Net Present Value? Yes/No________

2. Why? __________

c. What is the Internal Rate of Return?_________

1. Should we accept the project based on Internal Rate of Return? Yes/No________

2. Why? ___________

d. What is the Simple Rate of Return?_________

1. Should we accept the project based on Simple Rate of Return? Yes/No_________

2. Why? ___________

Answer 1

Annual cash inflows = Net Operating Income + Depreciation

= $200000+92500 = $292,500

a. Payback period = Initial investment / Annual cash inflows

= 1000000/292500 = 3.42 years

1. Yes, project should be accepted.

2. Because payback period is less than the life of the project.

b. Net Present Value = 292500*5.650-1000000 = $652,625

1. Yes, project should be accepted.

2. Because NPV is positive.

c. Discount factor = Initial investment / Annual cash inflows

= 1000000/292500 = 3.419

Internal Rate of Return = 26%

1. Yes, project should be accepted.

2. Because IRR is more than company's required rate of return.

d. Simple Rate of Return = Net Operating Income / initial investment

= 200000/1000000 = 20%

1. Yes, project should be accepted.

2. Because Simple Rate of Return is more than company's required rate of return.