Question

Question 1: Evaluating investment projects

You are planning to invest $50,000 in new equipment. This investment will generate net cash flows of $30,000 a year for the next 2 years. The salvage value after 2 years is zero. The cost of capital is 25% a year.

a) Compute the net present value
NPV = $
Enter negative numbers with a minus sign, i.e., -100 not ($100) or (100).
Should you invest? Why?

YES -- the NPV is positive, which indicates that the investment is profitable

YES -- the NPV is negative, which indicates that the investment will reduce costs    

NO -- the NPV is negative, which indicates that the investment is unprofitable

b) Compute the payback period.
payback period =  years

c) Compute the accounting rate of return (ARR).
To compute ARR, first compute:
   annual depreciation=$
   annual income=$
   average investment=$
ARR =  %
If your answer is 10%, enter 10 without the percent sign.

d) Which of the three methods in (a)-(c) should you use in real life?

NPV only

payback method only   

ARR only

always use all three methods to reach the best decision

Answer 1

Solution :-

(a) NPV :

NPV = Present Value of Future Inflows - Initial Investment

Initial Investment = $ 50,000

Present Value of Future Inflows = Cumulative Annuity Factor (25%, 2 Years) * $ 30,000

= 1.44 * 30,000

= 43,200

NPV = 43,200 - 50,000

NPV = - 6,800

Should you invest? Why?

Ans .  NO -- the NPV is negative, which indicates that the investment is unprofitable.

(b) Payback Period :

Payback Period = Initial Investment / Cash Inflow per annum.

= 50,000 / 30,000

Payback Period = 1.67 Years.

(c) Accounting Rate of Return or ARR

Annual Depreciation = $ 50,000/ 2

= $ 25,000

Annual Income = $ 30,000 - $ 25,000

= $ 5,000

Average Investment = $ 50,000

ARR = Annual Income / Average Investment * 100

= $ 5,000 / $ 50,000

= 10%

ARR = 10

(d) Which of the three methods in (a)-(c) should you use in real life?

Ans. : Always use all three methods to reach the best decision.