Question

Blackmores company is evaluating the feasibility of investing $80000 in a project with a 5 years life. The firm has estimated the cash inflows associated with the proposal as shown in the following table. The firm’s cost of capital is 8%. Company’s policy to recoup investment is four years or less. Average book value is $13550

Year | cash inflows | Net income |

1 | $25000 | $3000 |

2 | $25000 | $2500 |

3 | $25000 | $2250 |

4 | $25000 | $2600 |

5 | $25000 | $3200 |

Require:

a. Calculate the NPV (Net Present Value), Payback Period, profitability Index and AAR ( Average Accounting Return) for the proposed investment

b. Should Blackmores company accept or reject the proposed investment

Answer #1

a) | Year | Cash inflows | PVIFA at 8% | PV at 8% | ||

1 | 25000 | 0.92593 | 23148 | |||

2 | 25000 | 0.85734 | 21433 | |||

3 | 25000 | 0.79383 | 19846 | |||

4 | 25000 | 0.73503 | 18376 | |||

5 | 25000 | 0.68058 | 17015 | |||

99818 | ||||||

NPV = PV of cash inflows-Initial investment = 99818-80000 = $19,818 | ||||||

Profitability index = PV of cash inflows/Initial investment = 99818/80000 = 1.25 | ||||||

Payback period = initital investment]Annual cash inflow = 80000/25000 = 3.2 years | ||||||

Year | Net income | |||||

1 | 3000 | |||||

2 | 2500 | |||||

3 | 2250 | |||||

4 | 2600 | |||||

5 | 3200 | |||||

13550 | ||||||

ARR = Average net income/Average investment = (13550/5)/13550 = 20% | ||||||

b) | The company should accept the project, because | |||||

*the NPV is positive, because of which PI is >1. | ||||||

*payback period is less than the maximum 4 years prescribed. | ||||||

*ARR is greater than 8%. |

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