You have purchased equipment for $100,000. The equipment will last 5 years. Assu

Question

You have purchased equipment for $100,000. The equipment will last 5 years. Assume you will depreciate the equipment to $0. The equipment will generate net income of $10,000 per year. You will calculate depreciation on the straight line basis. It is the only difference between net income and cash flows.

1. What is the accounting rate of return?

2. What is the payback period?

3. What is the estimated internal rate of return?

4. Your required rate of return is 14%. What is the NPV of the investment?

5. What is the profitability index of this investment (round to 3 digits)?

Explanation / Answer

Hi,

Please find the answer as follows;

Part 1:

Accounting Rate of Return = Average Income/Average Initial Investment*100 = 10000/(100000/2)*100 = 20%

Part 2:

Payback Period = Initial Investment/Annual Cash Inflows

Annual Cash Inflows = Net Income + Depreciation = 10000 + 100000/5 = 30000

Payback Period = 100000/30000 = 3.33 Years

Part 3:

To calculate IRR, you need to put the value of NPV as and solve for r as follows:

NPV = 0 = -100000 + 30000/(1+r)^1 + 30000/(1+r)^2 + 30000/(1+r)^3 + 30000/(1+r)^4 + 30000/(1+r)^5

Solving for r, we get IRR as :15.24%

IRR = 15.24%

Part 4:

NPV = -100000 + 30000/(1+.14)^1 + 30000/(1+.14)^2 + 30000/(1+.14)^3 + 30000/(1+.14)^4 + 30000/(1+.14)^5 = 2992.43

Part 5:

PI = Present Value of Cash Inflows/Initial Investment

PI = 102992.43/100000 = 1.029 or 1.030

Thanks.

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