Featured Exercise Willet Company provides the following information on a capital
ID: 2420185 • Letter: F
Question
Featured Exercise
Willet Company provides the following information on a capital-budgeting project:
Net initial investment
$100,000
Estimated useful life
4 years
Estimated before-tax annual cash flow from operations
$33,000
Estimated terminal disposal value
$7,000
Required rate of return
12%
Income tax rate
30%
Willet uses straight-line depreciation and ignores the terminal disposal value in computing depreciation for tax purposes.
Compute present values in this exercise by using either the tables in Appendix A at the back of the textbook or a calculator.
For this project:
a. Compute NPV.
b. Compute IRR (to the nearest tenth of a percent).
c. Compute payback.
Explanation / Answer
Computation NPV
Items and computations
Year(s)
Amount
Tax effect
After-tax cash flows
12% Factor
Present value of flows
Net initial investment
0
(100,000)
0
(100,000)
1
(100,000)
Operating Cash flows
1-4
33,000
0.7
23,100
3.0373493
70,163
Depreciation
1-4
8,250
0.3
2,475
3.0373493
7,517
Terminal Value
4
7,000
0.7
4,900
0.6355181
3,114
Net Present Value
(19,206)
Computation of IRR
Let us try with 14%
Year
Amount
PV Factor @ 14%
PV
0
(100,000)
1
(100,000)
1
33,000
0.8772
28,947
2
33,000
0.7695
25,392
3
33,000
0.6750
22,274
4
40,000
0.5921
23,683
NPV 1
297
As it is positive let us try with 15%
1.15
Year
Amount
PV Factor @ 15%
PV
0
(100,000)
1
(100,000)
1
33,000
0.8696
28,696
2
33,000
0.7561
24,953
3
33,000
0.6575
21,698
4
40,000
0.5718
22,870
NPV 2
(1,783)
IRR Formula
R1+[NPV1 x (R2-R1)/(NPV1-NPV2)]
=14 % +[297 x (15%-14%) /(297-(-1783))
=14% +[ 2.97/2080]
=14% + 0.14
=14.14%
Computation of Payback period
Year
Cash flow
Cumulative Cash flow
-
(100,000)
(100,000)
1
33,000
(67,000)
2
33,000
(34,000)
3
33,000
(1,000)
4
40,000
39,000
Payback period=3+[1,000/40,000]
=3+ 0.025
=3.025 years
Items and computations
Year(s)
Amount
Tax effect
After-tax cash flows
12% Factor
Present value of flows
Net initial investment
0
(100,000)
0
(100,000)
1
(100,000)
Operating Cash flows
1-4
33,000
0.7
23,100
3.0373493
70,163
Depreciation
1-4
8,250
0.3
2,475
3.0373493
7,517
Terminal Value
4
7,000
0.7
4,900
0.6355181
3,114
Net Present Value
(19,206)
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