4. Straightforward net-present-value and payback computations STL Entertainment

Question

4. Straightforward net-present-value and payback computations
STL Entertainment is considering the acquisition of a sight-seeing boat for summer tours along the Mississippi River. The following information is available:

Cost of boat    $500,000
Service life    10 summer seasons
Disposal value at the end of 10 seasons    $100,000
Capacity per trip    300 passengers
Fixed operating costs per season (including straight-line depreciation)    $160,000
Variable operating costs per trip    $1,000
Ticket price   $5 per passenger

All operating costs, except depreciation, require cash outlays. On the basis of similar operations in other parts of the country, management anticipates that each trip will be sold out and that 120,000 passengers will be carried each season. Ignore income taxes.

Instructions:
By using the net-present-value method, determine whether STL Entertainment should acquire the boat. Assume a 14% desired return on all investments- round calculations to the nearest dollar.

Explanation / Answer

Initial cost of the boat = $500,000

Service life (n) = 10 years

Desired return or Discount Rate (R) = 14%

Salvage / Disposal value = $100,000

Fixed operating cost per season including S.L. depreciation = $160000

S.L. depreciation per year = (500,000 – 100,000)/no. of years = 400,000/10=$40000

Thus, Fixed operating cost per year = 160000-40000 = $120000

120000 passengers are carried out in one season and one trip carries 300 passenger in a boat.

Thus, No. of trips per season = 120000/300 = 400

Variable operating cost per trip = $1000

Variable operating cost per season = $1000*400 = $400,000

Thus, total operating cost per season = Fixed operating cost + Variable Operating cost

Thus, total operating cost per season = 120000+400000 = $520000

Total revenue collection per season = ticket price * No of passengers in a season

Total revenue collection per season = $5*120000 = $600000

Net cash inflow per season = Revenue Received – Cost incurred = 600000-520000 = $80000

Net Present Value = Present value of net cash inflows + Present value of disposal value – Initial cost of the boat

Net Present Value = Yearly net cash inflows*(1-1/(1+R)^n)/R + 100000/(1+R)^n - 500000

Net Present Value = 80000*(1-1/1.14^10)/.14 + 100000/1.14^10 - 500000

Net Present Value = -$55736.4 or -$55736 approx.

Here, NPV is negative by $55736. Thus, STL Entertainment should not go to buy the boat.

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