Question 1 (evaluating investment projects) Generic Motors Corporation is planni
ID: 2462836 • Letter: Q
Question
Question 1 (evaluating investment projects) Generic Motors Corporation is planning to invest $175,000 in year zero (today) in new equipment. This investment is expected to generate net cash flows of $70,000 a year for the next 4 years (years 1-4). The salvage value after 4 years is zero. The discount rate (cost of capital) is 20% a year. Required: a) What is the net present value (NPV) of this project? NPV = $ Should the firm invest, based on NPV? (1-yes, 2-no) b) What is the payback period for this project? payback period years c) What is the modified payback period for this project? between 1 and 2 years O between 2 and 3 years between 3 and 4 years d) What is the accounting rate of return (ARR) for this project? To compute ARR, first compute: annual depreciation=$ annual income=$ average investment $ ARR =L % (enter say 10% as 10, not as 0.1 and not as 10%)Explanation / Answer
1
Calcualtion of NPV of the Project:
Year
Cash Flow (CF)
PVF (20%)
PV = CF*PVF
Investment
0
$ (175,000)
1
$ (175,000.00)
Net Cash Flows
1 to 4
$ 70,000
2.58873
$ 181,211.42
NPV = Sum of PVs
$ 6,211.42
The NPV is positive , hence the firm should invest in the project.
2
Calculation of Payback period:
Year
Cash Flows (CF)
Cummulative CF
0
$ (175,000)
$ (175,000)
1
$ 70,000
$ (105,000)
2
$ 70,000
$ (35,000)
3
$ 70,000
$ 35,000
4
$ 70,000
$ 105,000
Cummulative CF becomes Positive in year 3 hence Payback period shall be :
2 Years + 1 Year * (35000 / 70000) = 2.5 Years
3
Calculation of Modified Payback period:
Year
Cash Flows (CF)
PVF (20%)
PV =CF*PVF
Cummulative PV
0
$ (175,000)
1
-175000
$ (175,000.00)
1
$ 70,000
0.83333
58333.33333
$ (116,666.67)
2
$ 70,000
0.69444
48611.11111
$ (68,055.56)
3
$ 70,000
0.57870
40509.25926
$ (27,546.30)
4
$ 70,000
0.48225
33757.71605
$ 6,211.42
The Cummulative PV becomes positive in year 4 , hence the Payback period shall be between 3 and 4 years
4
Calculation of ARR:
Annual Depreciation = (Cost - Salvage Value) / Life in years
= (175000 - 0) / 4 =
$ 43,750.00
Annual Income = Net Cash Flows - Depreciation
= 70000 - 43750 =
26250
Average investment = (Initial Investment + terminal investment) /2
= (175000 +0) / 2 =
$ 87,500
ARR = Annual Income / Average investment
= 26250 / 87500 =
30%
1
Calcualtion of NPV of the Project:
Year
Cash Flow (CF)
PVF (20%)
PV = CF*PVF
Investment
0
$ (175,000)
1
$ (175,000.00)
Net Cash Flows
1 to 4
$ 70,000
2.58873
$ 181,211.42
NPV = Sum of PVs
$ 6,211.42
The NPV is positive , hence the firm should invest in the project.
2
Calculation of Payback period:
Year
Cash Flows (CF)
Cummulative CF
0
$ (175,000)
$ (175,000)
1
$ 70,000
$ (105,000)
2
$ 70,000
$ (35,000)
3
$ 70,000
$ 35,000
4
$ 70,000
$ 105,000
Cummulative CF becomes Positive in year 3 hence Payback period shall be :
2 Years + 1 Year * (35000 / 70000) = 2.5 Years
3
Calculation of Modified Payback period:
Year
Cash Flows (CF)
PVF (20%)
PV =CF*PVF
Cummulative PV
0
$ (175,000)
1
-175000
$ (175,000.00)
1
$ 70,000
0.83333
58333.33333
$ (116,666.67)
2
$ 70,000
0.69444
48611.11111
$ (68,055.56)
3
$ 70,000
0.57870
40509.25926
$ (27,546.30)
4
$ 70,000
0.48225
33757.71605
$ 6,211.42
The Cummulative PV becomes positive in year 4 , hence the Payback period shall be between 3 and 4 years
4
Calculation of ARR:
Annual Depreciation = (Cost - Salvage Value) / Life in years
= (175000 - 0) / 4 =
$ 43,750.00
Annual Income = Net Cash Flows - Depreciation
= 70000 - 43750 =
26250
Average investment = (Initial Investment + terminal investment) /2
= (175000 +0) / 2 =
$ 87,500
ARR = Annual Income / Average investment
= 26250 / 87500 =
30%
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