Dutch Lumber Company is planning a project that is expected to last for 8 years
ID: 2478749 • Letter: D
Question
Dutch Lumber Company is planning a project that is expected to last for 8 years and generate annual net cash inflows of $85,000. The project will require the purchase of $300,000 machine which is pected to have a salvage value of $20,000 at the end of the 8 year period. The machine will require a $65,000 overhaul at the end of the 5th year. The company presently has a 15% minimum desired rate of return.
Based on this information, an accountant prepared the following analysis:
annual the cash inflow $85,000
annual depreciation $35,000
annual cost of overhaul $8,125 $43,125
Average annual income $41,875
Return on investment = $41,875/$300,000 = 13.96%
The account recommends that the project be rejected because it does not meet the companys minimum desire rate of return. ignore income taxes.
REquired
A. what criticism would you make of the accountant's evaluation?
B. use the net present value method and determine whether the project should be accepted
Explanation / Answer
A. return on investment = net income / initial investment
= ($85000 - 43125) / ($300000 + 65000)
= $41875 / 365000
= 11.47%
Note:- depreciation and overhaul cost will be already adjusted to the net income , it does not need minus again for calculating Net Annual Income
B. Net present Value :
year cash flow PVAF( 15%,8years) PVF(15%,year) present value
0 -300000 1 -300000
5 - 65000 - 0.497 -32305
1-8 41875 4.487 - 187893
8 20000 - 0.327 6540
Net present value = present value of cash inflow - present value of cash outflow
= (187893 + 6540) - (300000 + 32305)
= 194433 - 332305
= -$137872
The project should not be accepted,because of negative NPV
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