Savanna Company is considering two capital investment proposals. Relevant data o

Question

Savanna Company is considering two capital investment proposals. Relevant data on each project are as follows:

                                                             Project Red           Project Blue

Capital investment                        $440,000               $640,000

Annual net income                            25,000                   60,000

Estimated useful life                        8 years                  8 years

Depreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value of an annuity of 1 for 8 periods is 5.747.

Instructions

(a)   Compute the cash payback period for each project.

(b)   Compute the net present value for each project.

(c)   Compute the annual rate of return for each project.

(d)   Which project should Savanna select?

Explanation / Answer

A.   

Project Red Project Blue Annual Net income $ 25,000. $ 60,000

Annual depreciation 55,000 (440000/8) 80,000 (640000/8)

Annual cash inflow. $ 80,000 $140,000

Cash payback period:

Project Red 440000 /80000= 5.5 years

Project blue = 640000/ 140000 = 4.6 years

(b)

Project Red Project Blue Present value of cash inflows 80000 ×5.747 140000×5.747

Less Capital investment $440,000 640,000 Net present value $19,760 $164,580

(c) Annual rate of return:

Project Red Project Blue

$25,000 / ($440000)/2 $60000/(640000/2)=18.75%

=11.36%

(d) Savanna should select Project Blue because it has a higher positive NPV and a higher annual rate of return. AND Project Blue has early cash back period also .

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