Year Income from Operations Net Cash Flow Income from Operations Net Cash Flow 1
ID: 2501946 • Letter: Y
Question
Year
Income from Operations
Net Cash Flow
Income from Operations
Net Cash Flow
1
$22,000
$38,000
$7,000
$23,000
2
$12,000
$28,000
$7,000
$23,000
3
9,000
25,000
7,000
23,000
4
(4,000)
$12,000
$7,000
$23,000
5
(4,000)
$12,000
$7,000
$23,000
$35,000
$115,000
$35,000
$115,000
Each project requires an investment of $80,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 12% for purposes of the net present value analysis.
Instructions
1. Compute the following:
a. The average rate of return for each investment. Round to one decimal place.
b. The net present value for each investment. Use the present value of $1 table appearing in this chapter (Exhibit 1).
2. Prepare a brief report for the capital investment committee, advising it on the relative merits of the two investments.
Year
Income from Operations
Net Cash Flow
Income from Operations
Net Cash Flow
1
$22,000
$38,000
$7,000
$23,000
2
$12,000
$28,000
$7,000
$23,000
3
9,000
25,000
7,000
23,000
4
(4,000)
$12,000
$7,000
$23,000
5
(4,000)
$12,000
$7,000
$23,000
$35,000
$115,000
$35,000
$115,000
Explanation / Answer
1.a. Average rate of return: (Average annual profits/Investment) * 100
Investment 1 = (7000/80000) * 100 = 8.75%
Investment 2 = (7000/80000) * 100 = 8.75%
1.b. The NPV for the projects are:
Investment 1 = $ 8,480
Investment 2 = $ 2,910
The calculations for NPV are given below:
2) Note to the Capital Investment Committee:
The total cash flows of both the investments is the same at $ 115,000.
The Investment 2 provides uniform cash flows, when compared to the cash flows of the Investment 1. The Investment 1 provides for higher cash flows in the initial years.
The Average Rate of Return of both the investments are the same at 8.75%, and hence appear to be equally good.
But the ARR method does not depend on cash flows and does not take into account the time value of money. Hence, a measure which takes both these aspects into acount should be used to evaluate the proposals.
NPV is the appropriate method. The NPV of both the investments is positive. Hence, both of them can be selected.
The NPV of Investment 1 is higher at $ 8,480. Hence, it should be ranked 1st.
Investment 1 Investment 2 Income from Net Cash PVIF @ Income from Net Cash PVIF @ Year Operations Flow 12% PV Operations Flow 12% PV 1 22000 38000 0.892857 33929 7000 23000 0.892857 20536 2 12000 28000 0.797194 22321 7000 23000 0.797194 18335 3 9000 25000 0.71178 17795 7000 23000 0.71178 16371 4 -4000 12000 0.635518 7626 7000 23000 0.635518 14617 5 -4000 12000 0.567427 6809 7000 23000 0.567427 13051 35000 88480 35000 82910 Initial Investment 80000 80000 NPV 8480 2910Related Questions
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