Linda\'s Luxury Travel (LLT) is considering the purchase of two Hummer limousine

Question

Linda's Luxury Travel (LLT) is considering the purchase of two Hummer limousines. Various information about the proposed investment follows: Initial investment (2 limos) Useful life Salvage value Annual net income generated LLT's cost of capital S 720,000 0 years s 100,000 59,040 14% Assume straight line depreciation method is used Required Help LLT evaluate this project by calculating each of the following: 1. Accounting rate of retum. (Round your percentage answer to 1 decimal place.) nti ng Rate of Return 2. Payback period. (Round your answer to 2 decimal places.) ayback Period Years

Explanation / Answer

1) Accounting Rate of return = Annual Net Income/Initial Investment

= $59,040/$720,000 = 0.082 or 8.20%

2) Pay Back Period = Initial Investment/Annual Cash Inflow

Depreciation Expense = (Cost - Salvage Value)/Useful Life

= ($720,000 - $100,000)/10 yrs = $62,000 per year

Annual Cash Inflows = Annual Net Income+Depreciation Expense

= $59,040+$62,000 = $121,040

Payback Period = $720,000/$121,040 = 5.95 years

3) Cash outflow (Beginning of year) = $720,000

n = 10 yrs, i = 14%

Present Value of Cash Inflows = [Annual Cash Inflows*PVAF(10 yrs, 14%)]+[Salvage Value*PVF(10 yrs, 14%)]

= ($121,040*5.216116)+($100,000*0.269744)

= $631,359+$26,974 = $658,333

Net Present Value = PV of Cash Inflows - PV of Cash Outflows

= $658,333 - $720,000 = ($61,667)

4) IRR is the rate at which net present value is zero (i.e. pof resent value cash inflows is equal to present value of cash outflows). In this given case, the NPV is negative (i.e. present value of cash inflows is less than present value of cash outflows). Thus IRR should be less than the cost of capital of 14%.

Therefore, IRR is less than 14%.

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