A farmer must choose between two possible investments that both require an initi
ID: 2553460 • Letter: A
Question
A farmer must choose between two possible investments that both require an initial outlay of $120,000 and will have no salvage value at the end of their economic life (3 years). The first investment is expected to yield annual net cash flows of $55,000 over a 3-year planning horizon. The second will yield $30,000 in the first year, $40,000 in the second and $50,000 in the third.
-The farmer finances 50% of the investment with an outside loan (interest rate 4%), and the principal will be paid in three equal yearly installments. Assume the farmer is in the 20% tax bracket and that the cost of capital is 5%. Assess the profitability of the two investments with the NPV for the ROE approach. (6 points)
Explanation / Answer
Investment Required
$ 120,000
Financed through loan
$ 60,000
Repayment Schedule
Year
Opening Balance
Interest @ 4%
Installment
Closing Balance
1
$ 60,000
$ 2,400
$ 22,400
$ 40,000
2
$ 40,000
$ 1,600
$ 21,600
$ 20,000
3
$ 20,000
$ 800
$ 20,800
$ -
Cash Flow Statement
Year
Option 1
Option 2
Cash Inflow
Interest
Tax
Net Cash Flow
Cash Inflow
Interest
Tax
Net Cash Flow
A
B
C = (A-B)*20%
D = A-B-C
A
B
C = (A-B)*20%
D = A-B-C
1
$ 55,000
$ 2,400
$ 10,520
$ 42,080
$ 30,000
$ 2,400
$ 5,520
$ 22,080
2
$ 55,000
$ 1,600
$ 10,680
$ 42,720
$ 40,000
$ 1,600
$ 7,680
$ 30,720
3
$ 55,000
$ 800
$ 10,840
$ 43,360
$ 50,000
$ 800
$ 9,840
$ 39,360
$ 128,160
$ 92,160
Net Present Value
Year
Particulars
Discounting Factor @ 5%
Option 1
Option 2
Cash Flow
Discounted Cash Flow
Cash Flow
Discounted Cash Flow
0
Initial Investment
1
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
1
Cash Flow
0.95
$ 22,080
$ 21,029
$ 2,080
$ 1,981
2
Cash Flow
0.91
$ 22,720
$ 20,608
$ 10,720
$ 9,723
3
Cash Flow
0.86
$ 23,360
$ 20,179
$ 19,360
$ 16,724
Net Present Value
$ 1,816
$ (31,572)
Investment Required
$ 120,000
Financed through loan
$ 60,000
Repayment Schedule
Year
Opening Balance
Interest @ 4%
Installment
Closing Balance
1
$ 60,000
$ 2,400
$ 22,400
$ 40,000
2
$ 40,000
$ 1,600
$ 21,600
$ 20,000
3
$ 20,000
$ 800
$ 20,800
$ -
Cash Flow Statement
Year
Option 1
Option 2
Cash Inflow
Interest
Tax
Net Cash Flow
Cash Inflow
Interest
Tax
Net Cash Flow
A
B
C = (A-B)*20%
D = A-B-C
A
B
C = (A-B)*20%
D = A-B-C
1
$ 55,000
$ 2,400
$ 10,520
$ 42,080
$ 30,000
$ 2,400
$ 5,520
$ 22,080
2
$ 55,000
$ 1,600
$ 10,680
$ 42,720
$ 40,000
$ 1,600
$ 7,680
$ 30,720
3
$ 55,000
$ 800
$ 10,840
$ 43,360
$ 50,000
$ 800
$ 9,840
$ 39,360
$ 128,160
$ 92,160
Net Present Value
Year
Particulars
Discounting Factor @ 5%
Option 1
Option 2
Cash Flow
Discounted Cash Flow
Cash Flow
Discounted Cash Flow
0
Initial Investment
1
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
1
Cash Flow
0.95
$ 22,080
$ 21,029
$ 2,080
$ 1,981
2
Cash Flow
0.91
$ 22,720
$ 20,608
$ 10,720
$ 9,723
3
Cash Flow
0.86
$ 23,360
$ 20,179
$ 19,360
$ 16,724
Net Present Value
$ 1,816
$ (31,572)
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