Linda’s Luxury Travel (LLT) is considering the purchase of two Hummer limousines

Question

Linda’s Luxury Travel (LLT) is considering the purchase of two Hummer limousines. Various information about the proposed investment follows:   

Assume straight line depreciation method is used.     

Required:
Help LLT evaluate this project by calculating each of the following:    

1. Accounting rate of return. (Round your percentage answer to 1 decimal place.)



2. Payback period. (Round your answer to 2 decimal places.)

  

3. Net present value. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided. Do not round intermediate calculations. Cash Outflows and negative amounts should be indicated by a minus sign. Round your "Present Values" to the nearest whole dollar amount.)

   

4. Without making any calculations, determine whether the IRR is more or less than 14%.

rev: 04_20_2017_QC_

Initial investment (2 limos) $ 1,140,000 Useful life 10 years Salvage value $ 130,000 Annual net income generated 101,460 LLT’s cost of capital 14 %

Explanation / Answer

1) Accounting rate of return (ARR)

ARR = Accounting income / initial investment

=101460 / 1140000

= 8.9%

2) Payback period

Annual cash flow = annual net income + depreciation

= 101460+101000 = 202460

Depreciation = (Investment - salvage value) / useful life

= (1140000-130000) / 10

= 101,000

Payback period = Initial investment / cash flow per period

= 1140000 / 202460

= 5.63 years

3) NPV

NPV = present value of cash flows - initial investment

The annual cash flows are equal for first 9 years, only in the last year, there is a recovery of the salvage value, thus increasing the cash flow.

Hence, we find the present value of annual cash flow of 202460 for 9 years by discounting it by 14% (cost of capital)

Cumulative present value of $1 per annum receivable at the end of every year for 9 years discounted by 14%

= 4.946

Present value of cash flows for 9 years = 4.946*202460

= 1,001,367

Cash flow in year 10 = 202460 + 130000 = 332,460

Now, we discount the above value by 14%.

Present value of $1 for 10 years at 14% = 0.270

Present value of cash flow in year 10 = 0.270*332460

= 89,764.2

Total present value of cash flows = 1,001,367 + 89,764.2

= 1,091,131.36

Net present value = 1,091,131.36 - 1,140,000

= -48,869

4) The IRR is less than 14%. this is because the NPV is 0 at the IRR. since the NPV is negative, the IRR is less than 14%.

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