Aaron Heath is seeking part-time employment while he attends school. He is consi

Question

Aaron Heath is seeking part-time employment while he attends school. He is considering purchasing technical equipment that will enable him to start a small training services company that will offer tutorial services over the Internet. Aaron expects demand for the service to grow rapidly in the first two years of operation as customers learn about the availability of the Internet assistance. Thereafter, he expects demand to stabilize. The following table presents the expected cash flows:

In addition to these cash flows, Aaron expects to pay $20,600 for the equipment. He also expects to pay $3,100 for a major overhaul and updating of the equipment at the end of the second year of operation. The equipment is expected to have a $1,100 salvage value and a four year useful life. Aaron desires to earn a rate of return of 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

a. Calculate the net present value of the investment opportunity. (Negative amount should be indicated by a minus sign. Round intermediate calculations and final answer to 2 decimal places.)

b. Indicate whether the investment opportunity is expected to earn a return that is above or below the desired rate of return and whether it should be accepted

Year of Operation Cash Inflow Cash Outflow 2019 $ 14,200 $ 8,300 2020 20,000 12,000 2021 21,400 13,300 2022 21,400 13,300

Explanation / Answer

a) Calculation of net present value of investment opportunity (Amount in $)

Present value of cash outflows = ($20,600*1)+($3,100*0.857) = $20,600+$2,656.70 = $23,256.70

NPV = Pv of cash inflows - PV of cash outflows = $25,512.80-$23,256.70 = $2,256.10

b) Rate of return from investment = (NPV/PV of cash outflows)*100

= (2,256.10/23,256.70)*100 = 9.70%

Desired rate of return = 8%

The return from investment is above the desired rate of return of 8%, therefore it should be accepted.

Year Cash inflow (a) Cash outflow (b) Net cash inflows (c = a-b) PVF@8%(d) Present value of cash flows (c*d) 2019 14,200 8,300 5,900 0.926 5,463.40 2020 20,000 12,000 8,000 0.857 6,856 2021 21,400 13,300 8,100 0.794 6,431.40 2022 21,400 13,300 8,100 0.735 5,953.50 2022 1,100 0.735 808.50 Total 25,512.80

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