1. Your company has been presented with an opportunity to invest in a project. T
ID: 2795033 • Letter: 1
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1. Your company has been presented with an opportunity to invest in a project. The facts on the project are presented below: Investment required Salvage value after 10 vears Gross income expected from the project Operating costs $60,000 None $20,000/year Labor Materials, insurance, etc Fuel and other costs Maintenance costs $2,500/year $1,000/year $1,500/year $500/year This project is expected to operate as shown for 10 years. If your management expects to make 25% on its investment before taxes, would you recommend this project? 2. The winner of a sweepstakes prize is given the choice of one million dollars or the guaranteed amount of $81,000 a year for 20 years. If the value of money is taken at 12% interest rate, which choice is better? 3. Given the following three mutually exclusive alternatives, which alternative is preferable if 10%? Alternative Initial cost Annual benefits Useful life (years $50$30 $40 10 35 2 15Explanation / Answer
Answer 1 We can calculate the NPV (Net Present Value) of the project to decide whether to accept or reject the project. If NPV is a positive figure we will accept the project and vice versa. Present value of annuity factor = [1-(1+r)^-n]/r r = rate of interest per annum = 25% n = no.of years =10 Present value of annuity factor = [1-(1+0.25)^-10]/0.25 Present value of annuity factor = 3.570503 Calculation of NPV Investment required -$60,000.00 Present value of Gross Income ($20000 * 3.570503) $71,410.07 Present value of Operating cost (-$5500 * 3.570503) -$19,637.77 NPV -$8,227.70 You should reject the project as NPV is negative. Answer 2 Present value of annuity factor = [1-(1+r)^-n]/r r = rate of interest per annum = 12% n = no.of years =20 Present value of annuity factor = [1-(1+0.12)^-20]/0.12 Present value of annuity factor = 7.469444 Present value of amount of $81000 a year receivable for 20 years = $81000 * 7.469444 = $6,05,024.93 As the present value of yearly guaranteed amount is lower than price money of 1 million receivable now , it is advisable to accept the prize money $1 million in lum sum. Answer 3 Present value of annuity factor at 10% for 5 year project = [1-(1+0.10)^-5]/0.10 = 3.790787 Present value of annuity factor at 10% for 2 year project = [1-(1+0.10)^-2]/0.10 = 1.735537 Calculation of Alternative A,B and C A B C Initial Cost -$50.00 -$30.00 -$40.00 Present Value of Annual benefits - $15 * 3.790787 $56.86 - $10 * 3.790787 $37.91 - $35 * 1.735537 $60.74 NPV $6.86 $7.91 $20.74 NPV of Alternative C is highest , hence alternative C is preferable.
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