Question 1

SK Manufacturing Company uses discounted payback period to evaluate investments in capital assets. The
company expects the following annual cash flows from an investment of $3,500,000:

No salvage/residual value is expected. The company’s cost of capital is 12%.

Required:

1. Compute discounted payback period of the investment.

2. Is the investment desirable if the required payback period is 4 years or less?

Solution: Computation of discounted payback period:

In order to compute the discounted payback period, we need to compute the present value of each year’s
cash flow.
Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash
flow during the year)

= 5 + (**$255,500/$456,300)

= 5 + 0.56

= 5.56 years

*Value from “present value of $1 table”.

**Unrecovered cost at start of 6th:

= Initial cost – Cumulative cash inflow at the end of 5th year

= $3,500,000 – $3,244,500

= $255,500

(2) Conclusion:

Because the discounted payback period is longer than 4-year period, the investment is not desirable
Question 2: Net present value method:

Sunlight company needs a machine for its manufacturing process. The cost of the new machine is $80,700.
The expected useful life of the machine is 8 years. At the end of 8-year period, the machine would have no
salvage value. After installation, the machine would increase cash inflows by $30,000 per year. Sunlight is
interested to know the net present value of the machine to accept or reject this investment. The minimum
required rate of return of the company is 16% on all capital investments.

Required:

1. Compute net present value of the machine.

2. Is it acceptable to purchase the machine?

Solution:

(1) Net present value computation:

* Value from “present value of annuity of $1 in arrears table“.

(2) Purchase decision:

The positive net present value (computed above) indicates that the investment is profitable, therefore the
machine should be purchased.

Internal rate of return method:

A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the useful life is 15
years with zero residual value.

Required:

1. Compute internal rate of return of the machine.

2. Is it an acceptable investment if cost of capital is 16%?

Solution:

(1) Internal rate of return (IRR) computation:

Internal rate of return factor = Net annual cash inflow/Investment required

= $223,000/$40,000

= 5.575

Now see internal rate of return factor (5.575) in 15 year line of the present value of an annuity if $1 table.
After finding this factor, see the corresponding interest rate written at the top of the column. It is 16%. Internal
rate of return is, therefore, 16%.

(2) Conclusion:

The investment is acceptable because internal rate of return promised by the machine is equal to the cost of
capital of the company.
Question 3: Preference ranking of investment projects

The Martin Company is considering the four different investment opportunities. The selected information
about each proposal is given below:

The present value of cash inflows given above have been computed using a 10% discount rate. The company
is unable to accept all available projects because the funds available for investment are limited.

Required:

1. Compute the profitability index (present value index) for all the projects.
2. Rank the four investment projects according to preference using:
(a). net present value (NPV).
(b). profitability index (PI).
(c). internal rate of return (IRR).
3. Which one is the best approach for Martin Company to rank five competing projects?

Solution:

(1). Computation of profitability index:

Formula of profitability/present value index is:

Profitability index = Present value of cash inflows/Investment required

Project 1: $1,134,540/$960,000 = 1.18

Project 2: $866,800/$720,000 = 1.20

Project 3: $672,280/$540,000 = 1.24

Project 4: $1,045,490/$900,000 = 1.16

Project 5: $759,520/$800,000 = 0.95

(2) Preference ranking of projects:

3. The best ranking approach:

The best method of ranking projects depends on the availability of good reinvestment opportunities. Under
internal rate of return (IRR) method, we assume that the funds released from a project are reinvested in
another project yielding the internal rate of return equal to the previous project. According to IRR, the project
4 is ranked at number one with 19% IRR. It means any funds released from project 4 must be reinvested in
another project yielding an internal rate of return of at least 19% but It might be difficult to find a project with
such a high IRR.

The profitability index (PI) shows the present value of cash inflow generated by each dollar invested in a
project. It assumes that the funds released from a project are reinvested in another project with a return equal
to the discount rate. In our problem, the discount rate is only 10%. Generally, the profitability index is
considered the most dependable method of ranking competing projects.

The net present value (NPV) method considers the net present value figure but does not take into account
the amount of investment required for the project. Therefore, this method is not appropriate for comparing or
ranking competing projects that require different amounts of investment. For example, project 3 is ranked at
number four because of its low net present value but it is the best option if we see at the present value of net
cash inflow generated by each dollar invested in the project (as shown by the profitability index).

Conclusion: From above discussion, we can conclude that the profitability index is the most appropriate and
dependable method of ranking projects for Martin Company.
Question 4: Net present value analysis – total and incremental cost approach
FacebookTwitterPrintEmailMore15

The National Transport Company has a number of large trucks. One of the trucks is in poor condition and
needs an immediate renovation at a cost of $100,000. An overhaul of engine will also be needed 6-years
from now at a cost of $10,000. If theses costs are incurred, the truck will be useful for 12 years. After 12-year
period, it will be sold at a salvage value (scrap value) of $30,000. At this time, the salvage value of the truck
is $35,000. The total annual revenues of the truck will be $200,000 and the total cost to operate the truck will
be $150,000 per year.

Alternatively, National Transport Company can purchase a new truck for $180,000. The new truck will require
some repairs at the end of 6-year period at a cost of $5,000. Its salvage value will be $30,000 after its useful
life of 12 years. The total annual revenues of the new truck will be $200,000 and its operating cost will be
$110,000 per year.

The company’s required rate of return is 15% before taxes.

Required: Should National Transport Company renovate the old truck or purchase a new truck. Use the
following approaches to net present value (NPV) analysis for your answer:

1. Total cost approach.

2. Incremental cost approach.

(Ignore income tax in your computations.)

Solution:

(1) Total cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.
**Value from “present value of $1 table”.

Net present value in favor of buying the new truck:

NPV with new truck – NPV with old truck

= $346,340 – $172,340

= $174,000

Since the NPV of new truck surpasses the NPV of old truck by $174,000, the company should buy the new
truck rather than renovating the old one.

(2) Incremental cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table“.