Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Question 1
Harper company is contemplating the purchase of a machine capable of performing certain operations that are now performed manually. The machine will cost $5,000, and it will last for five years. At the end of five-years period the machine will have a zero scrap value. Use of the machine will reduce labor costs by $1,800 per year. Harper company requires a minimum pretax return of 20% on all investment projects. a) What is the NPV? b) What is the Payback Period? c) What is the AARR?

Source: http://www.accountingformanagement.com/net_present_value_method.htm

Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Solutions 1
a) Initial Cost Life of the project (year) Annual cost savings Salvage value Required rate of return Item Annual cost savings Initial investment Net present value Years 15 Now Amount of cash flows $1,800 (5,000) $5,000 5 $1,800 0 20% Present value of 20% Factor cash flows 2.991* $ 5,384 1,000 (5,000) --------$ 384 ======

b) Payback Period = Investment/Annual Cost Savings = 5000 / 1800 = 2.78 years c) AARR = (Incremental Rev Amort Exp)/ Investment =(1800 1000*)/ 5000 = 16% *5000/5 = 1000

Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Question 2
T.H.E company is deciding the purchases between 3 machines capable of performing operations that are now performed with a machine that costs $3,000 that can be sold for $500 right now. Machine A will cost $5,000, and it will last for five years. At the end of five-years period the machine will have a zero salvage value. Using this machine will yield revenues of $1000 per year. Machine B will cost $2,000, and it will last for 8 years. At the end of eight-years period the machine will have a zero salvage value. Using this machine will yield revenues of $500 per year. Machine C will cost $10,000, and it will last for 4 years. At the end of four-years period that machine will have a $2,000 terminal value. Using this machine will yield revenues of $3,000 per year. T.H.E company requires a minimum pretax return of 20% on all investment projects. a) Which Investment option should T.H.E company decide to pursue? b) What are the Payback periods for each investment? c) What is the AARR for each investment?

Round all numbers to nearest whole number.

Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Solutions 2
Machine A a) Cost of Investment Disposal of Old Asset Net Initial Investment Annual Cost Savings NPV b) Payback Period = 5000/1000 = 5 years c) AAR = (1000 1000) / 5000 = 0% Machine B a) CHOOSE THIS INVESTMENT $1000 PVIFA(5,20%) $(5000) $500 -------------$(4500) $2991 --------------$(1509)

Cost of Investment Disposal of Old Asset Net Initial Investment Annual Cost Savings NPV b) Payback Period = 2000/500 = 4 years c) AAR = (500 250) / 2000 = 12.5% Machine C a) Cost of Investment Disposal of Old Asset Net Initial Investment Annual Cost Savings Terminal Value NPV b) Payback Period = 10000/3000 = 3.33 years c) AAR = (3000 2000) / 10000 = 10% $3000 PVIFA(4,20%) $2000 PVIF (4,20%) $500 PVIFA(8,20%)

$(2000) $500 -------------$(1500) $1919 --------------$419

$(10000) $500 -------------$(9500) $ 7766 $965 ---------------$(769)

Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Question 3
Gatorade Inc. currently has a bottle producing machine that costs $5,000. It is an in-efficient machine and they have decided to purchase another machine for $10,000. The new machine has a useful life of 4 years and a terminal value of $2,000. The old machine can be sold right now for $500.However, Gatorade will be able to sell the old machine to another company in 4 years for triple its current market value. The new machine will produce 500 bottles in its first year, 600 bottles it its second year, 700 bottles in its third year, and 1000 bottles in its last year. They sell the bottles for $5/bottle. They only want to invest in this new machine if it brings them a NPV of at least $2000. The Required Rate of Return is 10%. a) What is the Net Present Value? Should they invest? b) What is the Payback period?

Nitin Tailor Lec01

996804766

nitin.tailor@utoronto.ca

Solutions 3
a) Cost of Investment Disposal of Asset Net Initial Investment Annual Cost Savings Year 1 Year 2 Year 3 Year 4 Total Cost Savings Terminal Value Net Present Value No, they should not invest. (2000-1500) PVIF (4,15%) $(10000) $500 $(9500)

(500x$5) PVIF(1,10%) (600x$5)PVIF (2,10%) (700x$5)PVIF (3,10%) (1000x5)PVIF (4, 10%)

$2273 $2479 $2630 $3415 $10797 $286 $1583

b) Payback Period year 1 year 2 year 3 1000/5000 = 0.2

Accumulated 2500 5500 9000

Remaining 7500 4500 1000

Payback Period = 3.2 years