Demo 13-1 Basic Net Present Value Analysis

Given:
Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous area. The
tract contains a mineral deposit that the company believes might be commercially attractive to
mine and sell. An engineering and cost analysis has been made, and it is expected that the
following cash flows would be associated with opening and operating a mine in the area:

Cost of equipment required $850,000 $804,920.93

Net annual cash receipts $230,000 *** Cost (NPV = 0)
Working capital required $100,000 $804,920.93
Cost of road repairs in three years $60,000
Salvage value of equipment in five years $200,000

*** Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance,
and so forth.

It is estimated that the mineral deposit would be exhausted after five years of mining. At that
point, the working capital would be released for reinvestment elsewhere. The Company's
required rate of return is 14%.

Required: Determine the net present value of the proposed mining project. Should the project be
accepted? Ignore income t Explain.

Relevant Items: Now Year 1 Year 2 Year 3 Year 4 Year 5

Cost of equipment required ($850,000)
Working capital required ($100,000)
Net annual cash receipts $230,000 $230,000 $230,000 $230,000 $230,000
Cost of road repairs (Year 3) ($60,000)
Equipment Salvage Value (Y5) $200,000
Working capital released $100,000
Total ($950,000) $230,000 $230,000 $170,000 $230,000 $530,000

Accounting Approach:
Timing of Cash 14% PV of
Cash Flow PV Table Cash
Relevant Items: Flows Amounts Factor Flows
Cost of equipment required Now ($850,000) 1.000000
($850,000.00)
Working capital required Now ($100,000) 1.000000
($100,000.00)
Net annual cash receipts End of Ys 1-5 $230,000 3.433081
$789,608.62
Cost of road repairs in three years End of Year 3 ($60,000) 0.674972
($40,498.29)
Salvage value of equipment in 5 years End of Year 5 $200,000 0.519369
$103,873.73
Working capital released End of Year 5 $100,000 0.519369
$51,936.87
Net Present Value ($45,079.07)
No, the project should not be accepted; it has a negative net present value. This means that the
rate of return on the investment is less than the company's required rate of return of 14%

Finance Approach: 0.122465547

Timing of Yearly Cash 14% PV of
 Cash Flow PV Table Cash
Flows Amounts Factor Flows
Now ($950,000.00) 1.000000 ($950,000.00)
End of Y1 $230,000.00 0.877193 $201,754.39
End of Y2 $230,000.00 0.769468 $176,977.53
End of Y3 $170,000.00 0.674972 $114,745.16
End of Y4 $230,000.00 0.592080 $136,178.46
End of Y5 $530,000.00 0.519369 $275,265.39
3.433081 ($45,079.07)
3.433081
($39,543.04)
Note: Wrong NPV IRR
Excel formula is wrong 12.2465547%
($45,079.07)
Corrected NPV
Demo 13-2 Internal Rate of Return and Net Present Value
Given:
Scalia's Cleaning Service is investigating the purchase of an ultrasound machine for cleaning window
blinds. The machine would cost $136,700, including invoice cost, freight, and training of employees
to operate it. Scalia's has estimated that the new machine would increase the company's cash flows,
net of expenses, by $25,000 per year. The machine would have a 14-year useful life with no expected
salvage value.

Required: Ignore income taxes

1. Compute the machine's internal rate of return to the nearest whole percent.

IRR = the interest rate that yields a NPV = 0

[Annual cash inflows X Table Value ( Y%, 14 years) from PV of an Annuity Table] - Cost = 0
[$25,000 X Table Value ( Y%, 14 years) from PV of an Annuity Table] - $136,700 = 0
[$25,000 X Table Value ( Y%, 14 years) from PV of an Annuity Table] = $136,700
Table Value (Y%, 14 years) from PV of an Annuity Table = $136,700/$25,000 5.468

From PV of an Annuity Table, scanning along the row for 14 periods yields 5.468 for an IRR equal to 16%

2. Compute the machine's net present value. Use a discount rate of 16% and the format shown in
Exhibit 14-5. Why do you have a zero net present value?
Amount of 16% Present
Item Year(s) Cash flow Table Factor Value
Initial Investment Now ($136,700) 1.00000 ($136,700)
Net annual cash inflows 1-14 $25,000 5.468 $136,700
Net present value $0

The NPV is equal to zero because the discount rate used (16%) is also the IRR.

3. Suppose that the new machine would increase the company's annual cash flows, net of expenses,
by only $20,000 per year. Under these conditions, compute the internal rate of return to the nearest
whole percent.

IRR = the interest rate that yields a NPV = 0

Annual cash inflows X Table Value ( Y%, 14 years) from PV of an Annuity Table - Cost = 0
$20,000 X Table Value ( Y%, 14 years) from PV of an Annuity Table - $136,700 = 0
$20,000 X Table Value ( Y%, 14 years) from PV of an Annuity Table = $136,700
Table Value (Y%, 14 years) from PV of an Annuity Table = $136,700/$20,000 6.835

From PV of an Annuity Table, scanning along the row for 14 periods yields:

Interpolation
12% 6.628 6.628168
X ?% 6.835 6.835000 (0.206832)
0.01 11% 6.982 6.981865 (0.353697)

X = 0.206832
0.01 0.3536970011
0.353697 (X) = (0.01)(.206832)
0.353697 (X) = 0.00206832
X = 0.00584771
X = 0.584771%

?% = 12% - 0.584771% = 11.4152%

Rounded to nearest whole % = 11% IRR
NPV
 (pg. 628)

RR equal to 16%

(136,700) (136,700)
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000
20,000 25,000

11.405% 15.998%
0.000 0.000
Demo 13A-1 Net Present Value Analysis Including Income Taxes
Given:
The Crescent Drilling Company owns the drilling rights to several tracts of land on which natural gas has been found. Th
on some of the tracts is somewhat marginal, and the company is unsure whether it would be profitable to extract and sell
these tracts contain. One such tract is tract 410, on which the following information has been gathered:

Investment in equipment needed for extraction work

Working capital investment needed
Annual cash receipts from sale of gas, net of related cash operating expenses (before taxes)
Cost of restoring the land at completion of extraction work

The natural gas in tract 410 would be exhausted after 10 years of extraction work. The equipment would have a useful lif
it could be sold for only 15% of its original cost when extraction was completed. For tax purposes, the company would d
equipment over 10 years using straight-line depreciation and assuming zero salvage value. The tax rate is
tax discount rate is 10%. The working capital would be released for use elsewhere at the completion of the project.

Required:
1. Compute the NPV of tract 410.
Timing of After
Cash Pre-tax Tax
Normal Acctg. Approach Flows Amounts Effect
Investment in equipment Now ($600,000) None
Working capital required Now ($85,000) None
Net annual cash receipts End of Ys 1-10 $110,000 70%
Tax Savings (Depreciation tax shield) End of Ys 1-10 $60,000 30%
Restoration Expense End of Year 10 ($70,000) 70%
Salvage value of equipment in 10 years End of Year 10 $90,000 None
Tax Outflow from Salvage Gain End of Year 10 $90,000 30%
Working capital released End of Year 10 $85,000 None
Net Present Value

Normal Finance Approach Year 0 (Now) Year 1 Year 2

Net annual cash receipts $110,000 $110,000
Less Depreciation Expense (60,000) (60,000)
Less Restoration Expense
Taxable Salvage Gain
Income Before Taxes $50,000 $50,000
Less Income Taxes (30%) (15,000) (15,000)
Net Income $35,000 $35,000
Add back depreciation 60,000 60,000
Operating Cash Flow $95,000 $95,000
Working capital released
Cash Inflow $95,000 $95,000
Table Factor 10% (PV of $1 Table) 0.909091 0.826446
PV of cash inflows $621,902.66 $621,902.66 $86,363.64 $78,512.40
Initial Investment in equipment (600,000.00)
Initial Investment in Working Capital (85,000.00)
Net Present Value ($63,097.34)
 Net Present Value (Adj. Excel Formula) ($63,097.34)

2. Would you recommend that the investment project be undertaken?

No, the investment project should not be undertaken. The NPV is negative.

Calculation of Cash Inflow Y1-9 Finance Acctg. Net of Tax

Net annual cash receipts $110,000 $110,000 $77,000
Less Depreciation Expense (60,000) 18,000
Less Restoration Expense
Taxable Salvage Gain
Income Before Taxes $50,000
Less Income Taxes (30%) (15,000) (15,000)
Net Income $35,000
Add back depreciation 60,000
Operating Cash Flow $95,000 $95,000 $95,000

Calculation of Cash Inflow Y10 Finance Acctg. Net of Tax

Net annual cash receipts $110,000 $110,000 $77,000
Less Depreciation Expense (60,000) 18,000
Less Restoration Expense (70,000) (70,000) (49,000)
Taxable Salvage Gain 90,000 90,000 63,000
Income Before Taxes $70,000
Less Income Taxes (30%) (21,000) (21,000)
Net Income $49,000
Add back depreciation 60,000
Operating Cash Flow $109,000 $109,000 $109,000
ural gas has been found. The amount of gas
profitable to extract and sell the gas that
n gathered:

$600,000
$85,000
$110,000
$70,000

ment would have a useful life of 15 years, but

poses, the company would depreciate the
The tax rate is 30%, and the company's after-
mpletion of the project.

After-tax
Cash 10% PV of
Flow PV Table Cash
Amounts Factor Flows
($600,000) 1.000000 ($600,000.00)
($85,000) 1.000000 ($85,000.00)
$77,000 6.144567 $473,131.67
$18,000 6.144567 $110,602.21
($49,000) 0.385543 ($18,891.62)
$90,000 0.385543 $34,698.90
($27,000) 0.385543 ($10,409.67)
$85,000 0.385543 $32,771.18
($63,097.34)

Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9

$110,000 $110,000 $110,000 $110,000 $110,000 $110,000 $110,000
(60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000)

$50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000

(15,000) (15,000) (15,000) (15,000) (15,000) (15,000) (15,000)
$35,000 $35,000 $35,000 $35,000 $35,000 $35,000 $35,000
60,000 60,000 60,000 60,000 60,000 60,000 60,000
$95,000 $95,000 $95,000 $95,000 $95,000 $95,000 $95,000

$95,000 $95,000 $95,000 $95,000 $95,000 $95,000 $95,000

0.751315 0.683013 0.620921 0.564474 0.513158 0.466507 0.424098
$71,374.91 $64,886.28 $58,987.53 $53,625.02 $48,750.02 $44,318.20 $40,289.27
Year 10
$110,000
(60,000)
(70,000)
90,000
$70,000
(21,000)
$49,000
60,000
$109,000
85,000
$194,000
0.385543
$74,795.40
Demo 13-3 Uncertain Future Cash Flows
Given:
Union Bay Plastics is investigating the purchase of automated equipment that would save
$100,000 each year in direct labor and inventory carrying costs. This equipment costs $750,000
and is expected to have a 10-year useful life with no salvage value. The company requires a
minimum 15% rate of return on all equipment purchases. This equipment would provide
intangible benefits such as greater flexibility and higher-quality output that are difficult to
estimate and yet are quite significant.

Required:
1. What dollar value per year would the intangible benefits have to be worth in order to make
the equipment an acceptable investment? (Ignore income taxes).

If Union Bay Plastics uses a discount rate of 15% to calculate the NPV and the resulting NPV
equals zero, then the investment would be earning a return of exactly 15%; the IRR = 15%.

Therefore:

Annual cash inflows X Table Value (15%, 10 years) from PV of an Annuity Table - Cost = 0
(Annual cash inflows X 5.019) - $750,000 = 0
5.019 (Annual cash inflows) = $750,000
Annual cash inflows = $750,000/5.019 5.019 5.018769
Annual cash inflows = $149,432.16 $149,439.05

Thus the dollar value per year of the intangible benefits must be worth at least:

Annual cash inflows required $149,432.16 $149,439.05

Less known yearly savings 100,000.00 100,000.00
Minimum yearly intangible benefits $49,432.16 $49,439.05

Proof ($750,000.00) ($750,000.00)

$149,432.16 $149,439.05 1
$149,432.16 $149,439.05 2
$149,432.16 $149,439.05 3
$149,432.16 $149,439.05 4
$149,432.16 $149,439.05 5
$149,432.16 $149,439.05 6
$149,432.16 $149,439.05 7
$149,432.16 $149,439.05 8
$149,432.16 $149,439.05 9
$149,432.16 $149,439.05 10

NPV = ($34.57) $0.00

IRR = 14.998790% 15.000000%
Demo 13-4 Preference Ranking of Investment Projects

Given:
Austin Company is investigating four different investment opportunities. Information on the
four projects under study is given below:

Project Number 1 2 3 4
Investment required ($480,000) ($360,000) ($270,000) ($450,000)
Present value of cash inflows (10%) 567,270 433,400 336,140 522,970
Net present value $87,270 $73,400 $66,140 $72,970
Life of Project (in years) 6 12 6 3
Internal Rate of Return 16% 14% 18% 19%

Since the company's required rate of return is 10%, a 10% discount rate has been used in the
NPV calculations above. Limited funds are available for investment, so the company can not
accept all of the available projects.

Required:
1. Compute the project profitability index for each investment project.

Project profitability index = NPV / Investment Required

Project Number 1 2 3 4
Net present value $87,270 $73,400 $66,140 $72,970
Investment required $480,000 $360,000 $270,000 $450,000
Project profitability index 0.1818125 0.20388889 0.24496296 0.16215556

Present value of cash inflows (10%)/Investment Req. 1.1818125 1.20388889 1.24496296 1.16215556

2. Rank the four projects according to preference, in terms of:

Project Number 1 2 3 4
a. NPV 1 2 4 3
b. PPI 3 2 1 4
c. IRR 3 4 2 1

3. Which ranking do you prefer? Why?

Which ranking is best depends on the company's opportunities for reinvesting funds
as they are released from a project.

IRR: The internal rate of return method assumes that any released funds are reinvested
at the internal rate of return.

This means that funds released from project #4 would have to be reinvested at a
rate of return of 19%, but another project yielding such a high rate of return might
be difficult to find.

PPI: The project profitability index approach assumes that funds released from a project
 are reinvested at a rate of return equal to the discount rate, which in this case is only
10%. On balance, the PPI is generally regarded as the most dependable method of
ranking competing projects.

NPV: The net present value is inferior to the project profitability index as a ranking device
because it does not properly consider the amount of investment.

For example, it ranks project #3 fourth because of its low NPV; yet this project is
the best in terms of the amount of cash inflow generated per dollar invested.
 ($1,560,000)

(Not in text)

m a project
case is only

king device
Demo 13-5 Payback Period and Simple Rate of Return
Given:
The Heritage Amusement Park would like to construct a new ride called the Sonic Boom, which
the park management feels would be very popular. The ride would cost $450,000 to construct,
and it would have a 10% salvage value at the end of its 15-year useful life. The company
estimates that the following annual costs and revenues would be associated with the ride:

Ticket revenues $250,000

Less operating expenses:
Maintenance $40,000
Salaries 90,000
Depreciation 27,000
Insurance 30,000
Total Operating Expenses 187,000 Total Net Income
Net Operating Income $63,000 $945,000

Required: Ignore income taxes

1. Assume that the Heritage Amusement Park will not construct a new ride unless the ride
provides a payback period of six years or less. Does the Sonic Boom ride satisfy this
requirement?

Payback period = Investment Required / Net Uniform Annual Cash Inflow

Net Uniform Annual Cash Inflow

Net Operating Income $63,000
Depreciation 27,000 Total Cash Inflow
Net Uniform Annual Cash Inflow $90,000 $945,000

Payback period = $450,000 / $90,000

Payback period = 5.00 years

The Sonic Boom has a payback less than the maximum 6-year limit.
The Sonic Boom satisfies the payback criterion.

2. Compute the simple accounting rate of return promised by the new ride. If Heritage Amusement
Park requires a simple rate of return of at least 12%, does the Sonic Boom ride meet this
criterion?

Simple accounting rate of return = AROR

AROR = Annualized incremental NOI / Initial Investment Required

AROR = $63,000 / $450,000

AROR = 14.00%

The Sonic Boom has an AROR greater than the minimum 12% requirement.
The Sonic Boom satisfies the simple accounting rate or return criterion.

What if the required AROR was 16%? Should the investment opportunity be accepted?

($450,000)
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
135000
18.595% IRR
e Amusement
Demo 13-6 Payback Method
Given:
The management of Weimar Inc., a civil engineering design company, is considering
an investment in a high-quality blueprint printer with the following cash flows:

Investment
Cash Cash
Year Outflow Inflow
1 $38,000 $2,000
2 $6,000 $4,000
3 $8,000
4 $9,000
5 $12,000
6 $10,000
7 $8,000
8 $6,000
9 $5,000
10 $5,000

Required:
1. Determine the payback period of the investment.

Investment
Cash Cash Unrecovered
Year Outflow Inflow Investment
1 ($38,000) $2,000 ($36,000)
2 ($6,000) $4,000 ($38,000)
3 $8,000 ($30,000)
4 $9,000 ($21,000)
5 ***** $12,000 ($9,000)
6 ***** $10,000 $1,000
7 $8,000 $9,000
8 $6,000 $15,000
9 $5,000 $20,000
10 $5,000 $25,000

Payback = 5 0.90 5.9 years

2. Would the payback period be affected if the cash inflow in the last year
was several times larger?

Since the investment is recovered prior to the last year, the amount
of the cash inflow in the last year has no effect on the payback period.
The payback method ignores cash flows after the payback date.
Demo 13-7 Net Present Value Analysis of a Lease or Buy Decision

Given:
Blinko Products wants an airplane for use by its corporate staff. The airplane that the company wishes to acquire, a Z

Purchase alternative.
If the Zephyr II is purchased, then the costs incurred by the company would be as follows:

Purchase cost of the plane $850,000

Annual cost of servicing, licenses, and taxes $9,000
Repairs:
First 3 years (per year) $3,000
Fourth year $5,000
Fifth year $10,000

The plane would be sold after 5 years. Based on current resale values, the company would be able to sell it for ab
the five-year period.

Lease alternative.
If the Zephyr II is leased, then the company would have to make an immediate deposit of $50,000
years, a the end of which time the deposit would be refunded. The lease would require an annual rental payment o
of Year 1). As part of this lease cost, the manufacturer would provide all servicing and repairs, license the plane, a
plane would revert to the manufacturer, as owner.

Blinko Products' required rate of return is 18%

Required: Ignore income taxes.

1. Use the total-cost approach to determine the present value of the cash flows associated
with each alternative.
Timing of Amount of PV Table
Purchase alternative. Cash Flows Cash Flows Factor (18%)
Purchase cost of the plane Now ($850,000) 1.000000
Annual cost of servicing, etc. End of Ys 1-5 ($9,000) 3.127171
Repairs:
First Three Years End of Ys 1-3 ($3,000) 2.174273
Fourth Year End of Year 4 ($5,000) 0.515789
Fifth Year End of Year 5 ($10,000) 0.437109
Resale value of the plane End of Year 5 $425,000 0.437109

Timing of Amount of PV Table

Lease alternative. Cash Flows Cash Flows Factor (18%)
Damage Deposit Now ($50,000) 1.000000
Annual Lease Payments End of Ys 1-5 ($200,000) 3.127171
Refund of Deposit End of Year 5 $50,000 0.437109
 Net present value in favor of the leasing option

2. Which alternative would you recommend that the company accept? Why?

The company should accept the leasing alternative. The present value of the cash outflows is less negative under
at the company wishes to acquire, a Zephyr II, can be either purchased or leased

e as follows:

mpany would be able to sell it for about one-half of its original cost at the end of

deposit of $50,000 to cover any damage during use. The lease would run for five
d require an annual rental payment of $200,000 (the first payment is due at the end
cing and repairs, license the plane, and pay all taxes. At the end of five-years, the

2.174273

PV of Timing of Amount of PV Table PV of

Cash Flow Cash Flows Cash Flows Factor (18%) Cash Flow
($850,000.00) Now ($850,000) 1.000000 ($850,000.00)
(28,144.54) End of Year 1 (12,000) 0.847458 (10,169.49)
End of Year 2 (12,000) 0.718184 (8,618.21)
(6,522.82) End of Year 3 (12,000) 0.608631 (7,303.57)
(2,578.94) End of Year 4 (14,000) 0.515789 (7,221.04)
(4,371.09) End of Year 5 406,000 0.437109 177,466.34
185,771.42
($705,845.98) ($705,845.98) 3.127171 ($705,845.98)

PV of Timing of Amount of PV Table PV of

Cash Flow Cash Flows Cash Flows Factor (18%) Cash Flow
($50,000.00) Now ($50,000) 1.000000 ($50,000.00)
(625,434.20) End of Year 1 (200,000) 0.847458 (169,491.53)
21,855.46 End of Year 2 (200,000) 0.718184 (143,636.89)
($653,578.74) End of Year 3 (200,000) 0.608631 (121,726.17)
End of Year 4 (200,000) 0.515789 (103,157.78)
End of Year 5 (150,000) 0.437109 (65,566.38)
 ($653,578.74) ($653,578.74)

$52,267.23 $52,267.23 $52,267.23

cash outflows is less negative under the leasing option.