Problem 14-22

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
Net annual cash receipts
Working capital required
Cost of road repairs in three years
Salvage value of equipment in five years

$850,000
$230,000 ***
$100,000
$60,000
$200,000

$804,920.93
Cost (NPV = 0)

*** 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:
Ignore income taxes.
Determine the net present value of the proposed mining project. Should the project be accepted?
Explain.
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
3.433082 $789,608.86
Cost of road repairs in three years
End of Year 3
($60,000)
0.674972
($40,498.32)
Salvage value of equipment in 5 years
End of Year 5
$200,000
0.519369 $103,873.80
Working capital released
End of Year 5
$100,000
0.519369
$51,936.90
Net Present Value
($45,078.76)
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%

Timing of
Cash
Flows
Now
End of Y1
End of Y2
End of Y3
End of Y4
End of Y5

Yearly Cash
Flow
Amounts
($950,000.00)
$230,000.00
$230,000.00
$170,000.00
$230,000.00
$530,000.00
($45,079.07)
12.246555%

($39,543.0428)
Note: Wrong NPV
Excel formula is wrong

14%
PV Table
Factor
1.000000
0.877193
0.769468
0.674972
0.592080
0.519369
3.433082
IRR

PV of
Cash
Flows
($950,000.00)
$201,754.39
$176,977.64
$114,745.24
$136,178.40
$275,265.57
($45,078.76)

Exercise 14-11
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.
operating the car.
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
From PV of an Annuity Table, scanning along the row for 14 periods yields:

X
0.01

12%
?%
11%
X
0.01

6.628168
6.835000
6.981865
=

-0.206832
-0.353697
0.206832
0.353697

6.835

0.353697 (X) = (0.01)(.206832)

0.353697 (X) =
0.00207
X =
0.00585
X =
0.5848%
?% = 12% - 0.5848% =
11.4152%
Rounded to nearest whole % = 11%

IRR
NPV

RR equal to 16%

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

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

20,000
20,000
20,000
20,000
20,000

25,000
25,000
25,000
25,000
25,000

11.405%
0.000

15.998%
0.000

Exercise 14-3
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 the NPV = 0, then the investment would be earning a return of exactly 15% if the discount
rate is 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
Annual cash inflows =
$149,432.16
Thus the dollar value per year of the intangible benefits must be worth at least:
Annual cash inflows required
Less known yearly savings
Minimum yearly intangible benefits

$149,432.16
100,000.00
$49,432.16

Exercise 14-5:
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:

Year
1
2
3
4
5
6
7
8
9
10

Investment
Cash
Outflow
$38,000
$6,000

Cash
Inflow
$2,000
$4,000
$8,000
$9,000
$12,000
$10,000
$8,000
$6,000
$5,000
$5,000

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

Year
1
2
3
4
5 *****
6 *****
7
8
9
10
Payback =

Investment
Cash
Outflow
$38,000
$6,000

Cash
Inflow
$2,000
$4,000
$8,000
$9,000
$12,000
$10,000
$8,000
$6,000
$5,000
$5,000
0.9

Unrecovered
Investment
$36,000
$38,000
$30,000
$21,000
$9,000
($1,000)
($9,000)
($15,000)
($20,000)
($25,000)
5.9 years

2. Would the payback period be affected if the cash inflow

in the last year were 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.

Exercise 14-19:
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
Less operating expenses:
Maintenance
Salaries
Depreciation
Insurance
Total Operating Expenses
Net Operating Income

$250,000
$40,000
90,000
27,000
30,000

$945,000

187,000
$63,000

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 Expenses
Depreciation
Net Uniform Annual Cash Inflow

$63,000
27,000
$90,000

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 = Annualized incremental NOI
AROR =

$63,000

AROR =

14.00%

AROR
/

Initial Investment Required

$450,000

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

e Amusement

($450,000)
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
90000
18.415% IRR

Problem 14-26:

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
Investment required
Present value of cash inflows (10%)
Net present value
Life of Project (in years)
Internal Rate of Return

1
2
3
4
($480,000) ($360,000) ($270,000) ($450,000)
567,270
433,400
336,140
522,970
$87,270
$73,400
$66,140
$72,970
6
12
6
3
16%
14%
18%
19%

Since the company's required rate of return is 10%, a 10% discount rate has been used tn 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

Project Number
Net present value
Investment required
Project profitability index

Investment Required

1
2
3
4
$87,270
$73,400
$66,140
$72,970
$480,000
$360,000
$270,000
$450,000
0.1818125 0.20388889 0.24496296 0.16215556

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

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

2
2
2
4

3
4
1
2

4
3
4
1

3. Which ranking do you prefer? Why?

Which ranking is best will depend 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 or 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.

m a project
case is only

king device

Problem 14-37:

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. The amount of gas on some of the tracts is somewhat marginal,
and the company is unsure whether it would be profitable to extract and sell the gas that 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

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

The natural gas in tract 410 would be exhausted after 10 years of extraction work. The equipment
would have a useful life of 15 years, but it could be sold for only 15% of its original cost when
extraction was completed. For tax purposes, the company would depreciate the equipment
over 10 years using straight-line depreciation and assuming zero salvage value. The tax rate
is 30%, and the company's after-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.

Normal Acctg. Approach

Investment in equipment
Working capital required
Net annual cash receipts
Tax Savings (Depreciation tax shield)
Restoration Expense
Salvage value of equipment in 5 years
Tax Outflow from Salvage Gain
Working capital released
Net Present Value
Normal Finance Approach
Net annual cash receipts
Less Depreciation Expense
Less Restoration Expense
Taxable Salvage Gain
Income Before Taxes
Less Income Taxes (30%)
Net Income
Add back depreciation
Operating Cash Flow
Working capital released
Cash Inflow
Table Factor 10% (PV of $1 Table)
PV of cash inflows

Timing of
Cash
Flows
Now
Now
End of Ys 1-10
End of Ys 1-10
End of Year 10
End of Year 10
End of Year 10
End of Year 10

Year 0 (Now)

$621,902.53

Cash
Flow
Amounts
($600,000)
($85,000)
$110,000
$60,000
($70,000)
$90,000
$90,000
$85,000

After
Tax
Effect
None
None
70%
30%
70%
None
30%
None

Cash
Flow
Amounts
($600,000)
($85,000)
$77,000
$18,000
($49,000)
$90,000
($27,000)
$85,000

Year 1
$110,000
(60,000.00)

Year 2
$110,000
(60,000.00)

Year 3
$110,000
(60,000.00)

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$95,000
0.909091
$86,363.65

$95,000
0.826446
$78,512.37

$95,000
0.751315
$71,374.93

Initial Investment in equipment

Initial Investment in Working Capital
Net Present Value
Net Present Value (Adj. Excel Formula)

(600,000.00)
(85,000.00)
($63,097.47)
($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.

10%
PV Table
Factor
1.000000
1.000000
6.144567
6.144567
0.385543
0.385543
0.385543
0.385543

PV of
Cash
Flows
($600,000.00)
($85,000.00)
$473,131.66
$110,602.21
($18,891.61)
$34,698.87
($10,409.66)
$32,771.16
($63,097.38)

Year 4
$110,000
(60,000.00)

Year 5
$110,000
(60,000.00)

Year 6
$110,000
(60,000.00)

Year 7
$110,000
(60,000.00)

Year 8
$110,000
(60,000.00)

Year 9
$110,000
(60,000.00)

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$50,000
(15,000)
$35,000
60,000
$95,000

$95,000
0.683013
$64,886.24

$95,000
0.620921
$58,987.50

$95,000
0.564474
$53,625.03

$95,000
0.513158
$48,750.01

$95,000
0.466507
$44,318.17

$95,000
0.424098
$40,289.31

Year 10
$110,000
(60,000.00)
(70,000.00)
90,000.00
$70,000
(21,000)
$49,000
60,000
$109,000
85,000
$194,000
0.385543
$74,795.34

Problem 14-31

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 Zephyr II, can be either purchased or leased from the manufacturer. The
company has made the following evaluations of the two alternatives:
Purchase alternative.
If the Zephyr II is purchased, then the costs incurred by the company would be as follows:
Purchase cost of the plane
Annual cost of servicing, licenses, and taxes
Repairs:
First 3 years, per year
Fourth year
Fifth year

$850,000
$9,000
$3,000
$5,000
$10,000

The plane would be sold after 5 years. Based on current resale values, the company would
be able to sell it for about one-half of its original cost at the end of 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 to cover any damage during use. The lease would run for five years, at the end of
which time the deposit would be refunded. The lease would require an annual rental
payment of $200,000 (the first payment is due at the end of Year 1). As part of this lease
cost, the manufacturer would provide all servicing and repairs, license the plane, and pay
all taxes. At the end of the 5-year period, the 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

Lease alternative.
Damage Deposit
Annual Lease Payments
Refund of Deposit

Timing of
Cash Flows
Now
End of Ys 1-5
End of Year 5

Amount of
PV Table
Cash Flows
Factor (18%)
($50,000)
1.000000
($200,000)
3.127171
$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 under the leasi

at the company
acturer. The

e as follows:

mpany would

at the end of

ne, and pay

PV of
Cash Flow
($850,000.00)
($28,144.54)
($6,522.82)
($2,578.95)
($4,371.09)
$185,771.33
($705,846.07)
PV of
Cash Flow
($50,000.00)
($625,434.20)
$21,855.45
($653,578.75)

Timing of
Cash Flows
Now
End of Year 1
End of Year 2
End of Year 3
End of Year 4
End of Year 5

Amount of
PV Table
Cash Flows Factor (18%)
($850,000)
1.000000
($12,000)
0.847458
($12,000)
0.718184
($12,000)
0.608631
($14,000)
0.515789
$406,000
0.437109
($705,845.98)

PV of
Cash Flow
($850,000.00)
($10,169.50)
($8,618.21)
($7,303.57)
($7,221.05)
$177,466.25
($705,846.07)

Timing of
Cash Flows
Now
End of Year 1
End of Year 2
End of Year 3

Amount of
PV Table
Cash Flows Factor (18%)
($50,000)
1.000000
($200,000)
0.847458
($200,000)
0.718184
($200,000)
0.608631

PV of
Cash Flow
($50,000.00)
($169,491.60)
($143,636.80)
($121,726.20)

End of Year 4
End of Year 5

$52,267.32

cash outflows is less under the leasing option.

($200,000)
($150,000)
($653,578.74)
$52,267.23

0.515789
0.437109

($103,157.80)
($65,566.35)
($653,578.75)
$52,267.32