Problems
1. An investment opportunity costing $180,000 is expected to yield net cash
flows of $60,000 annually for five years.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment.
c. Find the IRR on the investment.
SOLUTION:
a. NPV: $36,300 [(3.605 x $60,000) - $180,000]
b. Payback period: 3 years ($180,000/$60,000)
c. IRR: between 18 % and 20% (3.0 is between 3.127 and 2.991)
2. Tofte is considering the purchase of a machine. Data are as follows:
Cost $100,000
Useful life 10 years
Annual straight-line depreciation $ 10,000
Expected annual savings in cash
operation costs $ 18,000
Tofte's cutoff rate is 12% and its tax rate is 40%.
a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.
SOLUTION:
a. Annual net cash flows: $14,800 [$18,000 pretax - 40% x ($18,000 -
$10,000 depreciation)]
b. NPV: Negative $16,380 [($14,800 x 5.650) - $100,000]
3. Willow Company is considering the purchase of a machine with the following
characteristics.
Cost $150,000
Estimated useful life 10 years
Expected annual cash cost savings $35,000
Marquette's tax rate is 40%, its cost of capital is 12%, and it will use
straight-line depreciation for the new machine.
a. Compute the annual after-tax cash flows for this project.
b. Find the payback period for this project.
SOLUTION:
a. Annual cash flows: $27,000 [$35,000 - 40% x ($35,000 - $15,000)]
b. Payback period: 5.56 years ($150,000/$27,000)
4. Bilt-Rite Co. has the opportunity to introduce a new product. Bilt-Rite
expects the product to sell for $60 and to have per-unit variable costs of
$40 and annual cash fixed costs of $3,000,000. Expected annual sales
volume is 250,000 units. The equipment needed to bring out the new
product costs $5,000,000, has a four-year life and no salvage value, and
would be depreciated on a straight-line basis. Bilt-Rite's cost of
capital is 10% and its income tax rate is 40%.
a. Find the increase in annual after-tax cash flows for this opportunity.
b. Find the payback period on this project.
c. Find the NPV for this project.
SOLUTION:
a. Increase in annual cash flows: $1,700,000
Income before taxes, 250,000 x ($60 - $40)
- $3,000,000 - $5,000,000/4 $ 750,000
Income tax (300,000)
----------
Net income $ 450,000
Plus depreciation 1,250,000
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Net cash flow $1,700,000
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b. Payback period: 2.94 years ($5,000,000/$1,700,000)
c. NPV: $389,000 [($1,700,000 x 3.170) - $5,000,000]
5. An investment opportunity costing $600,000 is expected to yield net cash
flows of $120,000 annually for ten years.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment.
c. Find the IRR on the investment.
SOLUTION:
a. NPV: $78,000 [(5.650 x $120,000) - $600,000]
b. Payback period: 5 years ($600,000/$120,000)
c. IRR: 15% (5.0 is about halfway between 5.216 and 4.833)
6. Scottso has an investment opportunity costing $300,000 that is expected to
yield the following cash flows over the next six years:
Year One $75,000
Year Two $90,000
Year Three $115,000
Year Four $130,000
Year Five $100,000
Year Six $90,000
a. Find the payback period of the investment.
b. Find the NPV of the investment at a cutoff rate of 10%.
SOLUTION:
a. Payback period: 3.15 years (75,000 + 90,000 + 115,000 + .15 x 130,000)
b. NPV: $130,530
Cash Factor PV
------ ------ ------
1 75,000 .909 68,175
2 90,000 .826 74,340
3 115,000 .751 86,365
4 130,000 .683 88,790
5 100,000 .621 62,100
6 90,000 .564 50,760
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430,530
Investment 300,000
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NPV 130,530
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