Problem 13-16

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)

$804,920.93

*** 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 taxes.
Explain.

Relevant Items:

Now

Cost of equipment required

($850,000)

Working capital required

($100,000)

Net annual cash receipts

Year 1

$230,000

Year 2

$230,000

Cost of road repairs (Year 3)

Year 3

$230,000

Year 4

Year 5

$230,000

$230,000

($60,000)

Equipment Salvage Value (Y5)

$200,000

Working capital released

$100,000

Total

($950,000)

Relevant Items:
Cost of equipment required
Working capital required
Net annual cash receipts
Cost of road repairs in three years
Salvage value of equipment in 5 years
Working capital released
Net Present Value

$230,000

$230,000

$170,000

$230,000

$530,000

Accounting Approach:
Timing of
Cash
Cash
Flow
Flows
Amounts
Now
($850,000)
Now
($100,000)
End of Ys 1-5
$230,000
End of Year 3
($60,000)
End of Year 5
$200,000
End of Year 5
$100,000

14%
PV Table
Factor
1.000000
1.000000
3.433081
0.674972
0.519369
0.519369

PV of
Cash
Flows
($850,000.00)
($100,000.00)
$789,608.62
($40,498.29)
$103,873.73
$51,936.87
($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%

cepted?

Finance Approach:
Timing of
Yearly Cash
Cash
Flow
Flows
Amounts
Now
($950,000.00)
End of Y1
$230,000.00
End of Y2
$230,000.00
End of Y3
$170,000.00
End of Y4
$230,000.00
End of Y5
$530,000.00

0.122465547

12.2465547%
($39,543.04)
Note: Wrong NPV
Excel formula is wrong

14%
PV Table
Factor
1.000000
0.877193
0.769468
0.674972
0.592080
0.519369
3.433081
3.433081
IRR

PV of
Cash
Flows
($950,000.00)
$201,754.39
$176,977.53
$114,745.16
$136,178.46
$275,265.39
($45,079.07)

($45,079.07)
Corrected NPV

Exercise 13-10
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
From PV of an Annuity Table, scanning along the row for 14 periods yields:
Interpolation
X
0.01

12%
?%
11%
X
0.01

6.628
6.835
6.982
=

6.628168
6.835000
6.981865

0.206832
0.3536970011

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

(0.206832)
(0.353697)

6.835

0.353697 (X) =
X =
X =

0.00206832
0.00584771
0.584771%

11.4152%
Rounded to nearest whole % = 11%
?% = 12% - 0.584771% =

IRR
NPV

(pg. 630)

RR equal to 16%

(136,700)
20,000
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
25,000

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

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

11.405%
0.000

15.998%
0.000

Problem 13C-6
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.

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 10 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
$621,902.66
Initial Investment in equipment
Initial Investment in Working Capital
Net Present Value
Net Present Value (Adj. Excel Formula)

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)

$621,902.66
(600,000.00)
(85,000.00)
($63,097.34)
($63,097.34)

Pre-tax
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

Year 1
$110,000
(60,000)

Year 2
$110,000
(60,000)

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

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

$95,000
0.909091
$86,363.64

$95,000
0.826446
$78,512.40

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

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

Calculation of Cash Inflow Y10

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

Finance
$110,000
(60,000)

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

Finance
$110,000
(60,000)
(70,000)
90,000
$70,000
(21,000)
$49,000
60,000
$109,000

Acctg.
$110,000

Net of Tax
$77,000
18,000

(15,000)

$95,000

$95,000

Acctg.
$110,000

Net of Tax
$77,000
18,000
(49,000)
63,000

(70,000)
90,000
(21,000)

$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 aftermpletion of the project.

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

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)
$473,131.67
$110,602.21
($18,891.62)
$34,698.90
($10,409.67)
$32,771.18
($63,097.34)

Year 3
$110,000
(60,000)

Year 4
$110,000
(60,000)

Year 5
$110,000
(60,000)

Year 6
$110,000
(60,000)

Year 7
$110,000
(60,000)

Year 8
$110,000
(60,000)

Year 9
$110,000
(60,000)

$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

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

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

$95,000
0.751315
$71,374.91

$95,000
0.683013
$64,886.28

$95,000
0.620921
$58,987.53

$95,000
0.564474
$53,625.02

$95,000
0.513158
$48,750.02

$95,000
0.466507
$44,318.20

$95,000
0.424098
$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

Problem 13-22

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
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 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

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 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
Cash Flow
($850,000.00)
(28,144.54)
(6,522.82)
(2,578.94)
(4,371.09)
185,771.42
($705,845.98)
PV of
Cash Flow
($50,000.00)
(625,434.20)
21,855.46
($653,578.74)

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

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

PV of
Cash Flow
($850,000.00)
(10,169.49)
(8,618.21)
(7,303.57)
(7,221.04)
177,466.34

($705,845.98)

3.127171

($705,845.98)

Amount of
PV Table
Cash Flows Factor (18%)
($50,000)
1.000000
(200,000)
0.847458
(200,000)
0.718184
(200,000)
0.608631
(200,000)
0.515789
(150,000)
0.437109
($653,578.74)

PV of
Cash Flow
($50,000.00)
(169,491.53)
(143,636.89)
(121,726.17)
(103,157.78)
(65,566.38)
($653,578.74)

$52,267.23

$52,267.23

cash outflows is less negative under the leasing option.

$52,267.23

Exercise 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
Less known yearly savings
Minimum yearly intangible benefits
Proof

NPV =
IRR =

$149,432.16
100,000.00
$49,432.16

$149,439.05
100,000.00
$49,439.05

($750,000.00)
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16
$149,432.16

($750,000.00)
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05
$149,439.05

($34.57)
14.998790%

$0.00
15.000000%

Problem 13-17

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 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
Net present value
Investment required
Project profitability index

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

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
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 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.

m a project
case is only

($1,560,000)

(Not in text)

king device

Exercise 13-7
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
187,000 Total Net 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
Depreciation
Net Uniform Annual Cash Inflow

$63,000
27,000
$90,000

Payback period =

$450,000

$90,000

Payback period =

5.00

Total Cash Inflow

$945,000

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.

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

Exercise 13-5:
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
0.90

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
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.