Question

Linda's Luxury Travel (LLT) is considering the purchase of two Hummer limousines. Various information about the proposed investment follows:

Initial investment (2 limos)	$720,000
Useful life	$10 years
Salvage value	$100,000
Annual net income generated	$59,040
LLT's cost of capital	14%

Assume straight line depreciation method is used.

Required:

Help LLT evaluate this project by calculating each of the following:

1. Accounting rate of return.

2. Payback period.

3. Net present value.

4. Without making any calculations, determine whether the IRR is more or less than 14 %.

Answer 1

Solution 1:

Accounting rate of Return
Choose Numerator	/	Choose Denominator	=	Accounting Rate of Return
Annual Net Income	/	Investment	=	Accounting Rate of Return
$59,040	/	$720,000	=	8.2%

Solution 2:

Computation of Annual net Cash Flows
Annual Net Income	$59,040
Annual Depreciation [($720,000-$100,000)/10]	$62,000
Annual Cash Flows	$121,040

Payback Period
Choose Numerator	/	Choose Denominator	=	Payback Period
Cost of investment	/	Annual net Cash flow	=	Payback Period
$720,000	/	$121,040	=	5.95
				Years

Solution 3:

Computation of NPV - Linda's Luxury Travel
Particulars	Amount
Table or calculator function:	Present Value of $1
Cash Outflows (Beginning of year)	-$720,000
n=	0
i=	14%
Present Value	-$720,000
Table or calculator function:	Present Value of annuityof $1
Cash Inflow (for next 10 years)	$121,040
n=	10
i=	14%
Table Factor	5.21612
Present Value	$631,359
Table or calculator function:	Present Value of $1
Cash Inflow (for 10th year)	$100,000
n=	10
i=	14%
Table Factor	0.26974
Present Value	$26,974
Total Net present value	-$61,667

solution 4:

As NPV is negative, it means IRR is less than 14%.