Question

The management of Hansley Corporation is investigating an investment in equipment that would have a useful life of 5 years. The company uses a discount rate of 18% in its capital budgeting. Good estimates are available for the initial investment and the annual cash operating outflows, but not for the annual cash inflows and the salvage value of the equipment. The net present value of the initial investment and the annual cash outflows is -$273,300. (Ignore income taxes.) Click here to view Exhibit 7B-1 and Exhibit 7B-2, to determine the appropriate discount factor(s) using the tables provided. Ignoring any salvage value, to the nearest whole dollar how large would the annual cash inflow have to be to make the investment in the equipment financially attractive? Multiple Choice $54,660 $49,194 $87,400 $273,300

Answer 1

Given that the equipment has a useful life of 5 years.

Therefore the PV of annual cash inflows for 5 years should be more than net present value of initial investment and annual cashoutflows which is ($273,000).

First two options are out of contention (even if we multiply them by 5 without even discounting they wouldbe less than $273,000 which makes the project nonviable and unattractive.

Therefore lets try option 3

PV of annual cash inflows for 5 years under option 3 would be -

87400 + (87400/1.18) + (87400/1.182) + (87400/1.183) + (87400/1.184)

87400 + 74068 + 62769 + 53194 + 45080

$322,511 (which is greater than $273,00)

Therefore, inorder to make investment financially attractive, the company has to earn atleast $87400 per annum.