Question

Exercise 10-6A Determining net present value LO 10-2 Aaron Heath is seeking part-time employment while he attends school. He is considering purchasing technical equipment that will enable him to start a small training services company that will offer tutorial services over the Internet. Aaron expects demand for the service to grow rapidly in the first two years of operation as customers learn about the availability of the Internet assistance. Thereafter, he expects demand to stabilize. The following table presents the expected cash flows: Year of Operation 2019 2020 2021 2022 Cash Inflow $13,900 19,000 22,300 22,300 Cash Outflow $ 8,600 11,100 12,600 12,600 In addition to these cash flows, Aaron expects to pay $20,000 for the equipment. He also expects to pay $2,700 for a major overhaul and updating of the equipment at the end of the second year of operation. The equipment is expected to have a $1,200 salvage value and a four year useful life. Aaron desires to earn a rate of return of 9 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) Required a. Calculate the net present value of the investment opportunity. (Negative amount should be indicated by a minus sign. Round intermediate calculations and final answer to 2 decimal places.) b. Indicate whether the investment opportunity is expected to earn a return that is above or below the desired rate of return and whether it should be accepted. a. Net present value b. Will the return be above or below the cost of capital? Should the investment opportunity be accepted? Above Accepted

Answer 1

a. Net present value of the investment opportunity

Year of operation	Cash inflow	Cash outflow	Net cash flows	PV factor @ 9%	Present value of net cash flows
2019	-	$20,000	-$20,000	1	-$20,000
2019	$13,900	$8,600	$5,300	0.9174	$4,862.22
2020	$19,000	$11,100 + $2,700 (overhauling and updating charges)	$5,200	0.8417	$4,376.84
2021	$22,300	$12,600	$9,700	0.7722	$7,490.34
2022	$22,300 + $1,200 (salvage value)	$12,600	$10,900	0.7084	$7,721.56
Net Present Value of the investment opportunity					$4,450.96

Cash outflow in 2019 - It will consist of two outflows. 1st for the purchase of equipment for $20,000 which will be done in the start of the year which makes the present value factor to be 1. 2nd for the cash outflows incurred for tutorial services.

In 2020 - cash outflows will also consist of overhauling and updating charges for the equipment.

Lastly, in the last year of operations, salvage value will be realized from the equipment which will form part of the cash inflows.

b. Will the return be above or below the cost of capital - Above, as the NPV comes out to be positive.

c. Should the investment opportunity be accepted - Accepted, as the NPV is positive, which shows that the investment in the equipment will result in more income above the cost of capital.