Question

Question 1 (evaluating investment projects) Generic Motors Corporation is planning to invest $100,000 in year zero (today) in new equipment. This investment is expected to generate net cash flows of $40,000 a year for the next 4 years (years 1-4). The salvage value after 4 years is zero. The discount rate (cost of capital) is 20% a year. Required: a) What is the net present value (NPV) of this project? NPV = $ Should the firm invest, based on NPV? (1=yes, 2=no) b) What is the payback period for this project? payback period = years c) What is the modified payback period for this project? O between 1 and 2 years O between 2 and 3 years O between 3 and 4 years d) What is the simple rate of return (SRR) for this project? To compute SRR, first compute: annual depreciation=$ annual income=$ investment=$ SRR = % (enter say 10% as 10, not as 0.1 and not as 10%)

Answer 1

Solution

Initial Investment = $ 100000

Life = 4 Years

Salvage Value = Nil

Depreciation per year (Straight-Line Method) = $ (100000 / 4) = $ 25000

(1)

Year	Cash Inflow	Depreciation	Cash Flow after Tax	Cumulative CFAT	PVIF @ 20%	Discounted CFAT	Cumulative Discounted CFAT
	($)	($)	($)	($)		($)	($)
1	40,000.00	25,000.00	65,000.00	65,000.00	0.833	54,166.67	54,166.67
2	40,000.00	25,000.00	65,000.00	1,30,000.00	0.694	45,138.89	99,305.56
3	40,000.00	25,000.00	65,000.00	1,95,000.00	0.579	37,615.74	1,36,921.30
4	40,000.00	25,000.00	65,000.00	2,60,000.00	0.482	31,346.45	1,68,267.75
				Total Discounted CFAT		1,68,267.75
				Less: Initial Outflow		-1,00,000.00
				NET PRESENT VALUE		68,267.75

Therefore as it is having a positive NPV, this proposal should be selected

(2)

Year	Cumulative CFAT (See Table 1)
	($)
1	65,000.00
2	1,30,000.00
3	1,95,000.00
4	2,60,000.00

As per the given table, it can be said that the company can recover $ 100000 sometimes in between 1st to 2nd year.

Therefore, using interpolation method by assuming at "X" year, the company will recover $ 100000

(X - 1) / (2 - 1) = (100000 - 65000) / (130000 - 65000)

Or, X - 1 = 35000 / 65000

Or, X - 1 = 0.5 (Approx)

Or, X = 1.5

Therefore, the payback period is about 1.5 years.

(3)

Year	Cumulative Discounted CFAT (See Table 1)
	($)
1	54,167
2	99,306
3	1,36,921
4	1,68,268

As per the given table, it can be said that the company can recover $ 100000 sometimes in between 2nd to 3rd year.

Therefore, using interpolation method by assuming at "X" year, the company will recover $ 100000

(X - 2) / (3 - 2) = (100000 - 99306) / (136921 - 99306)

Or, X - 2 = 694 / 37615

Or, X - 2 = 0.02 (Approx)

Or, X = 2.02

Therefore, the payback period is about 2 years, or sometimes between 2nd to 3rd year

(4)

Simple Rate of Return = (Annual Cash Flow - Annual Depreciation) / Initial Investment

Here, Annual Cash Flow = $ 40000

Annual Depreciation = $ 25000

Initial Investment = $ 100000

Therefore, Simple Rate of Return = (40000 - 25000) / 100000 = 15000 / 100000 = 0.15, or 15%

Therefore, Simple Rate of Return = 15%