Question

Required information [The following information applies to the questions displayed below.] Falcon Crest Aces (FCA), Inc., is considering the purchase of a small plane to use in its wing-walking demonstrations and aerial tour business. Various information about the proposed investment follows: Initial investment Useful life Salvage value Annual net income generated FCA's cost of capital $ 110,000 10 years $ 10,000 $ 4,200 10% Assume straight line depreciation method is used. Required: Help FCA evaluate this project by calculating each of the following: 1. Accounting rate of return. (Round your answer to 2 decimal places.) Answer is complete and correct.

1. Account Rate of return %

2. Payback period in years

3.Net Present Value

4. Net Present Value assuming the cost of capital is 6 percent

Answer 1

Solution: Falcon Crest Aces, Inc. 1. Calculation of Accounting Rate of return (ARR): ARR = Average Annual Net Income after Tax and Depreciation / Average Investment Initial Outlay = $110,000 Useful Life = 10 years Salvage Value = $10,000 Net Annual Income = $4,200 The given revenue is after depreciation expense, so there is no need to reduce the Revenue by the amount of depreciation. (a) Average Investment: = (Initial Investment + Salvage Value)/2 = ($110,000 + 10,000) / 2 = $60,000 Average Rate of Return = Average Net Income / Average Investment = $4,200 / 60,000 = 7 %

2. Computation of Pay Back Period: Initial outlay for Capital Investment = $110,000 Life of the Project = 10 years Calculation of Net Annual Cash Inflow: Net Income = $4,200 Add: Depreciation 10,000 Cash Inflow After Tax and Before Depreciation = $14,200 Note: Depreciation is a non cash expense so we will add back it to net income for calculation of Net Cash Inflow Calculation of Depreciation: (According Straight Line Method) Depreciation = (Cost of asset-Scrap Value) / Useful Life = (110,000 - 10,000) / 10 = $10,000 Pay Back Period = Initial Investment/ Annual Cash Inflows = 110,000 / 14,200 = 7.746 or say = 7.75 Years

3. Calculation of Net Present Value: Cost of Capital = 10% Net Present Value = Present Value of Cash Inflows - Present value of Cash Outflows Step-1: Present Value of Cash Outflows: Initial Cash Outlay=$110,000 Present Value Factor @10% at 'Zero' Year = 1 Present Value of Initial Cash Outflow = 110,000x 1 Present Value of Initial Cash Outflow= $110,000 Step-2: Present Value of Annual Cash Inflow: Annual Cash Inflow = $14,200 per year for 10 years Terminal Cash Inflow = $10,000 Present Value Annuity Factor @10% for 10 Years = (1-Present Value Factor @10% for 10th Year) / Discounting Rate = (1-0.38554)/0.10 = 0.61446/ 0.10 = 6.1446 Present Value Factor @10% for 10th Year=1/(1+r) =1/(1+0.10) 10 =1/(1.10) 10 = 1/2.59374 = 0.38554

Present Value of Annual Cash Inflows = Annual Cash Inflow X Present Value Annuity Factor = $14,200 x 6.1446 = $87,253.32 Present value of Terminal Cash Inflow: Terminal Cash Inflow x Present Value Factor at the end of 10th year @ 10% 10,000 x 0.38554 = 3,855.43 Step-3: Calculation of Net Present Value: Net Present Value = Present Value of Inflow-Present Value of Outflow = 87,253.32 +3,855.43-110,000 = 91,108.75-110,000 = -18891.25

4. Calculation of Net Present Value: Cost of Capital = 6% Net Present Value Present Value of Cash Inflows - Present value of Cash Outflows Step-1: Present Value of Cash Outflows: Initial Cash Outlay= $110,000 Present Value Factor @ 6% at 'Zero' Year = 1 Present Value of Initial Cash Outflow= 110,000 x 1 Present Value of Initial Cash Outflow= $110,000 Step-2: Present Value of Annual Cash Inflow: Annual Cash Inflow = $14,200 per year for 10 years Terminal Cash Inflow= $10,000 Present Value Annuity Factor @10% for 10 Years = (1-Present Value Factor @ 6% for 10th Year) / Discounting Rate = (1-0.55839)/0.06 = 0.44161/0.06 = 7.360 Present Value Factor @ 6% for 10th Year= 1/(1+r) =1/(1+0.06) 10 = 1/(1.06) 10 =1/1.79084 =0.55839

Present Value Factor @6% for 10th Year = 1/(1+r) =1/(1+0.06) 10 =1/(1.06) 10 =1/1.79084 = 0.55839 Present Value of Annual Cash Inflows = Annual Cash Inflow X Present Value Annuity Factor = $14,200 x 7.360 = $104,512 Present value of Terminal Cash Inflow: Terminal Cash Inflow X Present Value Factor at the end of 10th year @ 6% 10,000 x 0.55839 = $5,583.9 Step-3: Calculation of Net Present Value: Net Present Value = Present Value of Inflow-Present Value of Outflow = 104,512 +5,583.9-110,000 = 110,095.9-110,000 = 95.9 (Approx.)