Question

To receive credit you need to show work. For NPV and IRR, use tables in APP 12-B rather than results from a financial calculator to demonstrate your understanding of cash flows and table factors. Use the following information for questions 1 - 3 Gallatin, Inc., has assembled the estimates shown below relating to a proposed new investment with a 5-year life. If the investment is undertaken, new equipment must be purchased and existing old equipment will be sold immediately. The new equipment will have no salvage value at the end of the 5 year project. Annual cash sales $ 450,000 Annual out-of-pocket cash expenses 340,000 $ 60,000 Annual depreciation on new equipment Initial cost of new equipment $ 400,000 Sale of old equipment $ 25,000 Required: Compute the payback period for the investment (2 points)

Answer 1

Basic Data
	Annual Cash Sales			$                         4,50,000
	Less:
	Annual Out Of Pocket Expenses			$                       -3,40,000
	Annual Net Cash Inflow			$                         1,10,000
	Year 0 Cash Out Flow
	Initial Cost OF Invetsment			$                         4,00,000
	Less:
	Sale of old equipment			$                           -25,000
	Net Cash Outflow			$                         3,75,000
1)	Payback Period
	payback period means number of years in which investment will be recovered
	=Initinal Investment / Annual Inflow
	=$375000/110000
	=3.41 years		Or 3 year 5 month
2)	IRR
	Let us calculate NPV at 10% and 15%
	Year	Cashflow	Discounting Factor@ 10%	Discounted Cash Flow	Discounting Factor@ 15%	Discounted Cash Flow
	a	b	c	d=c*b	e	f=e*b
	0	-375000	1.000	$                 -3,75,000.00	1.000	$                 -3,75,000.00
	1	110000	0.909	$                   1,00,000.00	0.870	$                       95,652.17
	2	110000	0.826	$                       90,909.09	0.756	$                       83,175.80
	3	110000	0.751	$                       82,644.63	0.658	$                       72,326.79
	4	110000	0.683	$                       75,131.48	0.572	$                       62,892.86
	5	110000	0.621	$                       68,301.35	0.497	$                       54,689.44
			NPV	$                       41,986.54		$                       -6,262.94
		IRR = 10% +   41986.54/(41986.54+6262.94) *5
		=14.292%	(approximate)
	3)	Simple rate of return
			= Total Cash Inflow - Initial outflow / initial cash outflow
			=(110000*5)-375000/375000
			=$175000/375000
			46.67%

4)

Pay back period

3.41 years

Working

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Annual Sales		$          450,000.00	$          450,000.00	$        450,000.00	$       450,000.00	$   450,000.00
Sale of old Equipment		$            25,000.00
Available Cash	$                              -	$          475,000.00	$          450,000.00	$        450,000.00	$       450,000.00	$   450,000.00
Purchase Of Machinery	$            400,000.00
Less Out of Pocket expenses	0	$          340,000.00	$          340,000.00	$        340,000.00	$       340,000.00	$   340,000.00
Net Cash flow	$          (400,000.00)	$          135,000.00	$          110,000.00	$        110,000.00	$       110,000.00	$   110,000.00
Cumulative Cash Flow	$          (400,000.00)	$       (265,000.00)	$        (155,000.00)	$        (45,000.00)	$          65,000.00	$   175,000.00

IRR= 13.95

Simple Rate of Return: Average Profit/ Investment = 55000/400000

=13.75%