Question

Ursus, Inc., is considering a project that would have a ten-year life and would require a $1,000,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows (Ignore income taxes.):

Sales				$	2,000,000
Variable expenses					1,400,000
Contribution margin					600,000
Fixed expenses:
Fixed out-of-pocket cash expenses	$	300,000
Depreciation		100,000			400,000
Net operating income				$	200,000

All of the above items, except for depreciation, represent cash flows. The company's required rate of return is 12%.

Refer to Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using the tables provided.

Required:

a. Compute the project's net present value.

b. Compute the project's internal rate of return to the nearest whole percent.

c. Compute the project's payback period.

Answer 1

Initial Investment = $1,000,000
Useful Life = 10 years

Annual Net Cash flows = Annual Net Operating Income + Annual Depreciation
Annual Net Cash flows = $200,000 + $100,000
Annual Net Cash flows = $300,000

Answer a.

Required Return = 12%

Net Present Value = -$1,000,000 + $300,000 * PVA of $1 (12%, 10)
Net Present Value = -$1,000,000 + $300,000 * 5.6502
Net Present Value = $695,060

Answer b.

Let IRR be i%

$1,000,000 = $300,000 * PVA of $1 (i%, 10)
PVA of $1 (i%, 10) = 3.3333
Using table values, i = 27%

So, IRR is 27%

Answer c.

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $1,000,000 / $300,000
Payback Period = 3.33 years