Jesse’s Machining is looking to buy a new machine to handle a new four-year contract for machining windmill blades. The bookkeeper has provided the following information about the project. Jesse, the owner, says he will finance the machine at the local bank, which will charge 11% interest on the four-year loan. The machine requires a $1,500 annual maintenance payment, and will have a scrap value at the end of year four of zero.
| Year | Outflows | Inflows |
| 2019 | $49,500 | $0 |
| 2020 | $1,500 | $15,500 |
| 2021 | $1,500 | $17,775 |
| 2022 | $1,500 | $18,835 |
| 2023 | $1,500 | $19,984 |
| Total | $55,500 | $72,094 |
Which of the following is correct?
| A. |
All answers are correct. |
|
| B. |
The payback period is less than four years |
|
| C. |
The NPV is $1,173 |
|
| D. |
The IRR is greater than the loan rate |
Ans : Option A , all answers are correct
a.
| Payback period | ||
| Project A | ||
| Year | Cash flows | Cummulative cash flows |
| 0 | -49500 | -49500 |
| 1 | 14000 | -35500 |
| 2 | 16275 | -19225 |
| 3 | 17335 | -1890 |
| 4 | 18484 | 16594 |
| Payback period = A + B/C |
| a = year before where cash flow become positive |
| b = cummulative amount in the year where amount become positive |
| c = total amount of cash flow in the year where amount become positive |
Payback period = 3 + 16594 / 18484
= 3 + 0.8977
= 3.8977 years
b.
| NPV | ||||
| Year | Present value factor =1/(1+r)^n | Present value factor | Net Cash flows (inflows-outflows) | Present value of cash flows |
| 1 | 1/(1+11%) | 0.9009 | 14000 | 12613 |
| 2 | 1/(1+11%)^2 | 0.8116 | 16275 | 13209 |
| 3 | 1/(1+11%)^3 | 0.7312 | 17335 | 12675 |
| 4 | 1/(1+11%)^4 | 0.6587 | 18484 | 12176 |
| Present value of cash inflows | 50673 | |||
| Less: Initial outflow | 49500 | |||
| NPV | 1173 |
c. IRR is trail and error method, at IRR inflows will be equal to outflows
| Find the present value of cash flows at 12 % rate. | |||
| Present value factor (1/(1+rate)^n | Present value factor | Cash flows | Present value |
| 1/(1.12) | 0.892857143 | 14000 | 12500.00 |
| 1/(1.12)^2 | 0.797193878 | 16275 | 12974.33 |
| 1/(1.12)^3 | 0.711780248 | 17335 | 12338.71 |
| 1/(1.12)^4 | 0.635518078 | 18484 | 11746.92 |
| Present value of cash flows | 49560 | ||
| Initial investment | 49500 | ||
| 60 | |||
IRR is approximately 12% which is more than 11%
All options are true. therefore option A is true
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