21-26 (21-30 min.

) DCF, accrual accounting rate of return, working capital,

evaluation of performance.

1. a.
Present value of annuity of savings in cash operating
costs ($15,000 per year for 8 years at 14%):
$15,000 4.6389 $69,583
Present value of $12,000 terminal disposal price of
machine at 14% and at end of year 8: $12,000 0.3506 4,207
Present value of $5,000 recovery of working capital at
14% and at end of year 8: $5,000 0.3506 1,753
Gross present value 75,543
Deduct net initial investment:
Special-purpose machine, initial investment $60,000
Additional working capital investment 5,000 65,000
Net present value $ 10,543

1 b. Use a trial and error approach. First, try a 20% discount rate:

$15,000 3.837 $57,555
($12,000 + $5,000) 0.2326 3,954
Gross present value 61,509
Deduce net initial investment (65,000)
Net present value $ (3,491)

Second, try an 18% discount rate:

$15,000 4.078 $61,170
($12,000 + $5,000) 0.266 4,522
Gross present value 65,692
Deduct net initial investment (65,000)
Net present value $ 692


By interpolation:

Internal rate of return
= 18% +
(

+ 491 , 3 $ 692 $
692 $

= 18% + (0.165) (2%) = 18.33%



2. Accrual accounting rate of return based on net initial investment:

Net initial investment = $60,000 + $5,000
= $65,000

Annual amortization
[$65,000 ($12,000 + 5,000)] 8 years = $6,000
Accrual accounting rate of return = % 85 . 13
000 , 65 $
000 , 6 $ 000 , 15 $
=
(

3. If your decision is based on the DCF model, the purchase would be made because
the net present value is positive, and the 18.33% internal rate of return exceeds the
14% required rate of return. However, you may believe that your performance may
actually be measured using accrual accounting. This approach would show a 13.85%
return on the initial investment, which is slightly below the required 14% rate. Your
reluctance to make a buy decision may be natural, unless you are assured of
reasonable consistency between the decision model and the performance evaluation
method.














21-32 (45 min.) NPV, IRR and sensitivity analysis.

1. Net present value of project:
Period 0 Periods 1 - 10
Cash inflows $23,000
Cash outflows $(42,000) (16,000)
Net cash flows $(42,000)

Annual net cash inflows $ 7,000
Present value factor for annuity, 10 periods, 6% 7.36
Present value of net cash inflows $51,520
Initial investment (42,000)
Net present value $ 9,520

To find IRR, first divide the initial investment by the net annual cash inflow:
$42,000 $7,000 = 6.0.
The 6.0 represents the present value factor for a ten-period project with the given
cash flows, so look in Table 4, Appendix B for the present value of an annuity in
arrears to find the factor closest to 6.0 along the ten period row. You should find that
it is between 10% and 12%.

The internal rate of return can be calculated by interpolation:

Present Value Factors for
Annuity of $1 for 10 years
10% 6.145 6.145
IRR 6.000
12% 5.650 __
Difference 0.495 0.145

Internal rate of return = 10% +
|
.
|

\
|
495 . 0
145 . 0
(2%) = 10.6%.
Note: You can use a calculator or excel to find the IRR, and you will get an answer of
approximately 10.56%.

2. If revenues are 10% higher, the new net present value will be:
Period 0 Periods 1 - 10
Cash inflows $25,300
Cash outflows $(42,000) (16,000)
Net cash inflows $(42,000) $ 9,300

Annual net cash inflows $ 9,300
Present value factor for annuity, 10 periods, 6% 7.36
Present value of net cash inflows $68,448
Initial investment (42,000)
Net present value $26,448

And the IRR will be: $42,000 $9,300 = present value factor of 4.516, yielding a
return of 17.87% via interpolation (see below), or using a calculator, a return of
17.86%.

Present Value Factors for
Annuity of $1 for 10 years
16% 4.833 4.833
IRR 4.516
18% 4.494 __
Difference 0.339 0.317

Internal rate of return = 16% +
|
.
|

\
|
339 . 0
317 . 0
(2%) = 17.87%.
If revenues are 10% lower, the new net present value will be:
Period 0 Periods 1 10
Cash inflows $20,700
Cash outflows $(42,000) (16,000)
Net cash inflows $(42,000) $ 4,700

Annual net cash inflows $ 4,700
Present value factor for annuity, 10 periods, 6% 7.36
Present value of net cash inflows $ 34,592
Initial investment (42,000)
Net present value $ (7,408)


And the IRR will be: $42,000 $4,700 = present value factor of 8.936, yielding a return of
2.11% using interpolation (see calculations below) or, using a calculator, a return of
2.099%.
Present Value Factors for
Annuity of $1 for 10 years
2% 8.983 8.983
IRR 8.936
4% 8.111 __
Difference 0.872 0.047

Internal rate of return = 2% + |
.
|

\
|
872 . 0
047 . 0
(2%) = 2.11%.

3. If both revenues and costs are higher, the new net present value will be:
Period 0 Periods 1 10
Cash inflows $25,300
Cash outflows $(42,000) (17,120)
Net cash inflows $(42,000) $ 8,180

Annual net cash inflows $ 8,180
Present value factor for annuity, 10 periods, 6% 7.36
Present value of net cash inflows $60,205
Initial investment (42,000)
Net present value $18,205

And the IRR will be: $42,000 $8,180 = present value factor of 5.134, yielding a
return of 14.43% via interpolation, or using a calculator, a return of 14.406%.

Present Value Factors for
Annuity of $1 for 10 years
14% 5.216 5.216
IRR 5.134
16% 4.833 __
Difference 0.383 0.082

Internal rate of return = 14% + |
.
|

\
|
383 . 0
082 . 0
(2%) = 14.43%.

If both revenues and costs are lower, the new net present value will be:
Period 0 Periods 1 - 10
Cash inflows $20,700
Cash outflows $(42,000) (14,400)
Net cash inflows $(42,000) $ 6,300

Annual net cash inflows $ 6,300
Present value factor for annuity, 10 periods, 6% 7.36
Present value of net cash inflows $46,368
Initial investment (42,000)
Net present value $ 4,368

To compute the IRR, note that the present value factor is $42,000 $6,300 = present
value factor of 6.667, yielding a return of 8.15% from interpolation or, using a
calculator, a return of 8.144%.

Present Value Factors for
Annuity of $1 for 10 years
8% 6.710 6.710
IRR 6.667
10% 6.145 __
Difference 0.565 0.043

Internal rate of return = 8% + |
.
|

\
|
565 . 0
043 . 0
(2%) = 8.15%.

4. To find the NPV with a different rate of return, use the same cash flows but with a
different discount rate, this time for ten periods at 8%.
Annual net cash inflows $ 7,000
Present value factor for annuity, 10 periods, 8% 6.71
Present value of net cash inflows $46,970
Initial investment (42,000)
Net present value $ 4,970

The NPV is positive, so they should accept this project. Of course, this result is to be
expected since in requirement 1, the IRR was determined to be 10.6%. Therefore, for
any discount rate less than 10.6%, the NPV of the stream of cash flows will be
positive.