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The initial investment to purchase the building is $420,000, and an additional $50,000 in working capital is required. Since this store will be operating for many years, the working capital will not be returned in the near future. Tower expects to remodel the store at the end of 3 years at a cost of $100,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows.

Year 1 $ 80,000 Year 2 $115,000 Year 3 $118,000 Year 4 $140,000 Year 5 $155,000 Year 6 $167,000 Year 7 $175,000

The company’s required rate of return is 13 percent. Assume management decided to limit the analysis to 7 years. Required: 1. Find the net present value of this investment using the format presented in Figure 8.2 "NPV Calculation for Copy Machine Investment by Jackson’s Quality Copies". Round to the nearest dollar. 2. Use trial and error to approximate the internal rate of return for this investment proposal. 3. Based on your answer to requirements a and b, should Tower open the new store? Explain. 4. Use the format presented in Table 8.1 "Calculating the Payback Period for Jackson’s Quality Copies" to calculate the payback period (include working capital in the initial investment). Assuming management requires all investments to be recovered within three years, should Tower CD Store open the new store? 5. What is the weakness of using the payback period method to evaluate long-term investments? 6. Assume the manager of the company wanted to live in Houston and intentionally inflated the projected annual cash receipts so that the proposal would be accepted. The proposal would

641 .693) = $420.000 + $100.000 +$ 50.170 So IRR lies between 13% and 16%. Answer: Calculation of PV of Outflows: 1.693 .000 +$ 50.059 NPV = Pv of inflows .354 PV 68960 85445 75638 77280 73780 68470 61950 511.000 + $69.165 80.862 .476 .045 81.480 .130-539..743 .425 PV 70.759 2.300= -$28. . $420.774 85.783 .552 .820 84. .300 = 539.059-539.543 . Calculation of IRR Calculation of NPV of inflows@16% year Cash flow 1 80000 2 115000 3 118000 4 140000 5 155000 6 167000 7 175000 Pv of inflows PVF @16% .884 .613 .otherwise have been rejected.PV of Outflows = 567.000(. Explain how the company’s use of a post audit would help to prevent this type of unethical behavior.375 567.300= $27.130 NPV = Pv of inflows .300 Calculation of NPV of inflows@13% year Cash flow 1 80000 2 115000 3 118000 4 140000 5 155000 6 167000 7 175000 Pv of inflows PVF @13% .PV of Outflows = 511.720 90.410 .160 74.

759 13% (3) 55929 13 1.300 (16 13) 567. The payback period entirely ignores many of the cash inflows.000 313.488% 13% 3) On the basis of NPV As the NPV is positive the investment is lucrative and shall be given a go.13 0 IRR = 27.L R PV PV of of L R outflow L R PV of H R (H L ) R R 567.7358= 4.059 511.000 453. 5) 1.059 539.000 775.000 950. which generates substantial cash inflows in later years.000 608.000 195. On the basis of IRR As the IRR is greater than the required rate of return – accept the proposal 4) Calculation of PBP year Cash flow 1 80000 2 115000 3 118000 4 140000 5 155000 6 167000 7 175000 Pay Back period = 4 + (114. the project is rejected.7358 years Cumulative cash flow 80. . By restricting itself to answering the question „when will this project make it initial investment?‟ it ignores what happens after the initial investment is recouped.488 14. which occur after the payback period. This could be misleading and could lead to discrimination against the proposal.059/155000) = 4+ .000 Because the time required on the part of the company is 3 years .

The speed with which the initial investment is recovered is not a sufficient way to appraise the profitability.2. The payback period also ignores the salvage value and the total economic life of the project. Again. It ignores the timing of the occurrence of the cash flows. having part ownership in a company provides an incentive for managers to reject proposals that will not increase the value of the company. may be ignored (though more profitable it may be otherwise) in favor of a project with higher inflows in earlier years. Impliedly. it also ignores the concept of required rate of return and the discounting of future cash flows to find out their present values. which has substantial salvage value. Managers who provide misleading capital budget analyses are identified through this process. . It considers the cash flows occurring at different point of time as equal in money worth and ignores the time value of money. Another way to mitigate this conflict is to conduct a postaudit. It gives equal weights to all the cash flows before the payback date and no weight at all to cash flows occurring thereafter. A project. 3. It is insensitive to the economic life span and thus not truly meaningful criterion for determining the economic viability of a proposal. 6) A conflict exists between the company‟s desire to accept projects that meet or exceed the required rate of return and the manager‟s desire to get approval for a “pet” project regardless of its profitability. Postaudits provide an incentive for managers to provide accurate estimates. which compares the original capital budget with the actual results.

shown below are also expected to be significant: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 $160.000 $190.000 $280. and will be sold at the end of 8 years for $40. Use trial and error to approximate the internal rate of return for this investment proposal. 1. Based on your findings in requirements a. and c.000 $200. Determine the payback period for this investment. 2. Round to the nearest dollar. should the company purchase the production equipment? Explain.000 $155. b. Assume the company requires all investments to be recovered within five years. Calculation of NPV . 4.000 $220.000.Sherwin Moore Paint Company would like to further automate its production process by purchasing production equipment for $660. Find the net present value of this investment. 3. Labor and material cost savings. The equipment requires significant maintenance work at an annual cost of $75.000 $240.000 $180. Use excel to calculate NPV and IRR Answer: 1.000. The equipment is expected to have a useful life of 8 years.000 The company's required rate of return is 11 percent.000.

000 945.000 325.000 Cumulative cash flow 85. Calculation of IRR IRR =11.000/205000) = 4+ .000 $145.000 PV of inflows NPV = 11825.000 $165. the project is ACCEPTED.47% 3.000 $115.000 $80.000 $205.829 YEARS Because the time required on the part of the company is 5 years . Calculation of PBP year 1 2 3 4 5 6 7 8 Cash flow $85.000 $205.000 695.000+$40.000 =120.000 Pay Back period = 4 + (170.000 $105.000 490.000 =120.000 $125.829= 4. .000 $105.year 1 2 3 4 5 6 7 8 Cash flow PVF @11% PV $85.000 $115.45 ( SHOWN IN EXCEL) 2.000 $145.000+$40.000 200. 4.000 1025.000 $165.000 $80. On the basis of NPV As the NPV is positive the investment is lucrative and shall be given ACCEPTED.000 840.000 $125.

On the basis of IRR As the IRR is greater than the required rate of return – accept the proposal .

assignment on npv

assignment on npv

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